The taxes, they are a-changin'

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Posted by Courtney Kopec, CPA

A recent Supreme Court decision upheld a South Dakota sales tax law requiring sales tax to be collected by large internet retailers, such as Wayfair and Overstock, who are not physically present in South Dakota, but “maintain an extensive virtual presence.” The law applied only to out-of-state sellers who deliver more than $100,000 of goods or services into the state or engage in 200 or more separate transactions. For South Dakota, a state with no income tax, the effect of the losses from online sales tax revenue to state and local services was critical. While the Supreme Court decision seems reasonable, it effectively gutted the bright-line physical presence standard established by the Quill decision. Prior to the Supreme Court decision, businesses relied on the Quill decision to avoid nexus (a connection to a state upon which the obligation to pay or collect sales tax is based).

The physical presence standard limited the burden of businesses required to collect sales tax to those with a physical presence, such as an office, employee, or inventory. In this new decision, the Court reasoned: “Each year, the physical presence rule becomes further removed from economic reality and results in significant losses to the States. These critiques underscore that the physical presence rule, both as first formulated and as applied today, is an incorrect interpretation of the Commerce Clause.”

The Court opinion further explained that the physical presence test espoused in Quill was “flawed on its own terms” and could no longer uphold, because a business need not have a physical presence in a State to satisfy the demands of due process. This resulted in market distortions caused by the desire of business to avoid tax collection and a “judicially created tax shelter for businesses that limit their physical presence. … [the] rule produces an incentive to avoid physical presence in multiple states. And this Court should not prevent States from collecting lawful tax through a physical presence rule.”

What’s next for nexus?

Other states, including New York, that passed similar sales tax legislation based on “click-through nexus” as far back as 2008 may now rely on the South Dakota law as a constitutionally upheld example. The Supreme Court noted the effects of the South Dakota law as minimizing the burden on interstate commerce by including a safe harbor provision on certain transactions “so small and scattered that no taxes should be collected,” forgoing retroactive application, and through the Streamlined Sales and Use Tax Agreement providing state-funded sales tax administration software intended to reduce compliance costs. While the South Dakota law has been constitutionally upheld, the Court did not address economic nexus laws in other states, nor the possibility of imposing sales tax retroactively.

Because no international treaty provisions apply to sales tax, foreign sellers are subject to the same rules as domestic sellers.

Will states seek back taxes?

In its case, South Dakota noted that advances in computer technology have made it easier to determine appropriate sales tax based on the purchaser's location and that requiring such "poses a minimal obstacle."

In the summer of 2017, the Multi-State Tax Commission Online Marketplace Seller Voluntary Disclosure Initiative offered sales tax amnesty. Twenty-five states offered to waive all past tax, interest, and penalties for companies that agree to register for and collect sales tax for online sales going forward.

Therefore, it stands to reason that states will engage in litigation to verify how much sales tax revenue they can attempt to collect and the constitutionality of the sales tax statutes already in place. However, the guidelines written in the decision stressed: “The Court has consistently explained that the Commerce Clause was designed to prevent States from engaging in economic discrimination so they would not divide into isolated separable units.”

Federal legislation from Congress has proposed a destination-based collection system based on the location of the buyer and the local sales tax rate where the buyer receives the product.

What about my company’s exposure?

The evolving concept of nexus also applies to income and franchise tax, so a good understanding of the regulations is critical. The analysis and interpretation of these laws is challenging, in part because the Court’s most recent decision upended prevailing state statutes. Now, a modern “economic nexus” standard is required, but not yet written nor agreed upon by the fifty United States. We can expect revised statutes based on a new form of nexus to potentially broaden the states’ claim on income and franchise tax.

While the Court favors prospective legislation, companies that have received notice from state taxing authorities regarding past sales transactions should not consider the Court’s recent decision as constitutional protection.

Our recommendation

When a sales transaction is complete, it is difficult to impossible to retroactively collect sales tax for which the taxpayer may be responsible upon audit. What should have been a tax collection process becomes an expense to the seller.

In states that already have sales tax requirements for online sales and have enacted legislation similar to South Dakota, such as Georgia, we recommend registering to do business in that state and complying with sales tax collection. The odds are they will offer some type of amnesty.

If a state has not yet enacted legislation, we recommend a “wait-and-see” approach that may offer prospective amnesty. This decision gives some certainty that companies with sales in other states will have to register and collect sales taxes according to each state’s laws.

If your business has transactions out-of-state and you would like to review whether your business has nexus in another state, contact your CPA to review the latest guidelines.