Whether or not your company has proactively addressed its state and local sales tax compliance requirements in the past, now is definitely the time to do so again (or for the first time as the case may be). The reason for the sudden urgency is a result of a recently issued ruling by the U.S. Supreme Court in South Dakota v. Wayfair (Dkt 17-494, 6/21/2018) where the Court eliminated the long standing physical presence standard for state and local sales and use tax collection responsibilities. (A high-level overview of this case can be found here).
While this ruling is historic, do not panic. First step is to begin identifying states where taxable sales are made and sales tax collections may need to be initiated. Not all states will need to begin having sales taxes collected immediately as many states are still reviewing the implications of this ruling and/or have implementation dates that begin on or after October 1, 2018. Of course there are always exceptions with currently eleven states that have or may require current and possibly retroactive compliance (see below for summary of where each state currently stands).
For years, states and their localities have been prohibited by judicial doctrine from requiring companies that are located outside of their state and do not have any physical presence inside their states from having to register for, collect and remit state and local sales taxes (technically these are use taxes, but we will just use the term sales taxes to minimize confusion). The estimated amount of taxes that states have lost is billions of dollars. This tax shortfall occurs as individual residents rarely volunteer to pay the corresponding state use taxes that they owe on their purchases, and also because most states only take limited, if any, actions to enforce such compliance on their residents.
The counter argument from remote sellers is that the compliance burden to register for, collect and remit taxes accurately to over 12,000 different taxing jurisdictions is onerous and a substantial burden on interstate commerce. Thus, businesses should only be required to collect and remit sales taxes in limited states where a clear and substantial presence exists, such as when a business owns or leases an office, warehouse, or factory or at least has in-state presence through the ownership of property or visits into the state by employees or representatives.
As a result, states have been attempting for years to get Congress to pass legislation that would remove the physical presence barrier so that companies based outside of their states, especially online retailers, can be required to collect their state and local sales taxes. In the meantime, states have also aggressively challenged companies by creating alternative means of establishing physical presence. These alternative methods look at the physical presence of affiliated companies; the use of in-state third parties that post a business’s website link on to servers; and most recently through the use of a company’s “apps” or website tracking “cookies.”
Several states have also been passing notice reporting requirements that impose significant penalties and require remote sellers to notify their customers that they may have a responsibility to self-assess state and local sales taxes on their purchases, provide the customers with an annual report, and submit an annual report to those states in order to help them facilitate collection of their state and local sales taxes from their residents. Finally, several states began to pass laws and/or regulations that impose their own sales tax laws with economic nexus that, until now, were in clear defiance to the physical presence standard. This is exactly what South Dakota did.
South Dakota passed a sales tax economic nexus law requiring out-of-state “remote” companies to collect their state and local sales taxes when in either the current or previous calendar year they:
- Have gross revenue from the sale of tangible personal property, any product transferred electronically, or services delivered into South Dakota that exceeded $100,000; or
- Sold tangible personal property, any product transferred electronically, or services for delivery into South Dakota in 200 or more separate transactions.
The South Dakota law was designed to be litigated and taken expeditiously to the U.S. Supreme Court with the mission of getting the Court to overturn the physical presence requirement. Large online retailers Wayfair and Newegg challenged this law, which resulted in the U.S. Supreme Court eliminating the physical presence standard. The Court then remanded the case back to South Dakota to confirm that their economic sales tax nexus law was constitutional under other aspects of the Commerce Clause not specifically ruled on by the Court.
U.S. Supreme Court’s Findings in Wayfair
Though the court ruled in a slim 5-4 majority decision, all nine justices felt that the physical presence standard was wrong. The majority opinion held that “Quill is flawed on its own terms. 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.” … “For these reasons, the Court concludes that the physical presence rule of Quill is unsound and incorrect.” Wayfair (Dkt 17-494, 6/21/2018, pg 10, pg22)
The dissenters felt that it was the role of Congress to overturn the physical presence standard and not that of the U.S. Supreme Court. The majority disagreed, holding that because the physical presence standard was created by the U.S. Supreme Court in Bella Hess, and upheld again for Commerce Clause purposes in Quill, that this was essentially a Court created issue and therefore should be solved by the Court.
Instead of using an arbitrary physical presence test, the Court referred back to its 4-prong test in Complete Auto Transit (430 U.S. 274; 1977) as the proper test to determine if a state’s law requiring collection responsibilities on a remote seller is constitutional. The 4 prongs to consider are as follows:
- The tax applies to an activity with a ‘substantial nexus’ in the state (this is where the physical presence test previously applied);
- The tax must be fairly apportioned;
- The tax must not discriminate against interstate commerce; and
- The tax must be fairly related to the services the state provides.
