Tax-collection Threat Looms for Internet Retailers

A U.S. Supreme Court Justice's opinion and a new Senate bill favor giving the states power to compel internet retailers to collect sales taxes.
David KatzMarch 18, 2015

Ripples of anxiety are likely to be coursing through internet retailers this month. That’s because two events — the introduction of the Marketplace Fairness Act in the U.S. Senate and an opinion written by Supreme Court Justice Anthony Kennedy — made it more likely than it has been in 50 years that they will have to collect taxes in states where they don’t have a physical presence.

If that happens, out-of-state retailers would be compelled to collect sales and use taxes in almost 10,000 state tax jurisdictions that, according to the Tax Foundation, exist across the United States.

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For small to midsize online sellers of goods or services, “something like this could put them out of business, because they don’t have the internal infrastructure to be able to administer the sales tax,”  says Mary Alice Cashin, a principal at Ryan, a tax consulting firm.

Besides the tax-collection responsibility, they might also be subject to the added cost of audits by a plethora of jurisdictions, she adds.

U.S. Supreme Court Justice Anthony Kennedy

U.S. Supreme Court Justice Anthony Kennedy

The threat began to materialize on March 3 when Kennedy wrote in his concurrence to a decision by the court that it should re-evaluate a nearly 50-year-old ruling under the Commerce Clause of the U.S Constitution. That ruling said that states can’t require a business to collect use taxes (which are the same as in-state sales taxes, except that they’re collected on out-of-state purchases) if the business doesn’t have a physical presence in the state. Although use taxes are still due, the customer has to pay them, not the out-of-state retailer.

In 1992, in Quill Corp. v. North Dakota, the court reaffirmed the physical presence requirement and rejected attempts to require a mail-order business to collect and pay use taxes. That holding, Kennedy wrote, is “now inflicting extreme harm and unfairness on the states.”

As result of Quill and the court’s previous decision on the Commerce Clause, the Justice contended, states haven’t been able to collect large amounts of taxes due. For instance, California estimates that it can to collect only about 4% of use taxes due on sales from out-of-state sellers. “The result has been a startling revenue shortfall in many states, with concomitant unfairness to local retailers and their customers who do pay taxes at the register,” Kennnedy wrote.

In 1992, U.S mail-order sales amounted to $180 billion, he pointed out. “But in 1992, the Internet was in its infancy. By 2008, e-commerce sales alone totaled $3.16 trillion per year in the United States.”

Thus, there’s “a powerful case to be made” that retailers doing large amounts of business in a state have a substantial enough physical presence in the state to justify the state’s “imposing some minor tax-collection duty, even if that business is done through mail or the Internet,” according to Kennedy.

Given the acceleration of changes in information technology and increasing consumer sophistication in its use, “it is unwise to delay any longer a reconsideration of the court’s holding in Quill,” according to Kennedy.

Restoring States’ Rights

On March 10, exactly a week after Kennedy’s opinion was issued, a bipartisan group of senators introduced the Marketplace Fairness Act of 2015 with the aim of “restoring states’ sovereign rights to enforce state and local sales and use tax laws.”

Besides using the argument that states are being drained of revenue by existing legal precedent, proponents of the measure contend that in-state brick-and-mortar retailers are being put at a disadvantage because they, unlike internet vendors, must charge customers sales taxes on purchases they’ve made.

That puts sellers with stores and warehouses in a state at a competitive price disadvantage because, they contend, they have to raise prices to make up for the portion of revenue they have lost via the sales taxes they have to remit to the state.

The MFA is substantially the same bill that passed the Senate but was not brought to a vote in the House as 2014 came to an end. It would give states the power to compel online and catalog retailers to collect sales tax at the time of purchases —“exactly like local retailers are already required to do,” according to a summary of the bill.

But there’s a catch. States would only be granted that authority only after they’ve simplified their sales tax laws, because collecting taxes under the current multi-jurisdictional system would be too hard for many small retailers.

Further, states will be faced with “an implosion of scale” in complying with the MFA, according to Jonathan Barsade, chief executive of Exactor, a sales-tax-compliance firm. Although many critics say the market will be able to provide solutions to the compliance challenges, “one also needs to look at the states,” he said in an email.

Barsade asks, perhaps rhetorically, are states “equipped to cope with the explosion of data and compliance? Do they have support staff sufficient in size and in training to timely and accurately respond to the influx of issues and questions? Can their systems handle the exponential growth of returns that will be filed?”

Despite the surge in momentum for the idea of leveling the playing field for brick-and-mortar businesses in the last few weeks, passage of a bill resembling the MFA still appears unlikely in the House.

The biggest barrier to such a bill’s making it through the House is the mistaken concern being voiced by representatives that the bill calls for new taxes rather than the collection of taxes that states have been entitled to all along, says Tom Smith, the state and local tax practice leader for the Southwest region for BDO, the accounting and tax firm.