Post-Wayfair Options for States

by Joseph Bishop-Henchman, Denise Garbe, Hannah Walker, Tax Foundation, August 29, 2018 (excerpted)

PDF: Download FISCAL FACT No. 609: Post-Wayfair Options for States 

Key Findings

• The U.S. Supreme Court in South Dakota v. Wayfair this year ruled that a state may require collection of sales tax by out-of-state internet retailers who sell into the state (“remote sellers”), so long as the law does not discriminate against or place excessive burdens on those engaging in interstate commerce.
• The Court strongly suggested that a law that follows what we call “the Wayfair checklist” would be constitutional. States can satisfy this checklist by adopting a de minimis threshold, explicitly rejecting retroactive enforcement, and adhering to uniformity and simplification rules in the Streamlined Sales and Use Tax Agreement (SSUTA).
• Policy choices for state officials include whether to adopt a more generous de minimis threshold, when the qualifying period for the threshold should be, what date enforcement should start, whether to include local taxes, and how to use the revenue.
• Thirty-two states are acting to pass laws or regulations to require sales tax collection by remote sellers now or in the immediate future….
• States we identify as “yellow light” and “red light” states, particularly those that are not SSUTA members, should undertake improvements to their sales tax systems and consider higher de minimis thresholds to minimize the risk of legal challenge to future remote seller tax collection. At minimum states should allow sellers to register with SSUTA rather than requiring state-by-state registrations, allow SSUTA service providers to work with their state, restrict multistate audits, and provide taxability, exemption, rate, and boundary data for download on their websites.  

Introduction

On June 21, 2018, the U.S. Supreme Court ruled in South Dakota v. Wayfair that South Dakota can require collection of its sales tax on sales to its residents by out-of-state internet retailers.[2] The 5 to 4 decision overruled two earlier precedents, National Bellas Hess, Inc. v. Illinois Department of Revenue (1967) and Quill Corp. v. North Dakota (1992), which had both held that only businesses with a physical presence in a state can be required to collect that state’s sales tax. The new rule, articulated in Wayfair, is that a state sales tax can be constitutionally collected so long as it does not discriminate against or place excessive burdens on those engaging in interstate commerce.

Since the decision, states have begun considering actions that they might need to take to collect sales tax on internet transactions while adhering to the Wayfair decision. The Court stopped short of upholding South Dakota’s collection of remote sales taxes as constitutional but gave several reasons why the state’s law in particular and its tax compliance system in general would not be a burden on interstate commerce. This report reviews the Wayfair decision and evaluates existing state laws to determine what further action each state may need to take.

South Dakota’s Law

South Dakota S.B. 106 was the law contested in Wayfair. It requires sales tax collection by out-of-state sellers if they have a minimum of $100,000 in sales or 200 transactions per year in the state. This de minimis threshold, or safe harbor, has the effect of excluding those sellers with incidental sales into the state and where establishing collection mechanisms might outstrip the business’s incremental revenue from selling into South Dakota. South Dakota’s statute also has a provision barring retroactive collection. South Dakota passed the law with unanimous votes and it was signed into law on March 22, 2016, to take effect on May 1, 2016.[3]

South Dakota was well-chosen as the state to bring the challenge to Quill, for four main reasons. First, the state is a full member of the Streamlined Sales Tax and Use Agreement (SSUTA), a multistate organization that works to increase uniformity and reduce complexity in sales tax collection. Second, South Dakota taxes nearly all goods and services under its sales tax, avoiding definitional and administrative problems encountered by other states in distinguishing among items. Third, while there are local sales taxes in South Dakota, the state keeps it simple in requiring them to adhere to the state base of transactions and only at uniform rates. Fourth, South Dakota has no state individual income or corporate income tax; sales and property taxes are essentially its only taxes and make up three-quarters of total South Dakota state and local tax revenue.

