Editor’s Note: You may have seen in the news lately – including on this blog – how some states are attempting to expand the definition of sales tax nexus, and increase the number of merchants who must collected sales tax from buyers within their state borders. One of the ways states are attempting to require more out-of-state sellers to require sales tax is by applying the concept of “economic nexus.”
We asked CPA Ned Lenhart to give us an overview of “economic nexus,” how we got to this point, and the current state of sales tax nexus.
The Evolution of Sales Tax Nexus
Before a taxing jurisdiction can require an out-of-state company to collect and remit sales tax or to file and pay income tax, the company must have some connection with the taxing jurisdiction. We call this connection, “nexus.” For sale tax purposes, the most widely supported nexus principle requires the out-of-state company to have some physical connection with the state. This ‘physical presence’ requirement was reaffirmed in the Quill Corp. v. North Dakota Supreme Court case in 1992 (“Quill”). This case involved the sale of office supplies made via a mail order catalogs by Quill to customers in North Dakota. Even though Quill owned some “floppy discs” in the state of North Dakota, the Supreme Court held that this presence was de minimis and not substantial. However, just because the retailer does not have nexus in the taxing jurisdiction the purchaser is required to remit use tax on the purchase price of the merchandise. In no surprise to anyone, individual consumers almost never pay the consumer use tax on their purchases. This leads to a slow but steady loss of sales tax revenue to the state.
In Quill, the U.S. Supreme Court indicated that the solution to this issue rests with Congress and would require federal legislation to modify the commerce clause to permit states to tax out-of-state sellers that do not have physical presence in their state. As remote commerce migrated from mail order catalogs to eCommerce the loss in sales tax revenue has mushroomed and is forcing states to make some short-term adjustments while they waited for Congress to act. This includes increasing sales tax rates, elimination of tax exemptions, and adjustments to income tax laws. It is now 24 years after Quill and Congress is not remotely close to reaching a consensus about how to act.
During this 24 year period, numerous House and Senate bills around sales tax have been introduced and voted on but comprehensive changes have never passed. The states have also combined forces to develop and adopt the Streamlined Sales Tax Program (SSTP). States have adopted new strategies to abide with the physical presence through the infamous “Amazon nexus rules” and other types of “click through nexus” rules. Finally, the states have passed legislation and other administrative policies implementing rules that are either classified as “virtual nexus” or “economic nexus.” In short, the states are hemorrhaging tax revenue and are tired of waiting for Congress to act. Tensions are high and the states are acting unilaterally.
Virtual and Economic Nexus, Explained
One of the first states to push these alternative nexus theories is Ohio. In 2005, the state adopted the “factor presence test” for purposes of determining what companies are subject to the Commercial Activity Tax (CAT). Under this test, companies with no connection at all to Ohio are still subject to the CAT if they have sales in Ohio of at least $500,000. That’s it! No need to have property or payroll in the state; just sales. Because the CAT is not an income tax, the provisions of P.L. 86-272 do not apply. Following Ohio’s lead, more states adopted the “factor presence test” which is also known as “economic nexus.” Under this theory, a company is deemed to have nexus with the taxing state only if it has sales in the state. Under this test, there is no need to have any physical connection with the state. In sort, under the various economic nexus tests adopted by a handful of states, Quill is irrelevant and inapplicable (or so the states believe).
In addition to the “factor presence” test adopted by Ohio, the state has also asserted a physical presence or virtual presence test over certain companies because they transmit “cookies” to Ohio users who access their website. Under this theory, Ohio could assert nexus over any eCommerce company regardless of the sales volume.
States Adopting Economic Nexus
In addition to Ohio, the legislatures in South Dakota, Alabama, and Washington have passed measures adopting various forms of economic nexus. In South Dakota, sellers with annual sales over $100,000 or with 200 separate transactions in the state are deemed to have nexus with the state and are obligated to collect and remit tax. In Alabama, sellers with over $250,000 of annual sales are deemed to have nexus in the state even though they don’t have any physical connection with the state.
Further, the state of Idaho, Illinois, Louisiana, Mississippi, Nebraska, Oklahoma, Utah, Rhode Island, and Vermont have also introduced legislation which would create a similar economic nexus test to create nexus. Colorado has also been in litigation for over five years on a controversial statute passed in 2010. While this law did not create an economic nexus test, it did require all eCommerce companies with Colorado sales to submit a list of those sales to the state and to prepare notices to customers showing purchases they made and to instruct them to pay the Colorado use tax. This requirement was recently held to be constitutional under the Quill test because it does not require that tax be collected.