The Court only addressed the first “substantial nexus” prong of the 4-part Complete Auto Transit test and remanded the case back to the South Dakota Supreme Court to determine if there were any other Commerce Clause challenges that would be applicable. In so doing, the Court pointed out several factors of the South Dakota law that it felt were helpful for the law to ultimately be upheld as constitutional. Specifically, the Court referenced the following three factors:
- The law provided a safe harbor for small companies ($100,000 of annual sales, or 200 sales transactions in South Dakota per year);
- The law was applied on a prospective basis only and not retroactively; and
- South Dakota was part of the Streamlined Sales Tax program and through that process had made attempts to simplify its sales tax laws.
Because tests 2-4 above from Complete Auto Transit case above are typically easily met (tax is just on sales to customers in-state so it is fairly apportioned; both in-state and remote sellers are required to collect, so it does not discriminate against interstate commerce; and the state provides benefits and protections to the remote seller’s customers in the state), it is expected to be upheld as constitutional.
State Responses and Wayfair Implications for Remote Sellers
With the removal of the physical presence standard, states now have the ability to require companies to collect their state sales taxes based mainly on the fact that the companies make sales to customers within their state. It is unclear from the holding in Wayfair if the South Dakota thresholds of $100,000 of sales or 200 separate sales transactions is required before a state can require an out-of-state company to collect their state’s sales taxes. What is fairly certain is that states can be confident that if they impose requirements similar to Wayfair that such laws will be upheld.
Companies will now need to evaluate the amount of sales of taxable goods and services sold to customers in states where they are not currently filing sales tax returns and determine:
- The strength of their current non-filing position;
- The materiality of the amount of taxable sales and services;
- If nexus issues exist for other tax types such as state income taxes; and
- The state’s specific response to the Wayfair case.
Participating in a state’s voluntary disclosure program remains to be a very good option for companies to take proactive steps to fully clean up and remove any significant state sales and income tax exposure that currently exists. Otherwise, if a prospective approach is to be taken as a result of the loss of the physical presence standard, companies can be strategic in the states they register in and begin collecting sales taxes. For example, many states have responded that they are reviewing the Wayfair case and will be providing guidance in the near future. Other states have sales tax economic nexus laws in place that become effective at a future date and can be complied with at that time. However, there are some states that will demand a more immediate focus as they have responded indicating a possible retroactive application or at least have an effective date back to July 1, 2018.
Assuming prior year exposure is not significant, taking a prospective compliance approach consistent with how states are responding to Wayfair will typically be the most practical approach for companies to take. Here is a breakdown of where states currently stand:
States to consider first due to imposing current or retroactive economic sales tax nexus rules:
- Colorado: No collection requirement, but there are a use tax notification and reporting requirements that took effect on July 1, 2017 with over $100,000 of taxable sales in prior year, or a reasonable expectation of over $100,000 of taxable sales in current year. The Colorado Department of Revenue has not issued any definitive guidance regarding the Wayfair case and appears to continue to look to enforce its reporting requirements.
- Hawaii: Effective July 1, 2018, but it is actually retroactive to the first day of the taxpayer’s tax year that begins on or after January 1, 2018. A grace period is available as long as taxes are caught up by next return due date (August 20th for monthly filers and October 20th for quarterly filers). Threshold is $100,000 of sales, or 200 sales transactions.
- Kentucky: Effective July 1, 2018 with $100,000 sales, or 200 sale transaction threshold.
- Maine: Effective July 1, 2018 with $100,000 sales or 200 sale transactions, but state has not yet issued any response to the Wayfair case.
- Massachusetts: Effective September 22, 2017 with $500,000 sales or 100 sale transactions, and imposes physical presence nexus based on having apps or “cookies” on customer devices within state. Massachusetts provided statement that Wayfair case had no impact on the applicability or enforcement of their economic sales tax nexus regulation.
- Mississippi: Effective June 21, 2018 with $250,000 sales. Mississippi DOR came out with brief guidance stating that remote sellers were now required to begin collecting and remitting sales taxes.
- Ohio if sales are software related: Effective January 1, 2018, with $500,000 sales and seller: (1) uses in-state software to sell or lease taxable property or services; or (2) seller provides or enters into agreement with another person to provide a content distribution network.
- Oklahoma: Effective July 1, 2018 with $10,000 sales threshold and election to provide notifications instead of collecting sales taxes.
