Sales tax nexus post-Wayfair: Addressing the risks
Over a year has passed since the landmark Supreme Court decision in South Dakota v. Wayfair, Inc., which fundamentally changed the sales tax nexus landscape in the United States. Now the wait is over to see how states will respond as nearly every state has adopted economic nexus laws or guidance, with the last states implementing economic nexus for sales tax purposes this fall. Seven states, including Texas and Massachusetts, adopted economic nexus as of Oct. 1, 2019 and Oklahoma will implement economic nexus as of Nov. 1, 2019.
For those practitioners who have clients not yet compliant with the new sales tax nexus rules, now is the time to get them current. And for those with clients already filing in states with economic nexus, it is essential to reflect on the new risks and how to minimize potential liability, especially as the threat of increased audit activity looms.
Understanding sales tax rules and establishing procedures
On June 21, 2018, the Supreme Court overturned the 50-year old physical presence standard established in Quill Corp. v. North Dakota and National Bellas Hess v. Department of Revenue. Specifically, Wayfair hinged on an economic nexus law that (1) had a de minimis threshold (i.e., $100,000 for 200 sales); (2) was not retroactive; and (3) the state was a member of the Streamlined Sales and Use Tax Agreement (SSUTA).
Taxpayers are responsible for determining how and when they will have nexus in each taxing jurisdiction, and must determine whether their goods and services are subject to sales tax. With over 10,500 taxing jurisdictions, the nuances and complexities of sales tax are staggering. States and localities are continually changing the sales tax rates, filing deadlines may be different across jurisdictions, sales taxable in one state may not be taxable in another, and even what constitutes a “receipt” for economic nexus purposes varies by jurisdiction.
Determining where your client has nexus
The first step in ensuring your client’s compliance is determining whether they are required to collect and remit sales tax in a particular jurisdiction. In other words, did your client’s company exceed the minimum statutory threshold for economic nexus? Although seemingly straightforward, the rules across jurisdictions are not the same. For example, in New York, the threshold to file for sales tax purposes is $500,000, but the threshold requires sales of tangible personal property only (i.e., sales of taxable services do not appear to fit within the economic nexus threshold). In contrast, New Jersey has a $100,000 threshold, but looks to sales of tangible personal property, specified digital services and taxable services.
Moreover, practitioners should pay particular attention to “home rule” jurisdictions, where the rules vary by locality. For example, in Colorado, certain localities self-administer their sales tax and have separate filing requirements from the state (noting that Colorado's sales and use tax rate is lower than many of the local sales and use tax rates). In these localities, taxpayers may be required to file for Colorado state tax purposes, but may not be required to file for local tax purposes (e.g., if the taxpayer does not have physical presence in the locality). The opposite could also be true — for example, Alaska does not impose a state sales tax, but the city of Nome imposes an economic nexus requirement for local purposes.
No state has applied economic nexus laws similar to Wayfair (i.e., with a factor-presence threshold) retroactively at this time. However, many states that are not members of the SSUTA have adopted Wayfair-type laws. Does this mean that taxpayers do not need to comply? This is a challenging question and it is unlikely for the U.S. Supreme Court to address it. The short answer: unclear, but real risk exists. For “home rule” jurisdictions (such as Colorado and Louisiana), the argument against being required to file is likely stronger when compared to a non-SSUTA state that centrally administers sales tax. However, we fully expect all states to attempt to enforce their laws, with some home rule jurisdictions (e.g., Alabama) being proactive to address this potential issue.
