States probing boundaries of ‘physical presence’

By Jennifer Jensen, CPA

States are experiencing lackluster revenue growth in 2017, with only modest improvements expected in 2018. In fact, according to the Center on Budget and Policy Priorities, in 2017, 25 states are facing or already have addressed revenue shortfalls. Further, more than half the states lack enough revenue to maintain services at existing levels going into 2018. This means that two-thirds of the states are facing or addressing revenue shortfalls this year, next year, or both.1

A number of factors contribute to the weakness in state tax collections. One key reason is slower-than-average sales tax collections, which are still below their historic average as consumers have remained cautious after the end of the recession, and untaxed internet sales continue to grow.2 Slower-than-average sales tax collections present significant concerns for state budget officials because sales taxes represent a substantial revenue source for the states that impose them. According to the Tax Foundation, which used data from the U.S. Census Bureau, sales taxes generated about 31.4% of state tax revenue in fiscal year 2014.3

With such a large percentage of state tax revenue coming from sales and gross-receipts taxes, states are considering strategies to raise additional revenue from these sources. Since retailers are required to collect and remit tax only in states where they have a taxable presence, or nexus, one strategy to increase revenues is to enact laws that expand the definition of nexus-creating activities. Though individuals who make purchases upon which sales or use taxes are due are responsible for self-remitting the taxes if the vendor does not collect them, states have found that enforcement at the individual purchaser level is difficult. Thus, the focus has been on the retailers and those entities that facilitate the retail sales (e.g., marketplace providers).

For example, New York state began its nexus expansion movement in 2008 with what is known as a "click-through" nexus law that addresses taxation of sales made over the internet by out-of-state sellers.4 Since then many states have followed suit with their own click-through laws, as well as other means to expand the definition of nexus-creating activities. This column provides an overview of these state efforts to expand nexus standards and focuses on other recent developments.

Nexus in general

Before gaining an appreciation of what states are doing to expand nexus principles, one must understand the limitations currently imposed on states through the Constitution as well as case law. In Quill Corp. v. North Dakota,5 the U.S. Supreme Court held that the Commerce Clause prevents a state from requiring an out-of-state retailer to collect and remit use tax if it does not have a physical presence in, or "substantial nexus" with, the state. States have struggled with the definition of physical presence ever since the Quill decision. Traditionally, a retailer established physical presence if it had in-state property and/or employees, employees visiting the state, or third-party agents working on its behalf in the state. It is the expansion of what constitutes a physical presence beyond these traditional activities that has been the focus of the majority of the nexus expansion laws, and, more recently, some states are even ignoring the physical presence requirement.

Click-through nexus

As mentioned above, in 2008, New York enacted its click-through nexus legislation, which requires out-of-state internet retailers to collect and remit state sales tax on tangible personal property or services sold through links on websites owned by in-state residents, referred to as "affiliates."6The law requires out-of-state sellers operating "affiliate programs" in the state to register to collect and remit sales tax. It provides that a "vendor" includes a person making sales of tangible personal property or services to New York customers through an agreement with a New York resident for a commission or other consideration, by which the resident directly or indirectly refers potential customers, by a link on an internet website, to the seller, if the cumulative gross receipts from those sales exceed $10,000 per year.

In other words, potential customers reach the out-of-state retailer's website by clicking on a link on the in-state affiliate's website (thereby creating click-through nexus). The state's position is that the in-state affiliate is operating in the state on behalf of the out-of-state retailer. A seller may rebut the presumption of nexus by providing proof that the resident with whom the seller has an agreement did not engage in any solicitation in the state on behalf of the seller that would satisfy the nexus requirement under constitutional principles.

Two days after the legislation was signed, filed suit. The case made its way to the U.S. Supreme Court.7 However, the Court declined to hear the case and, consequently, New York's law was upheld. Since 2008, approximately 20 more states have enacted similar legislation or issued guidance interpreting current state laws to allow comparable treatment.

Affiliate nexus

In response to opposition to the New York-style vendor presumption law, Colorado took a different approach to taxing out-of-state sellers. Effective March 2010, Colorado enacted controlled group nexus.

Under Colorado law, out-of-state sellers must collect Colorado use tax if they are part of a "controlled group," as defined in Sec. 1563(a) of the Internal Revenue Code, that has a "component member," as defined in Sec. 1563(b), that is a retailer with a physical presence in the state.8 However, this presumption may be rebutted by showing that the component member did not engage in any activities in this state that are sufficient under U.S. constitutional standards to establish nexus during the calendar year in question.

Other states have enacted similar provisions, albeit with slight variations. Some require the use of a similar trademark and/or the sale of similar products. Some laws contain a rebuttable evidentiary presumption, while others do not. Since 2010, over 20 states have enacted some form of controlled-group nexus.The states' positions are that the members of the same controlled group are establishing the physical presence required in Quill. Surprisingly, these provisions have not been challenged in the courts.

