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Supreme Court: Sales Tax for Out-of-State Online Sales

(posted: June 29th, 2018)

A recent U.S. Supreme Court decision allows state and local governments to impose sales taxes on more out-of-state online sales. The ruling in South Dakota v. Wayfair, Inc. is welcomed by brick-and-mortar retailers, who felt previous rulings gave an unfair advantage to their online competitors, as well as state and local governments are pleased to replenish their coffers.

But for businesses with out-of-state online sales that haven't had to collect sales tax from out-of-state customers in the past, the decision brings many questions and concerns.

How Was Sales Tax Applied to Out-of-State Businesses Before?

Even before Wayfair, a state could require an out-of-state business to collect sales tax on online sales from its residents if the business had a "substantial nexus" (connection) with the state. The nexus requirement is part of the Commerce Clause of the U.S. Constitution.

Previous Supreme Court rulings had found that a physical presence in a state (such as retail outlets, employees, or property) was necessary to establish substantial nexus. As a result, some online retailers have already been collecting tax from out-of-state customers, while others have not had to.

It's been estimated that states lose $8 billion to $33 billion in annual sales tax revenues because of the physical presence rule. States with no income tax, such as South Dakota, have been especially hard hit. South Dakota's losses are estimated at $48 million to $58 million annually.

What Does the Decision Change?

South Dakota had enacted a law requiring out-of-state retailers that made at least 200 sales or sales totaling at least $100,000 in the state to collect and remit sales tax. In the Wayfair case, the Supreme Court found that the physical presence rule is "unsound and incorrect," and that the South Dakota tax satisfies the substantial nexus requirement.

The Court said that the physical presence rule puts businesses with a physical presence at a competitive disadvantage compared with remote sellers that aren't required to charge customers for taxes.

In addition, the Court found that the physical presence rule treats sellers differently for arbitrary reasons. A business with a few items of inventory in a small warehouse in a state is subject to sales tax on all of its sales in the state, while a business with a pervasive online presence but no physical presence isn't subject to the same tax for the sales of the same items.

The Impact on Businesses

Wayfair doesn't necessarily mean that you must immediately begin collecting sales tax on online sales to all of your out-of-state customers. You'll be required to collect such taxes only if the particular state requires it.

Keep in mind that the substantial nexus requirement isn't the only principle in the Commerce Clause doctrine that can invalidate a state tax. The others weren't argued in Wayfair, but the Court observed that South Dakota's tax system included several features that seem designed to prevent discrimination against or undue burdens on interstate commerce, such as a prohibition against retroactive application and a safe harbor for taxpayers who do only limited business in the state.

Only about 15 states currently have sales tax laws similar to South Dakota's, so it's likely there will be a staggered imposition of sales tax collection and remittance responsibilities on online retailers. Other states may need to revise or enact legislation to meet the relevant constitutional tests.

Please contact us with any questions you have about sales tax collection requirements.

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