The Wayfair Decision

Justice Anthony Kennedy delivered the opinion for the five-justice majority. The opinion first recited the history of the dormant Commerce Clause, a doctrine that prevents states from discriminating against interstate commerce or placing undue burdens upon interstate commerce. The Court noted that the 1970 Complete Auto case[4] formulated a four-part test to evaluate state laws under the dormant Commerce Clause doctrine, with one of those parts being “substantial nexus,” a sufficient connection between the state and the taxpayer.

The opinion then gives three reasons for deeming Quill flawed. First, physical presence is not a necessary interpretation of substantial nexus from Complete Auto. Kennedy writes that “[t]he physical presence rule is a poor proxy for the compliance costs faced by companies that do business in multiple States,” comparing a company with a salesperson in each state that must therefore collect tax with a company with 500 people in one central location and a website accessible in every state that need only collect in one state. Second, the Quill rule creates market distortions between brick-and-mortar and online retailers–“a judicially created tax shelter,” in the Court’s words–and an incentive to avoid physical presence in multiple states purely for tax avoidance reasons.[5] Third, the physical presence standard is arbitrary and formalistic, rather than looking at the substance of a law’s compliance burdens or discriminatory effect.

The Court acknowledged substantial reliance on its earlier decisions, conducting a stare decisis analysis. Against this reliance the Court listed the need to correct an error depriving states from exercising lawful powers, the strong growth of e-commerce and consequent growth in the states’ revenue shortfalls from being unable to tax online sellers, and the variety of state laws working to “embroil courts in technical and arbitrary disputes about what counts as physical presence.”[6]

The Court also acknowledged burdens associated with tax compliance but expressed hope that software and other systems will be able to reduce these costs. The Court noted that South Dakota, as a SSUTA member, had done much to make compliance easier. If not, the Court stated, Congress could act to address these problems through legislation. Finally, small sellers seeking relief from future state laws that impose excessive burdens on them “may still do so under other theories.”[7]

The Court then stated that “the physical presence rule of Quill is unsound and incorrect,” and overruled Quill and Bellas Hess. The Court concludes that the statute’s standard of $100,000 in sales or 200 transactions can only be met if “the seller availed itself of the substantial privilege of carrying on business in South Dakota. And respondents are large, national companies that undoubtedly maintain an extensive virtual presence. Thus, the substantial nexus requirement of Complete Auto is satisfied in this case.”

The decision did not end there, and experts since have debated whether what follows is binding or not. The Court remands the South Dakota law for further consideration. But before concluding the decision, the Court offered a checklist of why the South Dakota law would likely be constitutional:

That said, South Dakota’s tax system includes several features that appear designed to prevent discrimination against or undue burdens upon interstate commerce. First, the Act applies a safe harbor to those who transact only limited business in South Dakota. Second, the Act ensures that no obligation to remit the sales tax may be applied retroactively. S. B. 106, §5. Third, South Dakota is one of more than 20 States that have adopted the Streamlined Sales and Use Tax Agreement. This system standardizes taxes to reduce administrative and compliance costs: It requires a single, state level tax administration, uniform definitions of products and services, simplified tax rate structures, and other uniform rules. It also provides sellers access to sales tax administration software paid for by the State. Sellers who choose to use such software are immune from audit liability.

Two justices wrote separate concurring opinions while joining the majority opinion. Justice Clarence Thomas concurred to write that he should have joined the Quill dissent in 1992. Justice Neil Gorsuch concurred, joining the majority in full and adding that he questions Commerce Clause doctrine.

Four justices dissented, in an opinion authored by Chief Justice John Roberts. The dissent agreed that “Bellas Hess was wrongly decided, for many of the reasons given by the Court,” but urged that any change to the physical presence rule be undertaken by Congress. Unlike in other contexts where only the Supreme Court can reverse a previous decision, Commerce Clause decisions by the Court can be changed by Congress.[8] Roberts also took issue with the Court’s sense of urgency, pointing out that states are already able to collect the vast majority of potential online sales tax revenue. He worried that the burden of getting it wrong will fall squarely on small sellers, another reason for Congress to draw where the line should be instead of the Court.

