State Options After Wayfair

In Wayfair, the Supreme Court overturned the bright-line physical presence rule imposed by Quill. A state can now require an out-of-state vendor to collect the use tax even if that vendor does not have a physical presence within the state. The underlying standard governing when states can impose a use tax collection obligation remains the same: there must be a “substantial nexus.” But what constitutes a substantial nexus? The Court does not give any general guidance, but does make it clear that this standard was satisfied in this case. Alas, the Court’s reasoning as to this case is reasoning is ambiguous. Here is the key paragraph:

Here, the nexus is clearly sufficient based on both the economic and virtual contacts respondents have with the State. The Act applies only to sellers that deliver more than $100,000 of goods or services into South Dakota or engage in 200 or more separate transactions for the delivery of goods and services into the State on an annual basis. S. B. 106, §1. This quantity of business could not have occurred unless 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 first sentence of this paragraph suggests that two inquiries are relevant to nexus: (1) a taxpayer’s economic returns from a state and (2) its activities directed toward a state. The second and third sentences of this paragraph suggest that the South Dakota thresholds require sufficient “economic contacts” for substantial nexus. The fourth sentence, emphasizing the size of respondents, focused on the so-called “virtual contacts” that large, national e-commerce vendors create through their extensive marketing and web presences.

What this paragraph does not do is to address precisely when small sellers have a substantial nexus. What if a small seller has exactly 200 sales, worth $20,000? Given this uncertainty, our advice for states at the moment would be to put in place thresholds similar to South Dakota’s. If they wanted to be better insulated from challenges from very small sellers, and likely at minimal revenue loss, we would suggest adopting even higher thresholds. This would be especially true for non-SSUTA states.

Alas for states looking for guidance, there is more ambiguity in the next paragraph of the opinion. The Court remanded the case to the lower courts to consider other possible challenges to the South Dakota law, including, apparently Pike balancing, which is odd considering that the substantial nexus test is a test for taxes and Pike balancing is a test for regulations. Here is the paragraph:

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.

Though we agree that Pike balancing should apply, we wish the Court would have explained why it should apply. Furthermore, and more importantly for states, the Court does not offer any guidance as to which of these aspects of South Dakota’s law is the most important. Crucially, it may not be too difficult for a state to emulate South Dakota’s thresholds, but it might be very difficult for a state to join the SSUTA or otherwise simplify its tax system in a comparable manner.

Our advice here is that states that cannot engage in substantial simplification — and perhaps even states that can — should offer meaningful vendor reimbursement for compliance costs and/or offer free compliance software that immunizes vendors who rely upon it. (One of us discussed this first approach at length in a prior article here; and two of us discussed this second approach in a prior essay here.)

We do not think that these approaches are necessarily required by the Court’s opinion; substantial enough simplification of a state’s sales and use tax, roughly equivalent to that required by the SSUTA, should suffice. But we do think that adopting one of these approaches makes for good, sensible policy. If, for whatever reason, a state wants to retain a more complicated sales and use tax system or simply does not wish to conform their sales and use tax system with that of other states, then it is only fair that states compensate vendors for the costs they incur in collecting sales and use taxes.

[Cross-posted from Medium]