The Supreme Court Got It Wrong on States’ Authority to Tax Out-of-State Retailers

In 2018 the Supreme Court ruled on South Dakota vs. Wayfair, Inc. “in which the court held by a 5–4 majority that states may charge tax on purchases made from out-of-state sellers, even if the seller does not have a physical presence in the taxing state.” Well even though this quote is directly from Wikipedia, it is not really accurate. What the Supreme Court ruled was that the states could force out-of-state retailers to collect tax on the state’s behalf, and of course be subject to all the compliance requirements that a state might try to enforce. There is a big difference.

The sales tax laws in many states require that people or businesses who purchase items from out-of-state, were no tax is paid, voluntarily calculate, and remit the appropriate tax to the state taxing authority. In California, where I live, the tax is actually called the Sale and Use Tax, and the “Use” part is pretty clear. The California Department of Tax and Fee Administration states specifically “Use tax may also apply to purchases shipped to a California consumer from another state, including purchases made by mail order, telephone, or Internet.” I think this is an important distinction because the argument is not that the sales should not be subject to tax, the argument is that the burden of collecting the tax and should not be placed on the out-of-state seller. The response by the state bureaucrats is of course that the retailers in the state are forced to collect this tax, so why shouldn’t the retailers that are located out-of-state also be required to collect the tax? I wonder if any of them every considered that maybe we shouldn’t require retailers to collect the tax at all. But I doubt it.

The primary argument by South Dakota was that the state and local brick and mortar stores within the state were being harmed financially. South Dakota pointed out a number of studies that showed lost taxes in the billions of dollars due to untaxed sales. The state also argued that e-Commerce and the Internet basically changed a state’s nexus (a term used to describe taxable activities of interest to the state). Finally, the state argued that compliance with the state’s sales tax rules and regulations are not a burden on retailers.

Wayfair and two other Internet retailers argued back that remote sellers are at a disadvantage because they have the cost of logistics and freight, concerns over retroactive tax liability, that congress was considering a bill that might pass laws on this matter and a final obscure legal point relating to the state’s ability to enact rules and regulations that restrict interstate commerce. There were numerous amicus briefs filed by various companies and organizations in support of Wayfair.

Previously, in Quill vs. South Dakota (504 U.S. 298), the Court ruled that a state could not compel an out of state retailer that did not have a physical presence in that state to collect and remit sales tax. The Court overturned that ruling, stating that “the physical presence rule of Quill is unsound and incorrect.” The Court’s reasoning includes the statement that “The physical presence rule has long been criticized as giving out of state retailers an advantage. Each year, it becomes further removed from economic reality and results in significant revenue losses to the States.”

The Court goes on to say, “That Quill creates rather than resolves market distortions….The rule also produces an incentive to avoid physical presence in multiple States.” In addition, it states that “Quill imposes….arbitrary, formulistic distinctions (and) treats economically different actors differently for arbitrary reasons.” The Court continues by stating that “the physical presence rule (helps) customers evade a lawful tax (and) unfairly shifts an increased share of the taxes to those consumers who buy from competitors with a physical presence in the State.”

The Court also says that “It is essential to public confidence in the tax system that the Court avoid creating inequitable exceptions.”

I understand that the Court’s job is to rule on whether a law is constitutional, but it is clear in looking at the reasoning behind the Court’s decision that the Court took into account much more than just a review of the application of the Commerce Clause in this particular case. Let’s look at the position of South Dakota and then the position of the Court, in detail.

The first point made by South Dakota is that brick and mortar stores are being harmed financially by online retailers, but the real point has nothing to do with brick-and-mortar stores being harmed by online retailers. The real point is that South Dakota, and other states are harmed financially by out of state retailers if those out of state retailers don’t collect and remit tax to the state. That may be true but is that justification for a state to be able to tax out of state retailers? States have many ways to collect taxes, including income tax, property tax and in the State of California some 40 plus other taxes administered by the California Department of Tax and Fee Administration. Maybe instead of forcing out of state business to collect and pay tax, the states who think they are being harmed by out of state retailers should think about other methods of taxing citizens in those states.

The next argument by South Dakota is that the nature of internet commerce has changed its nexus. For those of you who don’t understand the term, nexus is a word used by taxing authorities to determine if there is a sufficient relationship between the state and the person or business being taxed, for the tax to be lawful. Historically, as was judged in the Quill case, states could not tax a business that did not have some sort of operations in the state. According to South Dakota, the internet changed all of that. But if that is the case, why would only sales tax laws apply to out of state retailers? Why wouldn’t all state laws apply to that out of state retailer, such as labor laws, worker’s compensation laws, consumer protection laws, environmental laws, general trade, and commerce laws and more? Well, a lot of states are starting to think that all those laws do apply to out of state retailers and many states are going to great lengths to collect every and any sort of tax from any out of state retailers. I had one client of mine who had an employee go into the payroll system and change his address from California to Texas. Upon discovery, we immediately made the employee change his residency back to California. The employee subsequently quit. However, the State of Texas sent my client a bill for $60,000 for employment taxes and continued to hound my client with letters and legal threats for years.

