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Landmark Supreme Court Decision Clears the Way for Online Shoppers to Pay Sales Tax Nationwide


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6/24/2018
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Landmark Supreme Court Decision Clears the Way for Online Shoppers to Pay Sales Tax Nationwide

On June 21, 2018, the U.S. Supreme Court struck down the “physical presence” test of Quill and National Bellas Hess which barred states from imposing sales tax on out-of-state sellers who did not have sufficient in-state operations, reversing 25-years of jurisprudence.  The decision is South Dakota v. Wayfair, 585 U. S. ____ (2018). 

Online shoppers will face a tax hike to the tune of $15bn plus.  Small home-based sellers selling on eBay and Etsy will be crushed by the ruling.  Large national retailers will see decreased competition from small sellers who can’t absorb the cost of compliance with 12,000 separate taxing jurisdictions, leading to oligopoly.  Small businesses selling online will face steep barriers to entry with compliance costs making online sales out of reach for many.  Marketplaces like Amazon Marketplace will be tasked with supporting tax compliance services for sellers.  Software vendors will see demand skyrocket, and with their services in demand, are likely to raise their rates, further limiting the ability of small businesses to compete.  And the landscape will continue to change.

The Supreme Court’s Rationale For Allowing Taxation of Online Sales

Historically, online sellers did not have a sales tax obligation in a given state if they had no “nexus” to that particular taxing jurisdiction other than shipping product there.  “Nexus” was legal jargon for a physical presence, local office, sales force, and/or advertising campaign within the state.  Deriving the state’s benefits from being there.  In short, boots on the ground.  Quill v. North Dakota, 504 U.S. 298 (1992)(out-of-state sellers generally meet nexus standards if they have an office or place of business, agent, or significant property in the taxing state).[1]   All a remote seller had to do was ship from a remote location and have office operations in another, and a business could avoid sales tax in most jurisdictions nationwide.    

The Court discarded the “physical presence” requirement emphatically, calling it “anachronistic” and an “error” that led to a “judicially created tax shelter.”  The Court found that Quill “prevented … an even playing field,” disadvantaged brick-and-mortar businesses, “prohibit[ed] the States from exercising their lawful sovereignties,” and created market distortions favoring remote out-of-state sellers and disfavoring small Main Street shops who historically had greater sales tax collection requirements than large national operations like Amazon.

The Cost of Compliance

To state the problem in its simplest form: Mark’s Bongo Shop, with one storefront on Main Street, shipping specialized Bongo drums nationally to schools and marching bands, now has the same sales tax compliance obligations as Guitar Center.  How can Mark’s Bongo Shop absorb that cost and still compete?

Justice Breyer was very concerned about the costs of compliance for small business… which ironically fall on the same Main Street shops the Supreme Court said it was championing with the ruling.  Justice Breyer asked, “what does it cost for a mandolin seller who sells mandolins on the Internet to sell them in 50 states?  How much does it cost to sell them in 50 states?  How much does it cost him to enter that market?”[2]

Online Mandolin sellers?  It’s a thing.  We looked it up.  https://themandolinstore.com/

Justice Santomayor drilled down on the issue of costs:

“I -- I'm talking about the added cost of doing business for the small businessman, someone -- one of the briefs said it was a $250,000 cost to implement one of these sales programs, one of these sales tax programs?That doesn't include auditing. It doesn't include integrating the program with the existing sales program of the company. It doesn't account for the maintenance of the program. There's lots of costs that are inherent in a process of this type.”

A simple example shows what we already know – the costs are steep.  The South Dakota law that kicked-off the debate imposes sales tax on any seller who has over $100,000 in sales or at least 200 separate taxable transactions in the state.  The average internet transaction is $84 and 200 sales under the South Dakota statute would mean total sales of about $17,000.  Thus, a company with $17,000 of gross sales in South Dakota would have a sales tax collection and reporting requirement. 

