Taxing Online Sales: What You Need to Know

Online sales were once regarded as one of the last bastions safe from taxation. But are they really? While many online retailers have not previously collected tax for online sales transactions (nor have they been required to, if certain conditions are met), many people do not realize that the consumers themselves are actually obligated to pay the sales or use tax and report it themselves. Not surprisingly, few do.

Moreover, times are quickly changing, as laws at both the state and federal level, are moving towards enforcing the collection of online sales tax.

Quill v. North Dakota and the "Substantial Nexus" Test

The seminal case in this area of law is Quill v. North Dakota 504 U.S. 298 (1992). In Quill, the U.S. Supreme Court held that an out-of-state mail-order house that had neither outlets nor sales representatives in North Dakota was not obligated to collect and pay a use tax on goods purchased for use within North Dakota.

Writing for the majority, Justice Stevens reasoned that the Due Process clause did not bar enforcement of the use tax because Quill had purposefully directed its activities at North Dakota residents and those contacts were more than sufficient for due process purposes. However, under the Commerce Clause, a corporation must have a "substantial nexus" with the state in order to subject it to a tax, like the one North Dakota was attempting to impose on Quill.

The court affirmed prior precedent which held that companies whose only connection to the state is through a common carrier or the United States mail are free from state-imposed duties to collect sales and use taxes. As such, Quill, who did not have a physical presence in the state, did not have a substantial nexus with North Dakota. Therefore, the Court concluded that the State's enforcement of the use tax against Quill placed an unconstitutional burden on interstate commerce.

The court noted that Congress could enact legislation to change its ruling and in fact, clarified that the Due Process Clause did not prevent Congress from so doing: "Congress is now free to decide whether, when, and to what extent the States may burden interstate mail-order concerns with a duty to collect use taxes."

Although this case involved a mail order company, its holding has been applied to online retailers as well, thus limiting the enforcement of state sales and use taxes to those companies that maintain a "physical presence" within a state.

New York High Court Broadens Reach of the Substantial Nexus Test

New York amended its Tax Law in 2008, so that its Internet tax defined a vendor subject to the tax as a person making sales of tangible personal property or services taxable under the law who is presumed to be soliciting business through a resident if the resident, for commission or other consideration, directly or indirectly refers potential customers, by a link on internet website or otherwise, to the seller, and if the cumulative sales to customers in the state who are referred by this agreement with the seller exceeds $10,000 in prior four quarters. The presumption could be rebutted by evidence that "that the resident with whom the seller has an agreement did not engage in any solicitation in the state on behalf of the seller that would satisfy the nexus requirement of the United States Constitution during the four quarterly periods in question."

In Amazon.com LLC v. New York State Department of Taxation and Finance, decided on March 28, 2013, the New York Court of Appeals upheld this Internet tax as constitutional. Amazon.com and Overstock.com had challenged the tax, claiming that it violated the Commerce Clause by subjecting online retailers who did not have a physical presence in New York to the state's sales and use taxes. They also argued that the tax violated the Due Process Clause.

Amazon.com had an "Associates" program where third parties would place links on their own websites that would send those who clicked on them to Amazon. These associates were compensated on a commission basis. Overstock.com operated an "Affiliates" program, which was similar to Amazon's.

The Court noted that the physical presence test of Quill may be outdated given the ability of companies to impact another jurisdiction solely through the Internet, but opined that it was a question for the U.S. Supreme Court to revisit.

Prior New York case law held that physical presence need not be substantial, but the requirement would be satisfied if "economic activities are performed in New York by the seller's employees or on its behalf." Applying this standard, the Court found that the statute easily satisfied the substantial nexus test.

The record indicated that many websites, such as radio stations, religious institutions and schools, urged their local constituents to support them by making purchases through their Amazon links.

"The bottom line is that if a vendor is paying New York residents to actively solicit business in this State, there is no reason why that vendor should not shoulder the appropriate tax burden." However, the Court also recognized that the substantial nexus test would not be met if New York residents merely posted passive advertisements on their websites.

Judge Lippman further noted that, "Although it is not a dispositive factor, it also merits notice that vendors are not required to pay these taxes out-of-pocket. Rather, they are collecting taxes that are unquestionably due, which are exceedingly difficult to collect from the individual purchasers themselves, and as to which there is no risk of multiple taxation."

The companies' due process claims also failed because the "brigade of affiliated websites compensated by commission" was sufficient to subject them to the jurisdiction of the state, and because the statutory presumption was not irrebutable as they claimed.

Seventeen other states have enacted some type of "nexus" laws, according to the National Conference of State Legislatures.

There is also a significant movement to create a federal law that would create one single system for the collection of these taxes.

Streamlined Sales and Use Agreement

The Streamlined Sales and Use Tax Agreement is a multistate agreement for the administration and collection of sales and use taxes. It was adopted on November 12, 2002 and went into effect in 2005. The Agreement is a voluntary program that seeks to make it easier for companies to collect tax in the participating states.

According to the National Conference of State Legislatures, 24 states have enacted the legislation.

Marketplace Fairness Act of 2013

The most recent development is The Marketplace Fairness Act of 2013, the Congressional attempt to answer the invitation set forth in the Quill case. The bill passed the Senate on May 6, 2013.

The bill would require online retailers whose annual sales exceed $1 million to collect and remit taxes on "remote sales" and remit them to the appropriate jurisdiction.

Important points in the legislation include:

  1. "Remote sales" are defined as a sale of goods or services into a state in which the seller would not legally be required to pay, collect, or remit state or local sales and use taxes unless provided by this Act.
  2. Any online company with less than $1 million in annual revenue will be exempt from the law.
  3. States must implement certain minimum simplification requirements, including providing a single entity responsible for all state and local sales and use tax administration, a single audit of a remote seller for all state and local taxing jurisdictions, and a single sales and use tax return to be used by remote sellers to be filed with the single entity responsible for tax administration.
  4. States must provide online retailers with free software that is capable of calculating and filing sales and use taxes.
  5. Online retailers and certified software providers may be relieved of liability if there is an error in calculation, remittance or non-collection of the taxes, under certain specified conditions.

The Marketplace Fairness Act has not yet passed the House.

In the meantime, more courts will likely continue to interpret the "substantial nexus" test set forth in Quill, and expanded by the New York court. As states seek revenue so desperately needed, the end of the tax-free Internet era seems to be quickly approaching.