Internet Sales Tax Fairness

In a 1992 decision, Quill v. North Dakota, the U.S. Supreme Court ruled that retailers are exempt from collecting sales taxes in states where they have no physical presence, such as a store, office, or warehouse.  (The legal term for this physical presence is "nexus.")   Although the case dealt with a catalog mail-order company, the ruling has subsequently been applied to all remote sellers, including online retailers. The Court said that requiring these companies to comply with the varied sales tax rules and regulations of 45 states and some 7,500 different local taxing jurisdictions would burden interstate commerce.

In its ruling, the Court specifically noted that Congress has the authority to change this policy and could enact legislation requiring all retailers to collect sales taxes without running afoul of the Constitution.  "Congress," the Court declared, "is … free to decide whether, when, and to what extent the States may burden interstate mail-order concerns with a duty to collect use taxes."

Today, software has largely eliminated the difficulty of calculating and remitting sales taxes for the country's many state and local jurisdictions.  Indeed, Amazon.com, which opposes extending sales tax to online retailers on the grounds that it would be "horrendously complicated," collects sales taxes nationwide for Target as part of its management of the chain's online business.

Yet Congress has so far failed to extend sales tax collection to online retailers.  The result is a public policy with at least three pernicious impacts:

• It disadvantages local businesses.  Exempting online retailers from having to collect sales tax, as regular stores must, gives these companies a 4 to 9 percent price advantage over local stores — a sizable competitive advantage in retailing. 

• It undermines state and local governments by reducing tax revenue for schools, police, and other services.  This revenue loss that will only grow as internet sales continue to displace in-store sales.  Currently, 45 states assess sales taxes, from which they receive about 25 percent of their total revenue each year.  A 2009 University of Tennessee study estimated that uncollected sales taxes on e-commerce cost states $7.7 billion in 2008. 

• It makes a regressive tax more regressive, because only those with internet access, a credit card, and a home or workplace where they can accept daytime deliveries are able to take advantage of the tax exemption.   

(It is important to note that, while remote sellers are not required to collect sales taxes, the tax is still owed by the individual who made the purchase.  Individuals are suppose to keep track of these purchases and pay an amount equivalent to the sales tax as a "use" tax on their state tax returns.  Few people do, however, and the use tax is almost impossible to enforce, which effectively exempts these purchases.)

The Main Street Fairness Act

There are two primary strategies that states are pursuing to move toward a level playing field in which all retailers are subject to the same sales tax requirements.  

One involves persuading Congress that collecting sales taxes for numerous state and local jurisdictions is no longer a burden for remote sellers.  As noted above, software makes complying with state and local sales tax rules much simpler than when the Supreme Court issued its 1992 ruling.   

To further simplify things, the National Governors Association established the Streamlined Sales Tax Project, a multi-state effort to simplify and align sales tax policies. As of April 2009, 41 states and the District of Columbia had approved an interstate agreement that establishes uniform sales tax rules and definitions, and 23 states had taken the next step of passing implementing legislation.

Under this legislation, states and cities still have the authority to determine what goods are taxed at what rate, but must adhere to rules governing such things as how and when they can change tax rates, as well as uniform definitions (e.g., whether marshmallows are considered food or candy for tax purposes).

Having aligned and greatly simplified their sales tax policies, states are hoping to persuade Congress to pass the Main Street Fairness Act, introduced in 2009 by Senator Mike Enzi and Representative Bill Delahunt.  The bill would authorize those states that have implemented the Streamlined Sales Tax to require large online and catalog retailers to collect sales taxes.  (Small businesses would still be exempt.)

Clarifying Nexus

The second strategy states are pursuing does not rely on Congressional action, but instead uses existing state authority to clarify what constituents "nexus" for the purposes of sales tax liability.  (Under the Supreme Court's ruling, only retailers that have a physical presence, or nexus, in a state must collect sales tax on purchases made by that state's residents.)

In the past, many national chains, despite having nexus in every state by virtue of their stores, claimed their e-commerce sites were distinct legal entities, unrelated to their bricks-and-mortar stores and therefore were exempt from collecting sales taxes. This practice is known as "entity isolation."

State action in recent years has sharply curtailed the number of so-called "clicks-and-mortar" retailers using entity isolation to skirt collecting sales taxes on their online operations.  In 2001, California became the first state to issue an administrative ruling against the practice of entity isolation when its Board of Equalization ruled that Borders.com was not a separate entity, but the online extension of the chain Borders Books & Music and therefore must collect sales taxes on sales to California residents.

In the following years, several states amended their sales tax laws to clarify that the e-commerce arms of national chains still have nexus and that entity isolation does not absolve them of their obligation to collect sales tax.  (Below we include policy examples from Arkansas and Indiana.)

Increasingly concerned about the threat of court action by states and the potential liability, as well as the complexity and inefficiency of attempting to treat the e-commerce side of their operations as a separate company, in 2003 most national chains cut a deal with the states in which they were forgiven all of their back taxes in exchange for collecting sales taxes online from that point forward.   Although most national chains now collect sales taxes on online orders, there remain a few that do not.

In 2008, New York became the first state to further extend the definition of nexus to cover some web-only retailers, including Amazon.com. The legislature passed a bill, accompanying its budget, that said that web retailers have nexus in New York and must collect sales taxes if they have sales affiliates in the state that generate a combined total $10,000 a year or more in revenue for the retailer.   (Sales affiliates are individuals or organizations that are paid commission for linking to the online retailer's web site. Amazon.com has thousands of sales affiliates nationwide, as do many other online retailers.  In all, more than 30 companies are covered by New York's provision.)  

Now, several other states are considering legislation modeled on New York's.

More information:

• State and Local Government Sales Tax Revenue Losses from Electronic Commerce
  by Donald Bruce, William F. Fox, and LeAnn Luna, University of Tennessee, April 13, 2009. 

• Streamlined Sales Tax Project

• Multistate Tax Commission
  In 2002, Multistate Tax Commission created model state legislation ("Factor Presence Nexus Standard for Business Activity Taxes ") that prevents entity isolation.

• Selected Articles from the Hometown Advantage
  News on e-commerce and sales tax policy.  Sign-up to receive this monthly e-newsletter.

• American Booksellers Association's Sales Tax Initiative