Moreover, the initial cost of compliance was estimated by Wayfair at about $250,000 for small businesses operating nationwide.  Dividing that estimated figure by 50 states, the per state cost would be about $5,000 per state or a 30% compliance cost on our hypothetical mandolin seller’s South Dakota sales.  Add 6% sales tax, sales tax system maintenance, operating costs, Federal and State income taxes, payroll and the like and the effective tax rate and tax compliance cost is well over 50% on these estimates. 

Certainly, costs in these percentages will have a chilling effect on small businesses that want to participate in online sales.   Unlike their larger competitors, small businesses are not well situated to absorb implementation costs and cannot scale-up efficiently to streamline, economize, and spread ongoing compliance costs across operations.

A GAO Sales Tax Study[3] found that there are 12,000 separate sales tax jurisdictions in the United States, each with their own rules, compliance forms, and special enforcement regimes.  Wayfair’s brief cites an expert report filed in litigation that projects initial implementation and integration cost for a small to medium-sized business selling nationwide at $80,000 and $270,000, and annual costs of $57,500 to $260,000. South Dakota claimed the initial cost is $12.  South Dakota claimed that TaxCloud.net software could manage the complexity!  The site claims to handle all state and local tax rules and has a price point starting at $9/mo.  But, that is only for 1,000 transactions and a limited reach.  The price ramps up quickly to $6,000/yr and more for a minimal number of sales.  Moreover, the site categorically failed to get it right, dramatically overestimating sales tax owed, using a New Jersey example that Wayfair cited.[4]

Justice Breyer zeroed-in on the issue of sales tax compliance complexity and burden on small businesses even within the laws of a single state: “you have wildly different estimates of costs, revenues, and what states are losing or not”; “can you [find the correct tax rate] on the Internet [using software] – [the respondents] say there are 12 mistakes, even in South Dakota.”

As a sales tax practitioner, I can attest to the fact that the sales tax laws are byzantine patchworks of random legislative determinations that have no rhyme or reason to them, which are not governed by any ascertainable paradigm or structural wisdom, and which no intelligent person could ever comprehend or anticipate without referencing specific code provisions (which themselves are written in such a way as to baffle even the most highly-educated).  Even the informational bulletins and enforcement pamphlets promulgated by the various revenue offices in different states to bring clarity to the issue are difficult for a professional to understand, and beyond the reach of most laypeople. 

To expect a Main Street construction company run by a former foreman of construction jobs to understand all of the subtlety and nuance of the sales tax laws that apply to his business is unrealistic.  His only choice for compliance is to get expensive specialized sales tax software (which the business is then beholden to and reliant on for their life’s blood), consult with a tax attorney at $500+ per hour to opine on and structure how sales and sales offerings should be set-up, pay ongoing bookkeeping and accounting fees to run the system, as well as setting up internal controls to manage the collection and remittance of tax and payment to each separate taxing jurisdiction.  These compliance costs cut into the businesses revenues and decreases the company’s competitiveness vis-à-vis larger market players.  That is the burden to comply with one’s home state’s laws and any neighboring state’s one operates in.  For online sales across state borders, that burden is magnified exponentially.

If anything became clear from the oral arguments in South Dakota v. Wayfair, and the associated briefs, it is this: Software is woefully inadequate to order this chaos and eliminate the burden.  eBay’s amicus brief explains that “[s]light product differences can engender significant taxability issues”—in Minnesota, blankets are taxable, but baby receiving blankets are not; deodorant is taxable in Texas, but deodorant with antiperspirant is not; tax rates can vary by price (in Connecticut, dresses over $1,000 carry a higher tax rate), by use (in New Jersey, yarn for art projects is taxed but yarn for clothing is exempt); and by ingredients (Snickers are taxable in Illinois but Twix are not because items containing flour are not categorized as candy).  eBay’s amicus brief also noted that by geographic area complexities abound: Citing to a nearly 2% additional tax differential within the Kansas City suburb of Bonner Springs depending on zip code: “If a seller uses Bonner Springs’ five-digit zip code 66012, it will charge 7.5% state and local sales tax. But if the seller uses the nine-digit zip code 66012-1402 (still Bonner Springs), the rate will increase to 9.25%.