The state’s believe that companies who are able to generate $100,000 or $200,000 or more of sales annually without any physical connection with the state still enjoy the benefits and protections offered by the state to other businesses that have a physical connection and that these remote sellers should be required to support these benefits through the collection and remittance of sales tax.
Is this Even Legal?
The legality of the economic nexus tests adopted by these states is the million (or billion) dollar question. In short, (I believe) the states don’t really care whether these are legal or not. In their mind, it’s the law and they will enforce it against whomever they want. “If you don’t like it, sue us!” That’s essentially the statement made by Director of the Alabama Department of Revenue when the law was passed and they turned their sights on Amzaon.com (which is the prime target of all of this). If you think the states are looking for a fight in this area, you are 100% correct. If you think this sounds like a declaration of war against remote sellers and the Direct Marketing Association, you are also 100% correct. In the minds of many state tax administrators, Quill is not relevant, and it’s time to take matters into their own hands.
In the eyes of the taxpaying community, Quill is relevant and is the law. There has been no case that has overturned this opinion and there has been no Congressional action that has negated its legal standing as the benchmark for determining when a company has nexus in a state for sales tax purposes; Quill is still the law, whether the states like it or not.
The states want a fight. In fact, Alabama hopes to be the first state that has its economic nexus rule challenged in court. It wants to be the state that overturns Quill in the Supreme Court, and it’s looking for the first person to challenge the law. Amazon blinked and started collecting tax in January 2016 so there will be no fight there.
Legislation or Litigation
The fight to overcome the power of Quill is progressing down two different paths at the same time; the Congressional legislative path and the anticipated litigation path. This leads to two different questions; which will happen first and which is the best solution. Considering that Congress has been considering legislation since Quill was passed 24 years ago and seems incapable of moving anything through the process, I’m not entirely confident anything will happen in the near term. In case you haven’t noticed, 2016 is an election year which means that no legislation will be passed if it could remotely impact a legislator’s business donor.
Under the legislative path, the current Bill has some “small business provisions” and some other language that is supposed to protect the taxpayer. From what I’ve seen, these bills are written to provide maximum benefit to the state. Despite these issues, legislation will provide a uniform set of instructions for the states and taxpayers to follow. Like them or not, the rules would be the same.
In order for the litigation path to begin, all we need is a plaintiff ready to challenge a sales tax assessment made by one of the states under their economic nexus rules. Litigation does not involve anyone in Congress and can move as quickly or as slowly as the parties and the courts want it to move. Litigation is risky business for both parties, though. Despite their confidence, it’s still possible for some state or federal court to conclude that the economic nexus rules are not constitutional which would push the states to seek review before the U.S. Supreme Court. But, just because the state wants this court to review their case, that does not mean the court will actually hear the case.
The challenging taxpayer also has the same risk. If they challenge the law and lose in court, that could set off an avalanche of other states passing similar laws each with its own state specific nuances which could be worse than the current rules. If the taxpayer is successful in getting the Supreme Court to hear the case, and the Court holds that Quill no longer applies, then watch out.
An unconditional overturning of Quill would make the economic nexus rules irrelevant. In fact, it would make the concept of nexus irrelevant. Without Quill as the backdrop against which all sales nexus matters are evaluated, states would be unencumbered in forcing (not just requiring) every business in the country to collect and remit sales tax in their state on every single transaction that occurs in their state. The costs to businesses to comply and the risk of noncompliance would be crippling.
As I’m watching the state pass these economic nexus statutes, I fully believe they know that many companies, who cannot afford costly litigation, will comply; albeit reluctantly. The cost of not complying and being assessed tax under audit would kill small businesses. The cost of prospective sales tax compliance is cheap compared to an assessment and a court fight. This is clearly a strong-arm tactic but the states have few options left. We’ll see if it pays off.
Companies that are ignore these statutes run the risk of assessments and a costly court fight; but they may win that fight (or they may lose). Quill may withstand a challenge or it may fall. Federal legislation may pass before a court challenge or in the middle of a court challenge; that would be a real mess.
Multistate businesses are caught in the middle of this mess. My remote seller clients want to be in compliance but they also don’t want to be underpriced by competitors that are not charging tax on their remote sales. Just as the brick and mortar retailers are screaming for a level playing field against the remote sellers, many remote sellers are screaming for the same thing as they are forced to evaluate sales tax collection into their pricing model.
Do you have questions, comments or concerns about “economic nexus” and these latest trends in sales tax? Start the conversation in the comments or at our Sales Tax for eCommerce Sellers Facebook group.