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Supreme Court Overrules Physical Presence Test for State Tax Collection

The United States Supreme Court, in the case of South Dakota v. Wayfair, Inc., has held that a state may require retailers with no physical presence in the state to collect sales and use taxes on sales to customers within the state.  The decision overrules over 50 years of precedent that began with the decision in National Bellas Hess, Inc. v. Department of Revenue of Illinois, 386 U.S. 753 (1967) and was upheld in Quill Corp. v. North Dakota, 504 U.S. 753 (1992).  

The Court in the National Bellas Hess had held that, under both the Commerce and the Due Process Clauses of the Constitution, a state may not require tax collection by a seller that does not have a physical presence in the state.  After that decision, but before Quill, the Court determined that states could impose an income tax on exclusively interstate commerce so long as the tax (1) applies to activity with a substantial nexus in the state, (2) is fairly apportioned, (3) does not discriminate against interstate commerce, and (4) is fairly related to the services the state provides.  Complete Auto Transit, Inc. v. Brady, 430 U.S. 274 (1977).  In Quill, the Court held that the Due Process Clause did not apply, but upheld the National Bellas Hess analysis based solely on the Commerce Clause.  In so doing, it relied in part upon the dormant commerce rule in Complete Auto Transit that a tax have a “substantial nexus” with the activity being taxed.

At issue in Wayfair was a law passed by South Dakota that requires an out-of-state seller to collect and remit sales tax if the seller, on an annual basis, delivered more than $100,000 of taxable goods or services into the state or engaged in 200 or more separate transactions for the delivery of taxable goods and services into the state.  The state filed a declaratory judgment case against three prominent merchants making sales into the state but without a physical presence.  The action requested a declaratory judgment that the statute was valid and applicable to the respondents and an injunction requiring the respondents to collect and remit sales tax.  Based on the National Bellas Hess and Quill decisions, the trial court found for the respondents, and the South Dakota Supreme Court affirmed.  The U.S. Supreme Court reversed the decision and upheld the law.

The Court found that the physical presence rule was not “a necessary interpretation of the requirement that a state tax must be ‘applied to an activity with substantial nexus with the taxing state.  Further, the Quill decision was found to create distortion in the markets because of the substantial changes in modern e-commerce.  Finally, Quill created a distinction that modern Commerce Clause precedents disavow.  Consequently, the physical presence rule was found to be “unsound and incorrect.”

The decision does not establish a new standard to replace the physical presence test, other than the South Dakota formula.  Many other states have already adopted separate economic nexus rules to avoid the former physical presence requirement.  Arguably, under the Court’s decision, a single sale could require the seller to collect sales tax depending on the nexus standard adopted by the state.  Congress could still act to resolve this void by enacting uniform requirements through its Commerce Clause power.

Another issue raised by the decision is whether the states may impose tax collection responsibility retroactively based on the Wayfair decision.  The South Dakota law contained protection against retroactive application, but most states do not provide that protection.  However, 41 states filed a joint amicus curiae brief in which they advised the Court that retroactive application, if any, would be very limited.

Finally, there may be some concern that the analysis in Wayfair will be extended to other state taxes.  Again, Congress could resolve the issue by adopting uniform standards.  For example, by federal statute, states cannot impose a net income tax on a seller of tangible personal property if it does not have a physical presence in the taxing state.  Public Law 86-272, 15 U.S.C. § 381(a).