The GAO Sales Tax Study also found that sales tax audits of small businesses often identify non-compliance and produce revenue (since few small businesses have any hope of complying with all legal requirements or having a 100% rate of accuracy in capturing all sales transactions properly).  In a survey of sales tax professionals and attorneys, the GAO found that assessments prepared by revenue offices generally carry a presumption of accuracy.  In practice, this places the burden of proof on the retailer to rebut claims made by revenue offices.  A business representative explained that the CPAs and attorneys they employ, or have on retainer, may not be able to represent the business in an out-of-state venue.  As such, businesses would need to retain counsel qualified to practice in the assessing jurisdiction.

In short, every business in the United States is looking at several thousand dollars per state for new software, implementation, and integration, costs for having to have CPAs and attorneys retained in each-and-every state in which they do business for addressing inquiries from state revenue offices, sales tax registration and filing fees in all 50 states, and having staff to deal with all of the compliance and regulatory requests of each separate revenue jurisdiction on an essentially full-time basis.  We are talking hundreds of thousands of dollars of additional costs per year for even the smallest of sellers.  Someone selling trinkets out of their home office might expect $200,000 or $300,000 of compliance costs if they aim to comply with the laws of all 50 states and the 12,000 separate sales tax jurisdictions nationwide and thereby sell to anyone interested in their product across the country.

The Empirical Evidence

From the tone of the justices, one might conclude that local sellers are bearing the brunt of the national sales tax burden and large companies are getting away with murder.  Nothing could be further from the truth.

The Government Accountability Office concluded in a detailed study issued in November 2017 that “[m]any of the largest Internet sellers are established retail chains or consumer brands with a physical presence, such as retail stores, in all, or nearly all, of the 45 states (plus the District of Columbia) that have a statewide sales tax.” As a result, the GAO found that states already receive sales/use tax on between 87 and 96 percent of sales by the top 100 online retailers. And that is the vast majority of sales tax on online sales: The GAO estimates the uncollected sales tax for 2017 at between 2 and 4 percent—and says that more tax is being collected on online sales than on other types of remote sales (such as those via telephone and mail order). See GAO Sales Tax Study.

The empirical evidence suggests that 2-4% tax gap on sales tax consists almost entirely of small businesses or start-ups trying to compete against industry giants for a small amount of market share.

A $15.2 bn Tax on Online Shopping

A managing partner with Global Retail said, “The losers from the ruling are online-only retailers, especially smaller players, and consumers who will end up paying more for products. By our calculation, the additional costs for consumers could be up to $15.2 billion a year."

Barriers to Entry for Main Street Businesses

A heated exchange between Justice Breyer and the United States Solicitor General, Malcolm L. Stewart, on the issue of costs went as follows:

“JUSTICE BREYER: All right. But, look, the -- the part that's bringing me there, which I really think we can't do after reading these briefs, is what they -- their side puts up a certain specter which I'm sensitive to, which is that we have four or maybe five giant potential retailers in the country; I mean, there could be a very small number selling virtually anything. And they sell over the Internet. And the hope of preventing oligopoly, et cetera, is small business, which finds it easy to enter. Now you raise with this entry barriers, and they say a lot and you say a little. And I don't know if it's a little or if it's a lot. And if it is a lot, there might be ways of putting minimums in that would, in fact, preserve the possibility of competition and the possibility of new entry, stopping the entry barriers from raising too high. Now that's something the Antitrust Division could testify about, but they're not going to testify here. And so that's the kind of problem that worries me.

