Wayfair on its first anniversary

The Supreme Court in Wayfair v. South Dakota on June 21, 2018, expanded the reach of states across the country to impose sales and use tax obligations on retail and other businesses (so-called economic nexus). We predicted then that there would be many state tax changes to come as a result of Wayfair. Late June is the first anniversary of Wayfair — a good time not only to look back on key Wayfair-related developments but also to look forward to key trends and activities we predict are likely to happen during the second half of 2019 and beyond.

Growth of economic nexus states

At this writing, 40 states and Washington, D.C., have adopted some form of economic nexus with various start-collection dates.

Trend: I anticipate that by the end of 2019 or beginning of 2020, all the remaining states will fall in the Wayfair-line. This means that businesses across the country will likely face sales and use tax requirements in many more states than ever before. These new, often complex requirements include the obligation to register, to keep records, and to collect and remit sales and use taxes in many states in which they do not have a physical presence. These challenges will affect businesses, not only in the retail online and brick-and-mortar sector but in other industries across business types and up and down the supply chain; including wholesale, manufacturing, distribution, and construction.

Changes to the Wayfair-South Dakota economic nexus ‘model’

Most states that implemented an economic nexus standard soon after Wayfair cloned the South Dakota law that Wayfair reviewed. That law provided for a minimum level of economic activity (safe harbor) in the state before economic nexus kicks in. The elements of the safe harbor were:
  • The volume of business generated in the state ($100,000); and,
  • The number of “transactions” in the state (200).
Most states jumping on Wayfair, passed laws/issued guidance that mirrored South Dakota law.

Trend: States are now adopting other models and will do so going forward. Many will continue to put their stamp on their economic nexus laws as legislatures move to pass these bills. So, for example, both New York and California have raised the volume threshold to $500,000. In other states, additional conditions have been written into the language of the statute. For example, Tennessee adds “and systematic solicitation of sales,” and Mississippi adds “systematic exploitation of the market.” Other questions that are being asked and will continue to be answered differently by each state either explicitly in the law, or by administrative fiat include:
  • How do you measure the “volume of business?”
  • Do the number of transactions in a state matter?
  • Do both the volume of business and the number of transaction minimums have to be met or just one of them?
New state interpretations and focus will continue to evolve. Businesses and advisors need to closely monitor this ever-changing landscape to reduce the risk of non-compliance.

Alternative nexus laws still on the books

Before Wayfair, which paved the way for economic nexus, states aggressively stretched the limits of the meaning of the Quill “physical presence” test under several legal approaches currently on the books, including click-thru nexus, affiliate nexus, marketplace nexus, cookie nexus, and use tax notice/reporting laws.

Trend: Many of these “alternative” laws attempting to get around the Quill physical-presence requirement are being challenged in court. The prospects of continuing litigation and the accompanying drain on state legal resources may cast a shadow on most states’ primary objective -- finding new sources of revenue to fund state programs. So, as more and more states adopt economic nexus, look for these alternative statutes to be reviewed to determine if the costs of are outweighed by the benefits (e.g., revenue) of keeping them.

That said, past-year liabilities under these laws will remain a real and continuing risk for businesses, even though these laws may not be carried forward into the future.

Marketplace facilitator laws

Probably the most significant and recent development in state tax collection efforts is the rise of marketplace facilitator laws. These laws shift the sales tax collection and remittance obligations from a third-party seller to the marketplace facilitator. Placing the burden of sales and use tax compliance on the marketplace provider, and not the seller, means that the states can reduce the cost of compliance while also collecting more revenue efficiently, a clear win-win for the states.

Trend: Marketplace facilitator state rules have not only survived Wayfair but will continue to flourish. Although a rapidly moving target, currently, many states and Washington, D.C., already have statutes in place and many others have proposed legislation. I expect most states to have such laws in place by the end of 2019, or early 2020.

But wait, there’s more! Sellers are not completely off the hook. They will still have to track any sales not transacted within the marketplace facility. Also, it remains their responsibility to ensure that compliance rules and requirements are being met, and it’s important to note that this could result in significant and unexpected expenses to hit businesses.

Use tax notice/reporting laws

Before the Wayfair decision, states like Washington passed laws to get around the limitations of the physical presence standard. Those states were requiring remote vendors who did not collect sales tax from their customers to notify those customers in writing of the customer’s use tax reporting and payment responsibilities, and also to report information on the customer’s purchase to the customer’s states directly -- so-called “ratting” on their customers.

