A New York appeals court ruled that a trial court incorrectly dismissed a lawsuit brought by Amazon and Overstock challenging on constitutional grounds a state law that requires online retailers to pay sales tax on purchases by New York state residents.

The trial court had dismissed the suit, which was brought by the online retailers in 2008 after New York amended its tax law.

The new tax law required companies like Overstock and Amazon to collect sales tax on items shipped to New York addresses even when the retailer has no offices or employees in the state.

Both companies use New York-based “affiliates” or “associates” that receive a commission for sales made by referrals.

The companies argue that the presence of these individuals in New York does not meet the constitutional requirement that a retailer must have a “physical presence” in the state before the collection of sales tax is required.

On its face, the law survived the constitutional challenges, the court said.

But as applied to Amazon and Overstock, the court said it was unable to conclude that the plaintiffs’ “in-state representatives are engaged in sufficiently meaningful activity so as to implicate the state’s taxing powers, and thus should be given the opportunity to develop a record which establishes…whether their in-state representatives are soliciting business or merely advertising on their behalf.”

It remanded the case to the trial court, where Amazon and Overstock must establish whether their New York-based affiliates and associates are merely passive advertisers not subject to the tax law, or whether they engage in activity that “goes beyond mere advertising and actually amounts to solicitation.”

To read the court’s decision in Amazon v. New York State Department of Taxation and Finance, click here.

Why it matters: The court’s decision was a mixed bag for online retailers. While the court revived part of the suit, it declined to invalidate the law itself. Amazon and Overstock must still establish that they are “passive” advertisers, which would make the law unconstitutional as applied to them. Given the examples provided by the appellate court as to what constitutes direct solicitation on the part of the companies – “distributing flyers, coupons, newsletters, and other printed promotional materials, or electronic equivalents” – it could be an uphill battle for Amazon and Overstock. If they lose the case again, the companies could choose to end their affiliate relationships in the state of New York. Amazon has already stopped working with affiliates in North Carolina and Rhode Island, which enacted similar tax laws.