The Wayfair Checklist                               

The Court provided a checklist of factors present in South Dakota law that strongly suggested why it would be constitutional under this standard:

1. Safe harbor: Exclude “those who transact only limited business” in the state. (South Dakota’s is $100,000 in sales or 200 transactions.)
2. No retroactive collection.
3. Single state-level administration of all sales taxes in the state.
4. Uniform definitions of products and services.
5. Simplified tax rate structure. (South Dakota requires the same tax base between state and local sales tax, has only three sales tax rates, and limited exemptions from the tax.)
6. Software: access to sales tax administration software provided by the state.
7. Immunity: sellers who use the software are not liable for errors derived from relying on it.

In South Dakota, the first two items on the checklist were met through S.B. 106, the enabling law directly challenged in Wayfair. The other five items were met through other provisions in state law relating to South Dakota’s adherence to SSUTA.

Policy Choices for Legislators

Legislators may make several policy choices when complying with the Wayfair checklist:

• Adopt the same threshold as South Dakota ($100,000 in sales or 200 transactions) or a more generous one to account for larger population size or larger economy. A state could also drop the number of transactions requirement to avoid impacting a seller with many small transactions.
• Decide when the threshold period is measured. South Dakota’s law looked at the previous calendar year and current calendar year, with collection commencing only after the threshold was met. Other states have considered continuing most-recent-12-month periods, or 12 months ending on the most recent quarter. Small retailers, whom this provision is meant to protect, benefit from clear and easy-to-track rules in this regard, which mitigate in favor of calendar periods rather than roving periods.
• Setting an enforcement start date. States should give retailers enough notice before collection must begin. The National Conference of State Legislatures has recommended that states begin collection on a calendar quarter and consider waiting until at least January 1, 2019[9].
• Consider repealing click-through nexus and notice-and-reporting laws. If a seller is pressured to collect through those laws but would not meet the de minimis threshold, the enforcement of those laws could be a Due Process Clause or Commerce Clause violation.
• Decide how to collect local sales taxes. This may not be advisable in states that do not provide lookup software and unified collection under SSUTA. States with a large number of local sales tax jurisdictions might consider imposing a “flat” local sales tax on internet sales, as Alabama has done, if simplification is not possible. However, a flat sales tax higher than the lowest sales tax charged anywhere in the state is probably unconstitutional.[10]
• Decide use of the revenue. The Government Accountability Office estimated additional state and local government revenue from remote seller tax collection of between $8 billion and $13 billion per year[11]. Several states plan to use internet sales tax revenue for tax reductions….

Green Light: Georgia, Indiana, Iowa, Kentucky, New Jersey, North Dakota, South Dakota, Utah, Vermont, and Wyoming Can Proceed

Ten states have adopted all seven provisions of the Wayfair checklist, through SSUTA membership and enabling legislation with de minimis thresholds and retroactive bans similar to or better than South Dakota’s law. The collection of sales tax on internet transactions by these states is therefore permissible under current court rulings. …

Flashing Yellow Light: Arkansas, Kansas, Michigan, Minnesota, Nebraska, Nevada, North Carolina, Ohio, Oklahoma, Rhode Island, Washington, West Virginia, and Wisconsin Can Proceed with Caution

Thirteen states have completed items 3 through 7 of the Wayfair checklist as a result of SSUTA membership. They have not yet passed enabling legislation to make them compliant with items 1 and 2 of the Wayfair checklist. If they wish to pursue collection of sales tax on internet transactions, these states should pass enabling legislation with a de minimis threshold and a ban on retroactive collection similar to or more generous than the South Dakota standards. Some states may assert authority to collect through regulatory action, but to be on firm legal ground the state should pass enabling legislation as soon as practicable….

Steady Yellow Light: Alabama, Arizona, California, Connecticut, Florida, Hawaii, Idaho, Illinois, Maine, Maryland, Massachusetts, Mississippi, Missouri, New Mexico, New York, Pennsylvania, South Carolina, Tennessee, Texas, Virginia, and the District of Columbia Should Only Proceed After Making Legislative Changes

The remaining states have not completed several items on the Wayfair checklist, in large part due to their non-membership of SSUTA. Without action to adopt uniform definitions and simplify their sales tax systems, requiring collection from internet sellers will be under a cloud of legal uncertainty. At minimum states should allow sellers to register with SSUTA rather than requiring state-by-state registrations, limit multistate audits, allow SSUTA service providers to work with their state, and provide taxability, exemption, rate, and boundary data for download on their websites.

