Supreme Court overturns physical presence requirement

A U.S. Supreme Court decision was recently issued, overturning its prior ruling on sales tax, which until now has been a foundational ruling in applying sales tax rules across multiple states.

In South Dakota v Wayfair, the Supreme Court ruled that the physical presence standard should not apply when states look to impose a sales tax on businesses. Based on a prior U.S. Supreme Court case (Complete Auto) there are 4 tests as to whether a state may impose a tax on interstate commerce: 1) the activity is sufficiently connect to the taxing state (substantial nexus), 2) the tax is fairly related to the benefits provided to the state, 3) the tax is fairly apportioned, and 4) the tax does not discriminate against interstate commerce.

This recent case has ruled that the 1st prong is met even if the business does NOT have a physical presence in a state, as long as there is an economic presence (basically have sales to customers located in that state). By doing so, the U.S. Supreme Court overturned (not done lightly) the long-standing Quill case which said that there has to be a physical presence in order for the 1st test to be met, stating that the Quill decision “was wrong on its own terms when it was decided in 1992, [and] since then the Internet revolution has made its earlier error all the more egregious and harmful.”

The physical presence test is what held back most states from asserting sales tax responsibility on business outside of their states. But this case now allows for the states to easily get past the substantial nexus requirement, and we can expect to see most states follow suit and create laws similar to South Dakota. However, Congress may act first. There have been several bills proposed over the last few years that have not passed. But this recent decision may pave the way to change that and have Congress approve legislation to provide a national standard for sales taxes for online businesses.

Note that the case is now being directed back to South Dakota courts to determine if their sales tax law passes the other 3 tests. But general opinion is that South Dakota will prevail on the other tests.

What does this mean for businesses?

Prior law: Business selling widgets/physical things (NOT service-based businesses) – if you don’t have physical presence in a state, you don’t have to charge/remit sales tax in that state. (Note that service-based businesses never had this protection, which is why for income tax purposes, states could still charge income taxes even if that business wasn’t physically present in that state).

New law: Bottom line – the “physical presence” protection for sales tax purposes is GONE.

Summary: This case will have huge ripple effects for businesses who sell in various states and don’t collect sales tax for sales outside of their “home” state.
Simply put, a state’s sales tax laws have to be in-line with federal laws in order to be applied. The OLD federal law interpretation was that states couldn’t enforce sales tax on physical products being sold unless that seller was physically present in that state. Now that this interpretation has been overturned, states will be able to change their sales tax laws to enforce the collection of sales tax, even if a business is not physically present there. This is a game-changer for clients selling items across multiple states that are subject to sales tax.

How this impacts our clients: While impacted businesses don’t necessarily need to do anything now, they should have it on their radar. States will be changing their laws, and when they do, impacted businesses will have to start charging/remitting sales tax.

If you have questions or want to learn more, contact a ShindelRock tax professional today.