Trend: Washington State dropped its reporting law in October 2018 after the economic nexus law became effective, and other states may follow. Why? To the extent that the “collect or report” election would limit a state’s authority to require sales and use tax collection under economic nexus, the election provision might conflict with the change in federal law. Other states with these “notice/reporting” laws may follow suit in 2019 and beyond.

Federal legislation to address nexus in the states

Before the Wayfair decision, many thought that if the Supreme Court were to overturn Quill, that might spur Congress to act. The thinking was that if the court got rid of the physical presence test, states would go back to a very minimum test that increases the likelihood that most would be taxable, significantly hurting “mom and pop” businesses. This taxable “expansion” might then raise enough congressional concern expressed by taxpayers to result in federal legislation to “rein in” the states.

To be sure, every state is putting its unique stamp on nexus in general, and economic nexus in particular, leading to a meteoric rise in state “guidance” on economic nexus. Whether the states need to be “reined in” at this point is certainly controversial. However, historically, Congress has been unwilling to get involved. All past attempts to legislate rules on a federal level have failed.

It’s also important to note that federal legislation creating sales and use tax uniformity among the states likely is dead in the water for the foreseeable future.

Wayfair effect on state income tax nexus

Although the Wayfair case was technically only about use tax nexus, physical presence is not required to have nexus. Some commentators have continued to speculate on the potential impact that Wayfair might have on income tax nexus laws.

There are currently many states that have their case law confirming that an economic presence is sufficient to establish a substantial nexus for corporate income taxes. Some of these statutes provide that corporate income tax nexus is established when a corporation has a “substantial economic presence” or “significant economic presence.” The Supreme Court has not agreed to review these laws. I don’t expect either SCOTUS or Congress to intervene here in the foreseeable future.

Trend: At a minimum, this unwillingness on the part of the Supreme Court to review these laws, coupled with the Wayfair holding that physical presence is not required to have nexus, has many believing there is tangible support for the constitutionality of these income tax nexus statutes. So, for states that do not currently have such income tax nexus laws, Wayfair may now provide an impetus for them to pass such laws, using the rationale that they now have a constitutional “green light” to do so.

The taxation of cloud-based services will increase

More and more of the United States gross national product comes from “services.” And yet services are not taxed nearly as much as tangible personal property. However, according to the National Conference of State Legislatures, the use of cloud services has greatly increased over the past decade, especially the software-as-a-service distribution model. As a result, states have taken a wide range of legislative and administrative positions regarding the way they characterize cloud-based services for purposes of applying sales and use tax rules.

Trend: A perfect storm of the growth in cloud-based services, the expanding growth of state taxing power brought about by Wayfair, and the states’ needs to find new sources of revenue almost certainly will lead to more taxation of cloud-based and other technology-related services in 2019 and beyond. What is not clear is whether that increased taxation will take the form of explicit statutes or administrative interpretation.

Businesses can expect a greater frequency of sales and use tax audits

Trend: Since businesses may now be subject to sales and use tax compliance obligations in more states, they can expect not only a greater number of audits, but that those audits will become more aggressive and comprehensive as states struggle to find new resources to support growing demand for state-provided services, especially in infrastructure, higher education and health. An area that might not have been a particular focus of audits in the past — tax exemptions -- will likely now become one. State auditors will also be expected to use more sophisticated tools and data analytics to get more “bang for the buck” in their audit targets.

Businesses and their advisors need to take heed and increase their use of software and other technologies to ensure they accurately comply. The risks and the potential cost of incorrect compliance are growing and could be a huge, unexpected financial burden on any business.

The bottom line: What should companies do to prepare?

Businesses must take steps to ensure they reduce the substantial financial and other risks associated with the failure to comply with sales and use tax rules:
  • Understand their nexus profile — where do they have a sales and use tax obligation based on evolving standards, like economic nexus under Wayfair?
  • Assess their capability to accurately, consistently and efficiently meet their obligations, a.k.a. their sales and use tax competencies.
  • Adopt and deploy best practices to ensure decreased risk, increased efficiency, and improved productivity.
Special thanks to Jerome Nestor for his assistance with this article.