Finally, South Dakota claimed that collecting and remitting tax is not a burden on retailers. Clearly none of the people who work for the State of South Dakota, who wrote that statement, ever had to complete sales tax reporting. Sales tax rates vary by state, but not just by state, by jurisdiction. States like Washington and California have hundreds of sales tax rates and districts within the state. In some states there are multiple sales tax districts within a given zip code. Failure to properly collect and remit any of these taxes could result in penalties and fines. Now expand that to all 50 states. Further, each state has its own forms, its own method of reporting tax and in some states some things are taxable that are not taxable in other states. I had one client who tried to do the right thing and registered in a number of states but ended up not having any sales in those states. That client failed to report “zero” sales to one state for a few months and was fined $600 even though the business had no sales. Further, every state that has a sales tax has teams of auditors. When those auditors pounce on an accounting department they are a tremendous inconvenience, often requesting reports and detail that accounting systems are not designed to provide. Further, state sales tax laws allow these state auditors to collect all manner of information on a business, including financial statements, bank account information, property ownership information and more. Also, in some states, services are not taxes, and in other states, services are taxes. Even the application of tax to any given transaction is not uniform across all states that do charge a sales tax.

Of course, none of the above points were considered by the Court because those nine fine justices have never worked in the accounting department of a business in their entire lives. Maybe they should.

Let’s now look at the Court’s reasoning behind their decision. The Court made a number of points. One point was that “The physical presence rule has long been criticized as giving out of state retailers an advantage. Each year, it becomes further removed from economic reality and results in significant revenue losses to the States.” So what? Why is the Court concerned about government loss of taxes? And who are members of the Court to decide what is and what is not economic reality? So what if out of state retailers have an advantage? A lot of retailers have advantages. Better products, better locations, lower operating costs, better logistics and so on. Why is it any business of the Court to determine which advantages are ones that the Court should opine upon?

The court then goes on to say that “That Quill creates rather than resolves market distortions….The rule also produces an incentive to avoid physical presence in multiple States.” A lot of things states do produce an incentive to avoid physical presence in those states. Labor laws, environmental laws, payroll taxes, state income taxes, and a host of other state rules and regulations create disincentives for businesses to locate in those states. Is it the Court’s job to review each state rule and regulation and to opine on which ones it thinks are okay, and which ones are not?

Then the court says: “Quill imposes….arbitrary, formulistic distinctions (and) treats economically different actors differently for arbitrary reasons.” Welcome to the world of government regulation and taxation. Almost all government rules, regulations and taxes are arbitrary, formulistic, and treat different groups differently for arbitrary reasons. Even worse, government employees who get paid huge salaries sit around and arbitrarily make up these rules and regulations.

The court finishes by saying: “It is essential to public confidence in the tax system that the Court avoid creating inequitable exceptions.” Now I’d like to line up a random 100 people on the street and survey them to see if any of them have confidence in the tax system. The US Federal Tax code is comprised of some 10 million words of laws, interpretations, bulletins and other documents needed to effectively navigate the tax system and pay taxes correctly. And that is just the Federal Government. We are taxed to varying degrees by states, counties, cities, and even special taxation districts. Clearly the Court members have no clue about the tax system, or what people think of it (I suspect they all pay someone else to do their tax returns).

In this case, the Court made a bad ruling. It is bad because it does not strictly abide by the Commerce Clause of the Constitution, it is bad because it sets a precedent for overreach of states into the business operations of businesses located in other states, and it is bad because it shows how little people sitting behind the bench understand the way businesses work and the burden that taxing authorities place on businesses. This ruling has placed a huge burden on businesses, particularly small businesses. The cost of sales tax compliance for any business that markets its products into multiple states has skyrocketed and put those businesses at the risk and mercy of power and money hungry bureaucrats.

Yes, the Internet and Internet commerce have changed the way people buy, and yes that has resulted in states losing tax dollars. But maybe rather than using the Supreme Court to force businesses to spend money and time to comply with 50 different state taxing authorities, these state taxing authorities should figure out a way to collect the taxes to run their state budgets without forcing businesses, under the threat of fines, law suits, asset seizures and other Draconian government heavy handedness, to collect that money on the various states behalf. But then maybe that is expecting too much.