Earlier today, the U.S. Supreme Court issued its ruling in South Dakota v. Wayfair, Inc., in which the Court overturned a long-standing precedent and ruled that a business need not have a “physical presence” in a state in order to be subject to its tax jurisdiction.
In two prior cases, National Bellas Hess, Inc. v. Department of Revenue of Ill., 386 U.S. 753 (1967), and Quill Corp. v. North Dakota, 504 U.S. 298 (1992), the Court ruled that in order for a state to impose sales tax on goods sold by a business within the state, the Commerce Clause requires that the business have a “physical presence” in the state (e.g., real estate or employees within the state). Although states could not impose sales tax on a business without a physical presence, states could still require the consumers within the state to pay use tax on goods purchased for use within that state. In the decades since the Quill decision, however, e-commerce has dramatically expanded, and states have been left with significantly reduced sales tax revenue as compliance with use tax rules by consumers has been low.
In response to this loss of revenue, South Dakota enacted a statute in 2016 that required an out-of-state seller to collect and remit sales tax “as if the seller had a physical presence in the state” if that seller had more than $100,000 in sales of goods or services or engaged in 200 or more separate transactions for goods or services within the state on an annual basis (the “Statute”). South Dakota requested declaratory judgment in its state courts that the Statute was valid, but the state courts agreed with several out-of-state retailers, finding that the Statute was unconstitutional pursuant to the Bellas Hess and Quill decisions.
The Court in Wayfair, in a 5-4 decision written by Justice Kennedy, agreed with South Dakota and overruled its decisions in Bellas Hess and Quill, finding that the “physical presence” rule was an incorrect interpretation of the Commerce Clause. In reaching this decision, the Court found that the “physical presence” rule created market distortions by incentivizing businesses to limit their physical presence in multiple states and imposed arbitrary distinctions among retailers operating within a state that may have a small physical presence (who could be subject to the state’s sales tax) and retailers that may have a large Internet presence with significant sales within the state but that do not have a physical presence (who could not be subject to the state’s sales tax). Given the reality of modern e-commerce, the Court found that the “physical presence” test was no longer tenable.
Because the Court overruled Bellas Hess and Quill, the remaining test for whether a state may impose sales tax on a business is found in Complete Auto Transit, Inc. v. Brady, 430 U.S. 274 (1977). The test provided in that case asks whether the tax (a) applies to an activity with a “substantial nexus” to the state imposing the tax, (b) is fairly apportioned, (c) does not discriminate against interstate commerce, and (d) is fairly related to the services the state provides. The Court notes that the Statute clearly satisfies the first prong of this test given that the $100,000 in sales or 200 transactions minimum requirements limit the reach of the Statute to those businesses with substantial activity within South Dakota, though whether the Statute satisfies the Complete Auto requirements will be determined by the South Dakota courts based on the Supreme Court’s decision today.
It is likely that many other states will reconsider their laws regarding the taxation of e-commerce in the coming months based on today’s decision. Businesses operating primarily through e-commerce across multiple states should pay close attention to how states respond to today’s ruling in order to ensure that they have complied with any registration, collection and payment requirements in states where tax may now be imposed either as a direct result of this ruling or as a result of any changes in state law in response to this ruling. O’Melveny & Myers LLP can assist clients with analyzing and complying with any new sales tax requirements imposed as a result of today’s decision.