Several of these states have passed legislation or adopted regulations relating to taxation of internet sales:…

• Hawaii law[70] adopts a $100,000 or 200-transaction threshold (during the previous calendar year) for its sales tax (called the General Excise Tax), effective prospectively. The Hawaii Department of Taxation announced a collection effective date[71] of July 1, 2018, with the first filing due August 20, 2018. The Department has stated that those who met the $100,000 or 200-transaction threshold in 2017 or 2018 will not be required to remit tax for the period prior to July 1, 2018, but must begin filing thereafter. The state is not a member of SSUTA, does not adhere to common definitions, and does not provide base/rate lookup software or immunity from errors resulting from reliance on software, but does have centralized collection of sales tax. (Hawaii has only one local sales tax jurisdiction, Oahu County.) The state also taxes nearly all goods and services under its tax, unlike most other states, thereby avoiding base calculation and definition problems. While the state should pursue SSUTA membership, having only one sales tax jurisdiction and broadly taxing all goods and services does somewhat reduce the burden on interstate sellers.

Red Light: Colorado and Louisiana

Colorado and Louisiana have duplicative, outdated, inconsistent, and inefficient sales tax collection mechanisms that make it unlikely that any attempt to pass a South Dakota-style law would survive a legal challenge. Both states permit each tax jurisdiction (328 in Colorado, 370 in Louisiana) to administer, collect, and audit its sales tax separately, and define its base independently of the state sales tax base. Neither state is a member of SSUTA and therefore neither adheres to common definitions or provide base/rate lookup software. Adopting sales tax practices that are used by every other state, such as centralized collection of all sales taxes in the state and uniformity between the state and local bases, would be essential prerequisites before Colorado or Louisiana could take advantage of the Wayfair ruling. Both states are aware of these deficiencies and have in recent months begun taking tentative steps to improve their sales tax systems….

NOMAD States: Alaska, Delaware, Montana, New Hampshire, and Oregon

These developments are unpopular with online retailers in these five states, which have no statewide sales tax, as they must now collect tax on sales to customers in other states. (Alaska and Montana have limited local sales taxes, which would require centralized collection if internet sales were to be subject to them.) New Hampshire considered a proposal that would limit the ability of other states to subject New Hampshire businesses to collection obligations unless those other states adopted designated minimum simplifications, but that bill did not pass the New Hampshire Legislature[99] due to constitutional concerns.

Marketplaces

One open question is marketplace facilitators: websites such as eBay[100] or Etsy[101] that do not sell goods directly but provide a platform for sellers. The issue of who should collect tax on such transactions was not addressed by South Dakota’s law or the Wayfair case, and whether states have the power to require marketplaces to collect tax is an unresolved question. On one hand it is probably the least complicated option for these websites to collect on behalf of their sellers, but on the other are potentially unintended consequences from redefining who the seller, or merchant of record, is for transactions.

Several states have enacted laws requiring marketplaces to collect for their sellers….

Changes to marketplace taxation should only be done through legislative action, not administrative rule-making, and with sufficient notice.

Conclusion

As with any tax change, policymakers will be best served in approaching this issue in a deliberate fashion and with eyes wide open to second-order effects. The end goal of extending state sales taxes to online transactions is a broader, more stable sales tax base. Because that goal will impact state finances for years to come, policymakers should build systems meant to last; ones that are surely constitutional, that are free from the threat of lawsuit, and that uphold a system of voluntary compliance.

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[70] Haw. S.B. 2514.

[71] Hawaii Department of Taxation, “Implementation of Act 41”, Announcement No. 2018-10, 2018, http://files.hawaii.gov/tax/news/announce/ann18-10_amended.pdf.