Laws constantly evolve to adapt to modern society. Situations that were once impossible to imagine (such as buying hand soap from a distant warehouse at the click of a button and having it appear on your doorstep the next day) are now routine. As such, it is impossible to craft legal rules to anticipate the future. The power of the internet has amplified this discrepancy, and its ever-growing presence has sent shockwaves through the legal system. In this altered landscape, many existing legal rules no longer achieve their intended purpose and must be adapted to address the rapid advancement of technology and the growing e-commerce world. Sometimes, this may require long-standing precedent to be discarded, as we saw in the recent United States Supreme Court decision South Dakota v. Wayfair, Inc.
Prior to this Supreme Court decision, states were prohibited from collecting a sales tax unless the seller had a physical presence (e.g., an employee or a building) in the state where the item was sold. In a 5-4 decision, the Supreme Court reversed its prior decision and overturned 26 years of precedent, holding that a state can require internet retailers to collect sales and use tax even without a “physical presence” in that state. Through this decision, the Court leveled the playing field and decided the “physical presence” rule was no longer tenable in our technology-driven society. The result for in-state merchants (who had to compete with online retailers who didn’t have to charge sales tax) was a win.
How Did This Happen?
The case began in 2016 when South Dakota enacted a law that required out-of-state sellers to collect and remit sales tax “as if the seller had a physical presence in the state” if they sold more than $100,000 of goods or services in the state annually, or engaged in 200 or more separate transactions with in-state residents. Given that South Dakota does not have an income tax, it relies heavily on sales tax for revenue, which was eroding each day.
For decades, the “physical presence” rule has enabled online retailers to avoid charging sales tax, thereby depriving states of an estimated $8 to $33 billion each year in revenue. Not surprisingly, this rule has been adamantly criticized for providing out-of-state businesses an opportunity to exploit a tax loophole – colloquially called the 8% advantage as per the average sales tax rate across the country – and gain a competitive advantage over in-state merchants. Indeed, 41 states, two territories, and the District of Columbia have sought to overturn Quill. Ultimately, South Dakota initiated an action in state court to seek validation. Opposing South Dakota were online retailers with no physical presence in the state who, unsurprisingly, contended that South Dakota’s new law was unconstitutional.
These online retailers sought to uphold the “physical presence” rule articulated by the United States Supreme Court in 1992 to avoid having to charge the tax (and thus appeal to customers). The Supreme Court pointed out that internet sales giant Wayfair (the defendant in the case) actually flaunted its ability not to charge state sales tax in its advertising by stating, “One of the best things about buying through Wayfair is that we do not have to charge sales tax.” Wayfair’s principal argument was that small businesses, by not paying a sales tax, can leverage the internet to expand their small businesses nationwide. While the Court acknowledged that some small businesses may be adversely affected, its 2018 decision applies only to businesses that conduct a significant amount of business in the state—a larger business. The Supreme Court focused its analysis on the “physical presence” rule and highlighted the change of circumstances over time which led it to its new decision.
In 1992, when the Court’s decision was to not permit states to require collection of sales tax without a physical presence, less than two percent of Americans had internet access and Amazon and eBay did not exist. Fast-forward 25 years, and now 89 percent of Americans have internet access. The Court pointed out that in 1992 it did not “envision a world in which the world’s largest retailer would be a remote seller.” These days, consumers have little reason to leave the comfort of their home to go shopping, as they are “closer to major retailers” than ever before. Accordingly, the Court found no reason to continue to support the artificial distinction between being physically present in a state and conducting a significant amount of virtual business in a state.
How Does This Affect My Business?
With the “physical presence” rule now buried among other Supreme Court holdings that no longer fit in modern society, the shackles have been released for states to pass legislation mirroring that of South Dakota. States will now be able to require online retailers to collect sales tax from their customers and in turn, collect the millions of dollars in revenue that has eluded them for so long. Small businesses with limited multi-state sales could be burdened by state tax systems, but it remains to be seen how states will set the minimum requirements for sales tax collection. Only time will tell just how onerous such burdens will become. If you have questions regarding sales tax collection requirements for your business, please contact us.