- Rhode Island: Effective August 17, 2017 with $100,000 sales or 200 transactions, or provide use tax notifications. Rhode Island DOR has provided a release explaining different registration options and a subsequent publication indicating that it is possible for out-of-state companies to be subject to Rhode Island collection responsibilities back to the effective date of August 17, 2017.
- Vermont: Effective July 1, 2018 with $100,000 sales or 200 sale transactions threshold, plus some type of active soliciting (phone, internet, brochures, etc.).
- Washington: Effective March 1, 2018 with $10,000 sales threshold or meet use tax notification responsibilities. Washington DOR has indicated that they do not believe any law changes are necessary but are reviewing.
States to plan for future sales tax compliance due to having economic nexus rules in place:
- Alabama: Effective October 1, 2018 with $250,000 sales threshold economic nexus regulation. Remote sellers should participate in AL’s Simplified Sellers Use Tax Program.
- Arizona: Not imposing any economic nexus provisions so current physical presence nexus rules still apply (employee or rep in state for > 2 days, maintaining office, etc.).
- Connecticut: Effective December 1, 2018 with $250,000 sales or 200 sale transaction threshold.
- Georgia: Effective January 1, 2019 with $250,000 in sales or 200 sale transactions.
- Illinois: Effective October 1, 2018 with $100,000 in sales or 200 sale transactions.
- Iowa: Effective January 1, 2019 with $100,000 in sales or 200 sale transactions.
- New Jersey: Effective October 1, 2018 with $100,000 in sales or 200 sale transactions.
- North Dakota: Effective October 1, 2018 with $100,000 in sales or 200 sale transactions.
- Wisconsin: Effective October 1, 2018 with $100,000 in sales or 200 sale transactions.
States to monitor as they are reviewing the Wayfair case and will provide guidance:
- Indiana: Originally effective July 1, 2017, but under declaratory judgement. Threshold is $100,000 in sales or 200 sale transactions.
- Louisiana: Has $100,000 in sales or 200 sales transactions, plus some type of active soliciting activity (phone, internet, brochures, etc.) threshold with guidance forthcoming regarding effective date. Louisiana also has current notification reporting requirement that applies at just $50,000 of sales that became effective July 1, 2017.
- Pennsylvania: Has $10,000 sales threshold or elect to provide use tax notification reporting requirements, effective February 1, 2018. However, Pennsylvania DOR has indicated they are reviewing Wayfair and expect to provide further guidance.
- South Dakota: Has $100,000 sales or 200 sale transaction threshold, but law is still under injunction as it has been remanded by the U.S. Supreme Court back to South Dakota.
- Tennessee: Has $500,000 sales threshold effective July 1, 2017, but this needs legislative approval to go into effect.
- Texas: Looking to provide guidance for compliance in early 2019.
- Wyoming: Has $100,000 sales or 200 sales transactions threshold, but has indicated it is reviewing case and will provide further guidance and that they do not plan on implementing their economic nexus rules on a retroactive basis.
- States which do not currently have any specific economic sales tax nexus provisions in place and are awaiting definitive guidance are as follows:
- Arkansas, California, District of Columbia, Florida, Idaho, Kansas, Maryland, Michigan, Minnesota, Missouri, Nebraska, New Mexico, New York, North Carolina, Ohio (non computer software related), South Carolina (indicated they will use $100,000 sales or 200 transaction test but more guidance forthcoming), Utah, Virginia, and West Virginia (West Virginia Governor is opposed to requiring sales tax collection).
Another option in response to the Wayfair case, though not typically pursued (but we are now in atypical times from a sales tax perspective) could be to just simply register for and begin collecting sales taxes in all states – even if just doing so on a voluntary basis. Regardless, we recommend that you consult with your Sikich tax advisor to help analyze the various state tax exposures that your company may be dealing with and to help identify the best approach to address these significant sales tax compliance issues.
We will be regularly reviewing state tax developments in this area and plan on issuing regular tax alerts as states complete their analysis and provide more guidance. Such actions by states could be identifying the need for the state to pass new legislation; issue new rules or regulations; or simply an issue by a state agency administrative guidance declaring how that Department is now going to enforce sales tax collections. It may also be possible, but not expected, that additional states will conclude that they can assert sales tax collection responsibilities on a retroactive basis. Finally, it is still possible (though it is uncertain) that Congress may step in and exercise its authority to regulate interstate commerce by passing legislation providing common rules that states must meet before requiring the collection of sales taxes by remote sellers. Stay Tuned!