Just over a month ago, the U.S. Supreme Court surprised many in the state tax community when it announced that it granted certiorari in South Dakota v. Wayfair, Inc., Docket No. 17-494; appealed from 901 N.W.2d 754 (S.D. 2017). Granting cert. in Wayfair means that the U.S. Supreme Court may be willing to overturn precedent that, for over fifty years, has provided and continues to provide a bright-line physical presence nexus standard applicable to states’ ability to impose sales and use taxes. See National Bellas Hess Inc. v. Illinois, 386 U.S. 753 (1967), affirmed in part by Quill Corp. v. North Dakota, 504 U.S. 298 (1992). The U.S. retail economy and its transition from brick-and-mortar storefronts to e-commerce retailers have thus been shaped by the expectation that physical presence within a taxing state is required before that state may impose sales or use taxes on a retailer.
For better or worse, the physical presence standard has eroded significantly in recent years, as states have enacted legislation or promulgated regulations – ranging from expansive agency, affiliate, or “click-through” nexus provisions to use tax notice and reporting requirements – to recover revenue allegedly lost from the application of the physical presence nexus threshold to out-of-state retailers. In the wake of the 2016 Direct Marketing Association (“DMA”) decision from the Tenth Circuit Court of Appeals, some states enacted use tax notice and reporting measures for retailers that do not collect sales tax. Under these measures, such out-of-state retailers that meet certain sales thresholds to in-state customers are required to notify both the in-state customers of their use tax obligations and the state’s Department of Revenue of the identities and amounts purchased by the in-state customers (e.g., Colorado, Louisiana, Pennsylvania, Rhode Island, Vermont, and Washington). See Direct Marketing Assn. v. Brohl, 814 F.3d 1129 (10th Cir. 2016). See also States on the Verge of a Nexus Showdown, April 22, 2016, and The End is Just the Beginning: Implications of the DMA Settlement, March 14, 2017, for our prior coverage. These use tax notification requirements can create a heavy compliance burden for retailers, and some states also impose significant penalties for noncompliance. This onerous combination has caused many out-of-state retailers to opt out of the use tax notification and reporting requirements by electing to collect sales tax, even if they do not have any in-state physical presence.
The DMA case, which made its way through the U.S. Supreme Court before the Tenth Circuit’s decision, also effectively kicked off the so-called “kill Quill” movement with U.S. Supreme Court Justice Kennedy’s 2015 concurrence stating that “[t]he legal system should find an appropriate case for this Court to reexamine Quill and Bellas Hess.” Direct Marketing Assn. v. Brohl, 135 S.Ct. 1124, 1135 (2015) (J. Kennedy concurrence). States have responded to Justice Kennedy’s invitation. Several states adopted “kill Quill” measures, whereby out-of-state internet retailers that meet certain sales and/or transactional thresholds to in-state customers are required to collect and remit sales tax to the state – a result designed to directly contradict the physical presence nexus standard. See Is the “Kill Quill” Movement Gaining Momentum, April 4, 2017; The Possible Upshot of South Dakota’s Master Plan to “Kill Quill”, December 28, 2016; and Massachusetts Promulgates Controversial Remote Vendor Nexus Regulation; Virginia E-Commerce Retailer Files Suit Protesting Constitutional Overreach, October 30, 2017, for our prior coverage.
South Dakota’s Economic Nexus Legislation and the U.S. Supreme Court’s Prerogative
South Dakota is one of the states to respond to Justice Kennedy’s invitation, and it has achieved its goal of having the U.S. Supreme Court reexamine the physical presence nexus standard applicable to sales and use taxes. South Dakota enacted S.D. Codified Laws § 10-64-2 (“SD Economic Nexus Legislation”), effective May 1, 2016, which extended the obligation to collect and remit South Dakota sales tax to certain retailers with no physical presence in the state. Specifically, retailers (1) with gross revenue of over $100,000 per calendar year derived from sales to South Dakota customers; or (2) with 200 or more separate transactions to South Dakota customers in a calendar year are treated as if they had a physical presence in the state.
