Rosen Harwood Blog

Will Abandoning the Physical Presence Rule Affect Your Pocketbook?

State and Local Governments Can Now Require Vendors with No Physical Presence to Collect Sales Tax

On June 21, the United States Supreme Court ruled in South Dakota v. Wayfair that states and local governments can require vendors with no physical presence in the state to collect sales tax. In a 5-4 decision, the court ruled that “economic and virtual contacts” are enough to create a “substantial nexus” with the state allowing the state to require collection.

By way of background, mail order catalogs have existed since at least the 1880s, and came in to prominence throughout the depression and post-World War II era.  The question of whether those sales should be subject to local sales taxes has always vexed administrators.  In 1967 in National Bellas Hess v. Department of Revenue of Illinois, the Supreme Court held that its Commerce Clause jurisprudence compelled the conclusion that a business must have a physical presence in a state before the state or local government could require the business to collect sales tax on the business’s sales.  Customers buying from remote sellers still owe sales tax but they rarely pay it when the remote seller does not collect it.

Twenty-five years later in Quill v. North Dakota (1992), the Supreme Court reaffirmed the physical presence requirement but admitted that “contemporary Commerce Clause jurisprudence might not dictate the same result” as the Court had reached in Bellas Hess. Congress had the authority to overrule Bellas Hess and Quill but, despite many efforts, never did so.

In March 2015, Justice Kennedy wrote a concurring opinion in Direct Marketing Association v. Brohl stating that the “legal system should find an appropriate case for this Court to reexamine Quill.” Justice Kennedy criticized Quill for several reasons, but most significantly because internet sales have risen astronomically since 1992 and state and local governments are unable to collect most taxes due on sales from out-of-state vendors.  A November 2017 report by the Government Accountability Office estimated that state and local governments could “gain from about $8 billion to about $13 billion in 2017 if states were given authority to require sales tax collection from all remote sellers.”

Following the 2015 Kennedy opinion, a number of state legislatures passed laws requiring remote vendors to collect sales tax in order to challenge Quill. South Dakota’s law was the first ready for Supreme Court review. It requires out-of-state retailers to collect sales tax if they annually conduct $100,000 worth of business or 200 separate transactions in South Dakota.

In an opinion written by Justice Kennedy, the Court offered three reasons for why it was abandoning the physical presence rule. “First, the physical presence rule is not a necessary interpretation of the requirement that a state tax must be ‘applied to an activity with a substantial nexus with the taxing State.’ Second, Quill creates rather than resolves market distortions. And third, Quill imposes the sort of arbitrary, formalistic distinction that the Court’s modern Commerce Clause precedents disavow.”

While the dissenting Justices, in an opinion written by Chief Justice Roberts, would have left it to Congress to act, Justice Kennedy opined the Court should be “vigilant” in correcting its error. “Courts have acted as the front line of review in this limited sphere; and hence it is important that their principles be accurate and logical, whether or not Congress can or will act in response.”   

To require a vendor to collect sales tax the vendor must still have a “substantial nexus” with the state. The Court found a “substantial nexus” in this case based on the “economic and virtual contacts” Wayfair has with the state. A business could not do $100,000 worth of business or 200 separate transactions in South Dakota “unless the seller availed itself of the substantial privilege of carrying on business in South Dakota.”

In 2015, Alabama adopted the Simplified Sellers Use Tax Remittance Act (SSUT) which allowed sellers to voluntarily participate in a program to collect, report and remit a flat 8% sellers use tax on all sales made into the state of Alabama. Because Alabama has the lowest property taxes in the country, local governments rely heavily on sales and use taxes to pay for everything from road and bridge improvements, to essential services like public safety.  Tuscaloosa County receives a portion of the SSUT through a formula established by the Alabama Legislature which is placed in the county general fund to finance road improvement projects and other quality of life programs.  A future posting will explain the Simplified Sellers Use Tax Remittance Act and its recent amendments.