Determining what is subject to sales tax
Once you determine that a filing requirement is necessary, the next step is to confirm whether the goods or services sold are subject to sales tax. Determining taxability can be extraordinarily complex and is an ongoing process with sales tax laws often changing or evolving. Most states impose sales tax on tangible personal property and certain enumerated services, but there are countless examples of inconsistency and complexity within the law (for example, tax laws relating to food, medicine, clothing, information services, among many others). The dissent in Wayfair actually touched upon this issue by highlighting some sales tax quirks. Our favorite: “Illinois categorizes Twix and Snickers bars — chocolate-and-caramel confections usually displayed side by side in the candy aisle — as food and candy, respectively (Twix have flour; Snickers don’t), and taxes them differently.” Thus, seemingly obvious answers (the authors generally think of both Twix and Snickers as “food” and would colloquially consider them both to be “candy”) may not be the correct sales tax determination. With this in mind, the best course of action is to fully evaluate the facts and look to existing guidance on the topic to confirm the appropriate treatment prior to providing any advice.
What happens if your client meets the state thresholds but has not started filing yet? We recommend having them do so as quickly as possible. States are actively seeking noncompliant entities through the use of data mining (e.g., Connecticut, Illinois, New York, Ohio, Pennsylvania, among others) and other avenues (e.g., random sampling, reviewing economic nexus for income tax filings, etc.). This means that noncompliant entities risk audits and/or assessments from the states. Moreover, most states are permitted to share taxpayer information, which means that if one state finds a taxpayer is not collecting and remitting, the state may be able to pass that information to other states, potentially triggering multiple audits.
As many states have adopted Wayfair-type economic nexus rules for well over a year, we have found that states generally are reluctant to provide relief with respect to the tax liability due, noting exceptions may apply. Therefore, do not be surprised by a state’s position that the full sales tax liability is due since the inception of the state’s economic nexus law, plus potential interest. However, most states have been reasonable with providing formal or informal relief for penalties. If going through formal avenues, a state’s voluntary disclosure program may provide your client relief for penalties and potentially interest.
Additional complexity for foreign sellers
It is becoming increasingly common for foreign retailers to sell directly to U.S. customers and surpass a state’s de minimis threshold. Although Wayfair clearly created a bright-line test for determining sales tax collection and remittance obligations, foreign sellers may question whether Wayfair applies to them. This is an interesting issue, as Wayfair may not have provided the answer. Wayfair addressed the Commerce Clause implications of economic nexus under the four-prong standard set forth in Complete Auto v. Brady (focusing on the “substantial nexus” prong). For purely foreign sellers, the Foreign Commerce Clause is likely implicated, and Japan Line, Ltd., v. County of Los Angeles expanded Complete Auto’s four-prong test to add the following two prongs: (1) whether the tax creates a substantial risk of multiple taxation; and (2) whether the tax prevents the federal government from speaking with one voice. Therefore, the question becomes whether taxpayers’ activities in the U.S. satisfy this heightened standard.
Regardless of the implications of the Foreign Commerce Clause, we expect states to attempt to enforce their sales tax economic nexus laws on foreign sellers. This means that a foreign entity without a permanent establishment for federal income tax purposes may, in the state’s eyes, have an obligation to file for sales tax purposes in the U.S. States may also attempt to enforce similar economic nexus rules for income/franchise tax purposes on foreign sellers, noting that additional defenses may exist to combat such a position (such as Public Law 86-272, also known as the Interstate Income Act of 1959). Accordingly, foreign sellers may be put in a difficult position in determining whether to challenge or comply with these laws, and we recommend a comprehensive review of the nexus laws in each jurisdiction. It is also worth considering whether alternative structures or operations may exist to reduce potential liability on such sellers to avoid this issue in its entirety.
The wait to see how states were going to respond to Wayfair over the course of the last year is finally over. As a result of Wayfair, it is critical that practitioners explain to their clients the state and local tax filing obligations, recommend a formal procedure for compliance, and recommend engaging in remediation with the appropriate states and taxing jurisdictions if necessary. For foreign entities, an additional layer of complexity may exist and we recommend reviewing your client’s compliance obligations and whether alternative structures or operations may exist to minimize potential issues.
David Pope is a partner and Katie Piazza is an associate at Baker & McKenzie LLP, respectively. They both focus on state and local income tax, sales and use tax, property tax, payroll tax, personal income tax and unclaimed property. They represent clients in all aspects of state and local tax, including controversy, litigation, planning and restructuring matters.