Are New Tax Rules for Out-of-State Retailers Unconstitutional?

Such retailers should fight states that force them to collect sales taxes, a pair of attorneys argue.
Andy Yates and Clark CalhounJuly 11, 2016
Are New Tax Rules for Out-of-State Retailers Unconstitutional?

It’s a wild and scary time in the history of sales tax collection. Okay, for those of you who don’t live and breathe tax every day, putting “wild” and “sales tax” in the same sentence may feel like a stretch. But bear with us.

Clark Calhoun

Clark Calhoun

The long-standing rules that protect out-of-state retailers from sales tax collection are under attack. For companies that sell products nationwide — especially those that operate primarily through the Internet — this is a big deal.

Almost 50 years ago, the U.S. Supreme Court determined that retailers without a physical presence in a state were not required to collect sales tax on sales delivered to customers in that state. The Supreme Court reaffirmed that conclusion in 1992’s Quill Corp. v. North Dakota.

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The states have grumbled about the Quill case since it was decided, complaining that mail-order and internet retailing have made physical presence an antiquated standard for sales tax collection. But the states felt compelled to comply with Quill — until March of last year, that is. That’s when Supreme Court Justice Anthony Kennedy issued an open invitation to overturn Quill in his concurrence to Direct Marketing Association v. Brohl, calling Quill “questionable even when decided.”

Since Justice Kennedy’s call, six states have enacted measures that require remote sellers either to collect sales tax or to report sales made to customers in the state if their sales meet certain thresholds — regardless of physical presence.

Yet the physical-presence standard of Quill is still good law. So retailers are left with a dilemma: do they comply with these new rules, despite their dubious constitutionality? Or do they push back and risk assessment and potential litigation?

“Economic Nexus” Rules

There are two types of the new remote-seller rules. First, there are “economic nexus” provisions. Rather than require a seller to have a physical presence in the state, these provisions set transaction thresholds above which the seller is determined to have “economic nexus” sufficient to justify sales tax collection. Alabama and South Dakota have enacted such provisions, and Tennessee has proposed one.

Andy Yates

Andy Yates

For example, under the South Dakota law that went into effect on May 1, a retailer that either makes $100,000 of taxable sales into the state or sells merchandise into the state in 200 or more separate transactions is deemed to have established nexus with the state. Retailers with economic nexus are responsible for sales tax collection in the same manner as those with a physical presence in the state.

Economic nexus for sales-tax purposes is plainly unconstitutional under Quill — and the states know it. In fact, state revenue officials have invited taxpayers to challenge their new economic nexus provisions in court. In response to criticism over her state’s provision, Alabama Revenue Commissioner Julie Magee took to Twitter to proclaim: “Sue us.” She later attempted to lead a national gathering of state tax administrators in an inspirational chant of “Kill Quill” (reports suggest that, to the audience’s credit, there weren’t many eager participants).

Now taxpayers have taken up the fight against economic nexus. The American Catalog Mailers Association and Netchoice filed a lawsuit to block enforcement of South Dakota’s measure, and other taxpayers who were sued by South Dakota have filed a motion to remove the action to federal court. In Alabama, Newegg Inc. appealed a sales tax assessment, arguing that under Quill, Alabama has no jurisdiction to tax the company.

Reporting Rules

The second type of remote-seller rule is less obviously unconstitutional but nonetheless is an attack on Quill. Under “reporting” rules, an out-of-state seller that is not registered to collect sales tax — and has no physical presence in the state — must send an annual notice to the department of revenue listing its in-state customers and the amount of sales made to each customer. Colorado, Louisiana, and Vermont have enacted these reporting requirements.

Customers that, for various reasons, do not pay sales tax on a purchase are required to pay use tax on the purchased items instead. (Use taxes are complementary to sales tax and are always imposed on the same transactions and at the same rate.) These new reporting rules essentially require retailers to rat out their customers by disclosing to the state all that it would need to send those customers a use tax assessment.

But assessing use tax is not really the point of these reporting rules, for it is implausible (and probably politically unacceptable) that Colorado, Louisiana, and Vermont are going to spend the time and money necessary to collect thousands of $40 or $50 use tax obligations from individual customers. Rather, what these states really want is to make the burden on remote retailers great enough that they are coerced to “voluntarily” decide to collect sales tax rather than comply with the reporting rules. From a retailer’s perspective, what’s worse: collecting a bit of sales tax, or providing your customers’ purchase information to the government?

The rationale behind the physical presence rule of Quill is to limit the burden placed on interstate commerce by multistate sales tax collection, but these reporting rules do just the opposite. Even so, one federal court of appeals has already determined that Colorado’s reporting rule withstands constitutional scrutiny.

What to Do?

As Internet retailing has exploded over the past 20 years, the states have come to view Quill’s physical-presence rule as an unfair constraint on their ability to collect sales tax. In response, they have taken their fights to the courts. Multistate retailers are caught in the middle, left to decide whether to comply or to push back against these unregulated expansions of state taxing power.

When it comes to economic nexus provisions in particular, we encourage taxpayers to fight back. Unless and until the Supreme Court overturns Quill, states have no authority to require retailers with no physical presence in the state to collect sales tax, and it is an affront to our constitutional system for states to impose the costs of their desire to test the ongoing viability of Quill on business taxpayers.

Furthermore, preventing individual states from making their own determination of when and how to impose tax collection obligations on remote retailers was an express reason behind the Supreme Court’s 1992 Quill decision — reasoning that states seem to have overlooked in their rush to answer the invitation of one Supreme Court justice.

However, we recognize that resisting these new collection efforts comes with risks and costs. It takes time and resources to fight an assessment, and there is no certainty that the Supreme Court will uphold Quill’s physical-presence protection.

Therefore, each multistate retailer must take into account its circumstances and risk appetite and make a considered decision about how to respond. The decision should include consideration of the business and legal ramifications of compliance or noncompliance, whether to fight an assessment in the event of noncompliance, and whether to record a financial statement reserve with respect to noncollection under a state’s new economic nexus provision.

It’s worth pointing out that Congress could step in and end this fight. Under its power to regulate interstate commerce, Congress can establish a nationwide framework to determine when a state can tax remote retailers; in fact, that’s exactly what the Supreme Court, writing in Quill in 1992, asked Congress to do. But unless that occurs, we expect a bumpy and uncertain road ahead for multistate sales tax collection.

Clark Calhoun and Andy Yates are attorneys in the state and local tax practice of law firm Alston & Bird.