Supreme Court Prepares to Reconsider Limits on State, Local Tax Authority

The U.S. Supreme Court this week will turn its attention to a case involving the power states have to capture taxes on internet sales, a long-simmering issue with implications for billions of dollars of state and local budget revenue.

Arguments are scheduled for Tuesday in the case, known as South Dakota v. Wayfair, Inc.

Wayfair sells home goods, like furniture and rugs, online. Two other online retailers, Overstock.com, Inc. and Newegg, Inc. are also involved in the proceedings. The legal dispute centers on a state law the South Dakota legislature passed in 2016 requiring out-of-state retailers that meet certain conditions to collect and pay sales taxes.

The case offers the court a chance to revisit a legal standard it established before the rise of online commerce. This precedent blocks states from collecting sales tax from companies that don't have an in-state “physical presence”—like offices, warehouses or employees.

“It’s significant. This has been an issue going on 26 years,” Richard Auxier, a research associate in the Urban-Brookings Tax Policy Center at the Urban Institute, said of the Wayfair case.

When out-of-state online sellers forgo collecting and paying sales taxes to states, the responsibility for paying the tax typically shifts to consumers. But compliance is low on this front.

Two previous Supreme Court decisions provide key legal underpinnings for the physical presence rule. The most recent was the 1992 decision in Quill Corp. v. North Dakota. It reinforced a ruling in the 1967 case National Bellas Hess v. Department of Revenue of Illinois.

Quill and Bellas Hess both focused on companies with mail order, catalog sales operations. One of the amicus briefs filed in the Wayfair case points out that the Quill ruling was issued about two years before the world’s first secure retail transaction took place over the internet.

Online retail has evolved dramatically since then. U.S. e-commerce sales during 2017 checked in at an estimated $453 billion, according to U.S. Census Bureau figures. That total marked a 16 percent increase from the year prior. But e-commerce still only accounted for about 9 percent of the nation’s overall retail sales in 2017.

South Dakota argues in court filings that the “legal rationales” for the Quill standard “have imploded with experience,” while “its practical impacts have exploded with the rapid growth of online commerce."

The state warns of "crushing harm on state treasuries and brick-and-mortar retailers alike" resulting from the rule.

But Wayfair and the other firms involved in the case contend that Congress is best suited for making changes to the physical presence rule. And that: “The State has not overcome a basic truth: state sales and use tax systems remain inordinately complex and burdensome during the Internet era, just as they were before it began.”

A report the Government Accountability Office issued last November estimates state and local governments could have gained $8 billion to $13 billion in 2017 if states had the authority to require sales tax collections from all out-of-state “remote sellers,” like online retailers.

GAO says those amounts are equal to between 2 percent and 4 percent of total state and local revenues in 2016 from general sales tax and gross receipts tax—a tax similar to sales tax.

The companies in the Wayfair case highlight GAO findings that indicate states already receive tax on between 87 percent and 96 percent of sales by the top 100 online retailers.

Amazon, for instance, now collects and pays sales tax in all states where the tax is imposed—though the company does not do this for sales by third-party vendors using its platform. Wal-Mart, another big player in online retail, is on the hook for the taxes from its internet sales in states where it has stores and other facilities.

Lisa Soronen, executive director of the State and Local Legal Center, a group that files amicus briefs in support of state and local governments in the U.S. Supreme Court, voiced doubt the court will decide Wayfair “on some esoteric view of the dormant Commerce Clause, and how it intersects with due process."

"I think it’s going to be on more pragmatic considerations,” she said.

Among the possible considerations for the Supreme Court justices, in her view: “do we need to swoop in and save the states if there’s really not that much money on the table?” Or, conversely, “if we’re already so close to compliance, why don’t we just make it official?”

A tenet of the Quill and Bellas Hess Supreme Court decisions is that applying state and local sales taxes to out-of-state retailers threatens to chill interstate commerce, potentially saddling companies with unwieldy tax requirements across thousands of local jurisdictions.

“The many variations in rates of tax, in allowable exemptions, and in administrative and record-keeping requirements could entangle National's interstate business in a virtual welter of complicated obligations,” says the majority opinion in the National Bellas Hess case.

South Dakota said in its petition to have the Wayfair case heard before the Supreme Court that improved technology eases costs and difficulties for retailers to calculate and collect sales taxes, and that “practical realities have radically changed since 1967 and 1992.”

The state also touts work by the Streamlined Sales Tax Governing Board, an initiative aimed at making it cheaper and easier for remote sellers to collect sales taxes across jurisdictions.

But the companies counter that even with modern tax software it would still be burdensome and expensive to comply with sales tax rules across thousands of local governments.

And they argue that states that have signed onto an agreement that was crafted as part of the streamlined sales tax initiative only have about one-third of the nation’s population.

Hayes Holderness, an assistant professor at the University of Richmond School of Law, said “the problem with the physical presence rule has always been that it actually doesn't do a very good job of telling us when undo burdens on interstate commerce exist.”

He added: “It’s an easy to administer, bright line rule. But it’s actually not doing what we wanted it to do.”

Holderness suggested that a more effective alternative to the physical presence rule might consider the size and activities of a retailer.

The South Dakota law that prompted the Wayfair case takes factors like these into account in determining the companies that are required to pay sales tax. It’s written to only apply to retailers with over $100,000 of sales, or 200 separate transactions, in the state annually.

Wayfair and the other companies say the average value of an internet order is around $84, and point out that a retailer with 200 transactions at that price level in South Dakota would have receipts of $16,800.

“The statute will sweep in many small businesses,” they add in a court brief.

The South Dakota law also specifies that it is not meant to be applied retroactively, on past sales that went untaxed. But Wayfair and the other merchants flag the possibility of states and localities elsewhere seeking back sales taxes as a sizable risk.

They say if the physical presence rule is nixed it could expose thousands of companies to “crippling” retroactive tax liability.

Holderness described the retroactive tax issue as a major element in the case.

“It would be great if the court just came out and said: ‘this only applies prospectively,’” he said. “Traditionally the court has been reluctant to do that.” But he noted there are avenues the justices could potentially take to avoid getting tangled in this retroactivity issue.

“Part of the problem that South Dakota is going to face is that it's trying to overturn legal precedent,” Holderness added. “That's never easy.”