In a 5-4 decision, the US Supreme Court today overruled its landmark decisions in Quill Corp. v. North Dakota1 and National Bellas Hess, Inc. v. Department of Revenue of Illinois,2 disposing of the “physical presence” rule that has served as the bright-line standard for whether remote sellers are required to collect state sales taxes. Although the Court made clear its criticisms of the physical presence standard—referring to it as “arbitrary,” “artificial,” and a “judicially created tax shelter”—it was less clear in describing a new standard to replace it.
In 1992, the US Supreme Court held in Quill that a state could not require an out-of-state seller to collect sales or use taxes unless the seller established a physical presence within the state. In so holding, the Court reaffirmed its 1967 decision in Bellas Hess that also applied a physical presence nexus test. These decisions have been attacked by the states as unfair and unnecessarily restrictive of state taxing authority. As a result, states have enacted a variety of laws that challenge the physical presence nexus standard.
Physical Presence Not Necessary for “Substantial Nexus”
In South Dakota v. Wayfair, Inc.,3 the majority opinion authored by Justice Kennedy held that the taxpayer must comply with a South Dakota law (SB 106) that requires an out-of-state seller to collect tax if it makes at least 200 separate sales or $100,000 worth of sales in the state, regardless of whether it has a physical presence. Breaking from Quill and Bellas Hess, the Court concluded that physical presence is not necessary to meet the substantial nexus requirement set out in Complete Auto Transit, Inc. v. Brady.4
While many thought a reversal of the physical presence standard would be based on changing economic realities since 1992—namely the rise of Internet sales—the Court went a step further, characterizing Quill as being incorrect from the outset. Specifically, the Court referred to physical presence as a “false constitutional premise of [the] Court’s own creation,” now finding that physical presence is not necessary to satisfy the Commerce Clause.5 The Court noted that substantial nexus is “closely related” to the “minimum connections” required by the Due Process Clause.6 Although Quill held that the North Dakota law at issue in that case satisfied Due Process but not the Commerce Clause, the Wayfair Court borrowed Quill’s Due Process reasoning and applied it for Commerce Clause purposes.
The Court noted that the Quill Court saw physical presence as a way to protect remote sellers from undue burdens on interstate commerce, such as tax collection obligations in thousands of jurisdictions across the country. But the Court here rejected that interpretation, reasoning that such burdens bear little if any relation to physical presence. The Court explained that under the physical presence standard, a seller with a single salesperson in each state must collect tax in all 50 states, but a seller with hundreds of salespersons in one central location might only have to collect in that one state. Because the former would be more burdened by tax collection, despite its likely smaller pool of resources, the Court referred to physical presence as “a poor proxy” for the undue burden of compliance costs.7
Creating a Level Playing Field
The Court also criticized Quill for establishing a standard that “creates rather than resolves market distortions.”8 The majority characterized physical presence as creating an uneven playing field that favored remote sellers over local businesses and interstate businesses with physical presence in the state. In particular, the Court described physical presence as an incentive to out-of-state sellers to limit their physical presence by not establishing brick-and-mortar stores, distribution centers, or other facilities in the state, while nonetheless making sales to customers in the state.
“Sensitive, Case-By-Case Analysis” Required
Third, the Court reasoned that physical presence promoted an “arbitrary, formalistic” standard rather than a “sensitive, case-by-case analysis.”9 The Court again provided an example, this time where one seller has physical presence due to a small amount of inventory in the state, and another seller does not despite having a “sophisticated website with a virtual showroom” accessible in the state. Under Quill, the first seller would be required to collect, even though its sales were unrelated to its warehouse activities in the state, while the second seller would not, despite its “pervasive Internet presence.”10 The Court rejected this as “anachronistic formalism,” which states attempted to circumvent. The opinion cited the examples of Massachusetts’ proposed regulation that would consider “cookies” on an in-state web browser to be physical presence, New York’s click-through nexus provision, and Colorado’s use tax notice and reporting requirements.
While the Wayfair Court did not mince words in criticizing Quill’s physical presence standard, it was less clear in setting out its own nexus standard, generically calling for a “sensitive, case-by-case analysis of purposes and effects.”11 Perhaps the closest the Court came to articulating a standard is through its references to (and, presumably its reliance on) Wayfair’s “substantial virtual connections” to, “economic and virtual contacts” with, and “extensive virtual presence” in South Dakota.12 However, none of these terms were definitively set out as a standard to guide taxpayers going forward. Perhaps for that reason, the Court (both the majority and dissent) left the door open for Congress to weigh in.
Aftermath of the Court’s Decision
Although the Court clearly rejected Quill’s physical presence standard, it did not hold the South Dakota law constitutional in all respects. Rather, the Court only held that SB 106 satisfies the substantial nexus requirement of Complete Auto as applied to Wayfair. The Court left open on remand whether the law satisfies the remaining prongs of Complete Auto—specifically, whether the tax is fairly apportioned, whether the tax discriminates against interstate commerce, or whether the tax is fairly related to services provided by the state.
The Court laid the groundwork for why taxpayers might not succeed on such arguments—for example, that the South Dakota statute at issue set a safe harbor threshold of sales, would not apply retroactively, and adopted a Streamlined Sales and Use Tax Agreement system that simplifies administration by applying uniform definitions, simplified rates, and centralized collection by the state rather than by each locality.13 It remains to be seen how the Court’s decision will apply to safe harbor thresholds lower than South Dakota’s, if states seek to require collection retroactively, or in non-Streamlined states.
For now, South Dakota likely remains enjoined from collecting the tax despite today’s decision, as SB 106 itself provides that the filing of a declaratory judgment action by the state operates as an injunction during the pendency of the action, not just against Wayfair but against all taxpayers who lacked physical presence and did not voluntarily collect. While the case is on remand to the South Dakota Supreme Court to determine whether SB 106 satisfies the Court’s remaining Commerce Clause doctrine, the injunction will likely remain in effect.
However, at least a dozen other states including Connecticut, Georgia, Illinois, and Massachusetts passed similar laws modeled after SB 106, some of them “triggered” by the Court’s reversal of Quill. It also remains to be seen whether those states will begin collection enforcement immediately or wait for further developments regarding SB 106’s constitutionality under other Commerce Clause principles.