MALCOLM L. STEWART (U.S. as Amicus Curiae): Well, let me say two or three things about that. The first is that the GAO report said that something like 80 or 90 of the 100 biggest Internet retailers are paying their state sales taxes. So it's -- it's big companies, but it's not just the -- the four or five biggest giants. And so the question is kind of how far down the line do you go? How small does a company have to become in order for the – the burden of collecting state sales taxes to – to be substantial as -- as a practical matter? And, you know, a front-line answer is the dormant Commerce Clause doesn't entitle a fledgling business to the ability to make a profit if the obligation to collect sales taxes in various states pushes it from making a profit to -- to sustaining a loss. That's not a constitutional defect. But the other thing we would say is nobody on the other side is really seriously contending that the South Dakota law in and of itself places exorbitant burdens. And, indeed, nobody on the other side is even contending that if every state did exactly what South Dakota has done, that the burdens would be exorbitant.

JUSTICE ALITO: But South Dakota law is obviously a test case. You know, it was -it was devised to present the most reasonable incarnation of this scheme. But do you have any doubt that states that are tottering on the edge of insolvency and municipalities which may be in even worse position have a strong incentive to grab everything they possibly can?

Later in the argument, George S. Isaacson, counsel for Wayfair, argued further about barriers to entry would chill access to nationwide online sales for most small businesses:

MR. ISAACSON: The -- the problem, Justice Kagan, is that a number of the functions that I described simply cannot be performed by software. So, for example, if you need to collect resale and other forms of exemption certificates, states require that those be physical papers that -- that you collect. There's no software solution to that. If -- if a state is coming in to audit you, software doesn't solve that for you in -in any respect. So software can do certain functions, and those functions might improve by entrepreneurial initiatives, but they're not going to solve these other issues. And what will happen, because of the substantial expense that's associated with this, is that small and mid-sized companies will be deterred from entering that market. They have a choice. They can either invest in opening a store within the state and foregoing a national market, or they can develop a website and sell to a national market. The Commerce Clause was the promise

JUSTICE GINSBURG: But they say if they open a store within the state, then they're hit by these remote sellers, and so their store in the state is suffering. It is the small business person inside the state that's suffering.

MR. ISAACSON: It's interesting, Justice Ginsburg, that, currently, over 70 percent of all small businesses have a website. And by the end of 2018, it's estimated that 91 percent of small businesses will have a website. So the issue here is not between small in-state retailers and out-of-state direct marketers. The real competition is between the large companies, who are Omni merchants, who are multi-channel merchants, who are increasingly dominating the Internet. And one of the effects, if you increase the cost of admission, if you have barriers to entry, one of the inevitable effects is going to be that those small and medium-sized companies are going to be deterred and there will be even greater concentration by the largest retailers. Again, I think that is antithetical to what the objectives of the Commerce Clause were. The arguments that the United States made, I think, raise some very disturbing notions of what the future would -- would look like. The notion that Mr. Stewart presented that there is no constitutional minimum, if the Court overturns Quill, that any single sale would obligate a company to then comply with the particulars of that jurisdiction's tax, would really mean that you'd have most smaller merchants say that's not a -- a function that we can assume at an economic basis.

Winners & Losers

Winner: Large Retailers – Large retailers including Walmart, Costco, Lowe’s, Home Depot, Apple, Macy's, and Target which have brick-and-mortar stores nationwide and operate on a multi-channel basis, already generally collect sales tax from their customers who buy online and have systems that address the complexity in all 45 taxing states. That's because they typically have a physical store in whatever state the purchase is being shipped to. Amazon.com, with its network of warehouses, also collects sales tax in every state that charges sales tax.  But, Amazon’s third-party sellers who use the site to sell their own goods don't have to.  The National Retail Federation trade group called the decision a “Major Victory.”

Losers: Small Online Sellers – Small online sellers using platforms like eBay or Etsy to sell their goods typically don’t charge & collect sales tax.  Now they will have to collect sales tax nationwide and comply with a complex thicket of laws that no one without substantial investment capital and expensive software could ever hope to master and comply with.

Commentary: Will the Ruling Hurt Online Sales?

Sucharita Kodali, a retail analyst with Forrester, called the ruling "bad news" for online retailers and those that shop online. "Now those companies have to assess taxes on customers or they get sued. For products like furniture, jewelry, electronics, people will likely start to shop local again," she said. 