Following the enactment of the SD Economic Nexus Legislation, South Dakota commenced a declaratory judgment action in circuit court, requesting a declaration that three e-commerce retailers without a physical presence in the state must comply with the legislation. See South Dakota v. Wayfair, Inc., Overstock.com, Inc., and Newegg, Inc., Docket No. 32CIV16-000092 (S.D. Cir. Ct. 2017). See also South Dakota and Alabama Hatch Newegg Challenges to Quill, June 29, 2016, for our prior coverage. The retailers filed a motion for summary judgment arguing the law directly conflicts with Quill and is unconstitutional under the Commerce Clause. The circuit court granted the retailers’ motion, and, on appeal, the Supreme Court of South Dakota affirmed, properly holding that “Quill remains the controlling precedent on the issue of Commerce Clause limitations on interstate collection of sales and use taxes. We are mindful of the [U.S.] Supreme Court’s directive to follow its precedent when ‘it has direct application in a case’ and to leave to that Court ‘the prerogative of overruling its own decisions.’” Wayfair, 901 N.W.2d at 761 (Internal citations omitted). Now, the U.S. Supreme Court has found it appropriate to consider whether it should exercise its prerogative or let the physical presence standard live.
Better for the Physical Presence Standard to Burn Out? Or Fade Away?
If the U.S. Supreme Court wanted the physical presence standard to stand until Congress enacted superseding legislation, it could have sent a loud message to other states adopting unconstitutional economic nexus measures by flatly denying South Dakota’s petition for certiorari. The U.S. Supreme Court declined to do so. Therefore, the significance of the U.S. Supreme Court granting certiorari in Wayfair cannot be understated, and, frankly, it does not bode well for the continuing viability of the physical presence standard as established by the judiciary, considering that at least three of the current U.S. Supreme Court Justices may have telegraphed their intentions in prior decisions.
First, Justice Thomas, in a dissent, has stated that the Dormant Commerce Clause – the basis for the physical presence nexus standard – “. . . has no basis in the text of the Constitution, makes little sense, and has proved virtually unworkable in application. . . . I think it worth revisiting the underlying justifications for our involvement in the negative aspects of the Commerce Clause, and the compelling arguments demonstrating why those justifications are illusory.” Camps Newfound / Owatonna v. Town of Harrison, 520 U.S. 564, 610 (1997) (J. Thomas dissent).
Second, when DMA was before the Tenth Circuit, Justice Gorsuch – then a judge of the Tenth Circuit Court of Appeals – was critical of the bright-line physical presence standard in his concurrence, noting that “. . . Quill invited states to impose comparable [use tax notification] duties . . . . encouraging states over time to find ways of achieving comparable results through different means” and that “ . . . Quill’s very reasoning . . . seems deliberately designed to ensure that Bellas Hess’s precedential island would never expand but would, if anything, wash away with the tides of time.” Direct Marketing Assn. v. Brohl, 814 F.3d 1129, 1151 (10th Cir. 2016) (J. Gorsuch concurrence).
And third, but certainly not least, as noted above, Justice Kennedy’s concurrence in DMA sparked the “kill Quill” movement. His concurrence further noted that “[t]here is a powerful case to be made that a retailer doing extensive business within a State has a sufficiently ‘substantial nexus’ to justify imposing some minor tax collection duty, even if that business is done through mail or the Internet. After all, ‘interstate commerce may be required to pay its fair share of state taxes.’” Direct Marketing Assn. v. Brohl, 135 S.Ct. 1124, 1135 (2015) (J. Kennedy concurrence) (Internal citations omitted).
It remains to be seen whether such a powerful case will be made and how the U.S. Supreme Court will rule in Wayfair. But even if the taxpayer prevails, it may simply be delaying the inevitable result articulated by Justice Gorsuch above. That is, even if the physical presence nexus standard were upheld for sales and use tax purposes, it may then instead be destined to die a slower death through states adopting onerous use tax notification and reporting requirements and penalty regimes, designed to persuade internet retailers to collect sales tax.
But all is not lost. In Quill, the U.S. Supreme Court upheld the bright-line test of Bellas Hess, noting that, “This aspect of our decision is made easier by the fact that the underlying issue is not only one that Congress may be better qualified to resolve, but also one that Congress has the ultimate power to resolve. . . . Congress has the power to protect interstate commerce from intolerable or even undesirable burdens. In this situation, it may be that the better part of both wisdom and valor is to respect the judgment of the other branches of the Government.” Quill Corp. v. North Dakota, 504 U.S. 298 (1992) (Internal quotations and citations omitted). Congress passed federal tax reform; it just might be able to handle a workable solution for the states too.