An out-of-state company can’t be required to collect sales tax in a state unless the state has a strong enough connection to it. Determining whether this connection, or nexus, exists is increasingly complicated. More than twenty years ago, though, the U.S. Supreme Court provided some certainty for companies. The Court ruled in the case of Quill Corp. v. North Dakota that a seller has to have some “physical presence” in a state before the state can require the company to collect tax on its sales to customers there.
This physical presence can be through employees, agents, or related companies in the state or through property or activities in the state. However, it requires something more than making online or mail-order sales to customers in the state and shipping the items sold by mail.
When the Supreme Court issued its decision in Quill, it expressed some doubt, recognizing that commerce was becoming less dependent on traditional sales at brick-and-mortar companies. The Court invited Congress to clarify nexus for sales tax purposes, but so far Congress has not done so.
Meanwhile, states are getting more aggressive. Sales and use taxes were originally envisioned in the context of physical products. Pure e-commerce transactions such as sales of software downloads, digital products, cloud computing, and streaming entertainment have disrupted the traditional marketplace beyond even what was accomplished by mail-order and online sellers of goods. A number of states have amended or stretched their sales and use tax laws to encompass these kinds of transactions.
Companies have also seen states engaging in various nexus-expansion approaches, such as so-called click-through nexus. This kind of law, pioneered by New York State, asserts nexus over a company that enters into an agreement with state residents to post links to the company’s products on their websites in exchange for compensation.
Now states are lining up to challenge the physical presence rule more directly. Although the Supreme Court has consistently declined to revisit sales tax nexus since Quill, at least one sitting justice has shown support for overturning the physical presence rule. Last year, Justice Anthony Kennedy suggested in a concurring opinion in Direct Marketing Association v. Brohl that the Court should revisit its “questionable” decision in Quill. He called the delay in doing so unwise and suggested that extensive remote sales into a state might create “substantial nexus.” His opinion was not joined by any other members of the Court, but it fanned the flames of a growing revolt among states that could have enormous consequences for businesses.
Legislation pending before but not passed by the Washington State Legislature in 2015 characterized the Quill decision as “inflicting extreme harm and unfairness” on states. In February 2016, the National Conference of State Legislatures urged the states to enact laws bringing a direct challenge to Quill and even proposed draft language for an “economic presence” law.
Laws in the corporate income tax environment increasingly assert economic nexus over companies based on the dollar amount of sales in the state, but these laws arguably are not a challenge to Quill. The Supreme Court has never explicitly ruled that physical presence is required for corporate income tax purposes, and the last few decades have seen an emerging consensus that the Quill rule does not apply to corporate income taxes.
Companies now face assertions of economic nexus in the sales and use tax environment, too. On March 22, South Dakota’s governor signed into law legislation that claims “economic nexus” in the sales tax arena. As of May 1, the law requires an out-of-state seller to collect sales tax from South Dakota customers if the seller’s gross revenue from taxable sales (of tangible personal property, products transferred electronically, or services) delivered in South Dakota exceeds $100,000 or if the seller makes more than 200 deliveries of these sales in South Dakota annually. In considering only the dollar amount or number of taxable sales, the law blatantly and very intentionally contravenes Quill’s physical presence requirement, relying instead on economic presence.
The law follows a regulation adopted by the Alabama Department of Revenue with the support of the state’s governor last year, which also targets remote sellers. It requires sellers having “a substantial economic presence in Alabama” and engaging in specified activities to collect and pay Alabama sales and use tax on their sales into the state, whether or not the sellers have a physical presence in Alabama. Under the regulation, a remote seller has a substantial economic presence in the state if it has $250,000 or more in retail sales in Alabama in the prior tax year.
South Dakota’s law, which looks only to the dollar amount or number of taxable sales, clearly runs afoul of Quill’s physical presence requirement, as does Alabama’s regulation. Whether the Court will ultimately uphold or reject these laws is highly uncertain, but companies should be aware that economic nexus laws are likely to be a growing trend.
Rebecca Newton-Clarke, JD, is a senior editor and author for Checkpoint within the tax and accounting business of Thomson Reuters, where she has written articles about state and local taxes for more than fourteen years.