I don’t know if I agree.  As the empirical data suggests, you are already paying sales tax on most online purchases without even knowing it since the “major retailers” are already charging it.  So, no, I don’t think people will start shopping local again.  Nor do I think a few extra dollars will make the difference between buying online and going to the store.  But, what is likely is you will buy less overall as your spending power has diminished and you are no longer saving on small items, and what is likely is that small businesses trying to compete, who previously enjoyed a slight price advantage over large national retailers, may be frozen out of the market.

If you’ve ever shopped for a book on Amazon you can choose a discounted price from a “discount seller” or “buy used.”  But, the discount sellers that are offering this service (often through drop shipping the items) may also choose not to charge sales tax because they have no “nexus.”  That will change.  But, discount sellers seeking to arbitrage prices and make a buck as a “reseller” will still abound in the internet era.  As Gary Vaynerchuk points out fairly frequently –https://twitter.com/garyvee/status/817125572325347329?lang=en – anyone looking to make a buck can buy a $1 item at the dollar store and sell it for $3 on eBay and make a few dollars doing so.  Why?  People pay for time and convenience.  They would rather buy an item at a steep premium than spend the time and energy to search for it locally at a fair price.  The number of convenience stores is always increasing.  It is fast and they have what you want when you want something.  This is the same benefit from online sales.  A soda, tea or coffee at a convenience store may be 1.5 times as expensive as your local grocery store, but you pay the premium for convenience.  An online item, even if it is more expensive, is available now, when you want it, and you can comparison shop and research the item while you’re buying.

States are expected to quickly clamor to impose new legislation to take advantage of the availability of sales tax on remote sellers in order to broaden their tax bases.  An avalanche of challenges to test the limits of the new law are expected in states across the country.

Additional Reading:

https://www.thestreet.com/markets/online-retailers-hit-by-supreme-court-ruling-requiring-sales-tax-collection-14629295

https://fedsoc.org/commentary/blog-posts/south-dakota-v-wayfair-concerns-and-consequences-on-state-taxation-and-online-commerce

https://www.theverge.com/2018/6/22/17493298/supreme-court-internet-sales-tax-congress-amazon-etsy-ebay

https://www.youtube.com/watch?v=lPKQtvLdM78

https://taxfoundation.org/potential-outcomes-wayfair-online-sales-tax-case/

https://www.nytimes.com/2018/06/21/opinion/supreme-court-wayfair-south-dakota-online-shopping.html

http://money.cnn.com/2018/06/21/technology/wayfair-vs-south-dakota/index.html

https://itep.org/state-rundown-6-21-wayfair-decision-is-way-fair/

 

 

[1] New York's nexus law defines an out-of-state vendor having “nexus” with the state to include a person who solicits business “by distribution of catalogs or other advertising matter, without regard to whether such distribution is the result of regular or systematic solicitation,” and if because of the solicitation the person makes taxable sales into New York.

[2] Oral arguments can be listened to here – https://www.youtube.com/watch?v=lzX890NzfkM

[3] U.S. Gov’t Accountability Off., GAO-18-114, Sales Taxes: States Could Gain Revenue from Expanded Authority, but Businesses Are Likely to Experience Compliance Costs 3 (2017) (GAO Report).

[4] Wayfair Brief at Pg. 9: “Although TaxCloud.net correctly computed the New Jersey sales tax rate for “clothing” as 0%, it incorrectly computed the rate for “scarves” as 6.25% (TaxCloud.net category “Clothing: scarves”). The correct rate for scarves sold into New Jersey is 0%. Notice: Sales and Use Tax Exemption for Clothing Under the Streamlined Sales and Use Tax Law, N.J. Div. of Taxation, 1 (revised 9/1/06), perma.cc/XX8S-4PU8. A vendor using the TaxCloud.net software touted by South Dakota in its brief therefore would have over-collected New Jersey sales tax on its sale of scarves—an error, as we explain below (infra, pp. 13-14), that would subject the seller to suit by overcharged purchasers.4 See GAO Report at 17 (noting similar examples).”



Category: Tax Law


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