Retailer notification requirements

In addition to enacting controlled group nexus in 2010, Colorado enacted retailer notification requirements for out-of-state vendors. These are not nexus expansion provisions but, rather, represent yet another approach to ensuring tax gets remitted to the state. Colorado's law requires retailers that sell products to Colorado customers, but do not collect and remit Colorado use tax, to report certain information about those purchases to their customers and to the Colorado Department of Revenue (DOR).9 For example, those retailers must:

  • Notify Colorado customers on their invoices, catalogs, and websites that the retailers do not collect Colorado sales tax and, therefore, the customer is obligated to self-report and pay use tax to the DOR;
  • Provide each of their Colorado customers an annual report detailing that customer's purchases from the retailers in the previous calendar year, including a notice that the customer is obligated to pay use tax and that the retailers are obligated to report the customer's name and purchases to the DOR. This requirement applies only to customers who spend more than $500 with the retailer in the calendar year; and
  • Provide the DOR with an annual report, which includes customers' names and total purchases from the retailers.

However, these requirements apply only to retailers with $100,000 or more of Colorado gross annual sales.

While the obligations under this law were operative March 1, 2010, reporting was not scheduled to begin until Jan. 31, 2011. The legislation included penalties for noncompliance. However, the Direct Marketing Association (DMA) challenged the law. On Jan. 26, 2011, a federal district court issued a preliminary injunction enjoining the state from enforcing the notice-and-reporting obligations. Following a lengthy journey through the court system, including the U.S. Supreme Court, addressing whether the Tax Injunction Act bars federal court review of the notice and reporting law, the state and the DMA reached a settlement in February 2017.10

Under the settlement agreement, the DOR began enforcing use tax notice-and-reporting requirements but found reasonable cause for prior noncompliance due to the uncertainty caused by federal and state court actions. Accordingly, the DOR did not require compliance with the notice-and-reporting law until July 1, 2017, and will waive all penalties for noncompliance before that date.

While Colorado and the DMA were battling each other through the court system, several other states enacted similar provisions, though without the penalty provisions included in the Colorado law. However, since the settlement, two other states, Washington and Vermont, have enacted reporting requirements with penalties for noncompliance.11 In all, close to 10 states have enacted similar notice-and-reporting provisions since 2010.

Of note in the long legal journey this case took, while it was at the U.S. Supreme Court, Justice Anthony Kennedy wrote a concurring opinion pointing out that, although this case did not raise the issue of physical presence nexus under Quill, it provides "the means to note the importance of reconsidering doubtful authority. The legal system should find an appropriate case for this Court to reexamine Quill and [National] Bellas Hess [386 U.S. 753 (1967)]."12

Kennedy noted that the Quill Court should have reevaluated the sales-and-use-tax physical presence requirement "in view of the dramatic technological and social changes that had taken place in our increasingly interconnected economy. There is a powerful case to be made that a retailer doing extensive business within a State has a sufficient 'substantial nexus' to justify imposing some minor tax-collection duty, even if that business is done through mail or the [i]nternet."

Kennedy went on to write that "[g]iven these changes in technology and consumer sophistication, it is unwise to delay any longer a reconsideration of the Court's holding in Quill. A case questionable even when decided, Quill now harms States to a degree far greater than could have been anticipated earlier. It should be left in place only if a powerful showing can be made that its rationale is still correct."

Economic nexus

Many states, beginning with Alabama, have accepted Kennedy's challenge and enacted economic nexus laws for sales-and-use-tax purposes with the intent to challenge the physical presence requirement. Economic nexus, that is, nexus without a physical presence in the state, has been a state income tax concept for many years. However, for sales-and-use-tax purposes, the physical presence standard has until recently held. States enacting sales-and-use-tax economic nexus provisions have forsaken the physical presence standard and admitted that the purpose of enacting these laws is to drive the issue to the U.S. Supreme Court for consideration.

One such state is South Dakota. On March 22, 2016, South Dakota enacted S.B. 106, which provides in pertinent part that any entity exceeding an annual sales threshold of $100,000 or 200 separate transactions in South Dakota must collect and remit South Dakota sales tax. The law, effective May 1, 2016, contains provisions that (1) allow the state to quickly initiate court proceedings to address the constitutional validity of the collection and remittance requirements and (2) preclude the state from enforcing the provisions until the legal issue is resolved.

Following enactment of S.B. 106, South Dakota filed a declaratory judgment action against "remote sellers" with no physical presence in the state. South Dakota sought a determination that it may require the remote sellers to collect and remit sales tax. Organizations representing remote sellers filed a second declaratory judgment action to challenge the constitutionality of S.B. 106.

On March 6, 2017, the South Dakota Sixth Judicial Circuit Court ruled in favor of the remote-seller defendants and granted their motion for summary judgment.13 The court found that because the defendants lacked a physical presence in South Dakota, a requirement established under Quill, the state was prohibited from imposing sales tax collection and remittance obligations. The court further stated that S.B. 106 failed as a matter of law to satisfy the physical presence requirement that still applies to state sales and use taxes under Quill and its application of the Commerce Clause. The court held that the state is enjoined from enforcing the sales tax economic nexus provisions.

The state has appealed the decision by the Sixth Judicial Circuit Court to the state Supreme Court. Under the provisions set forth in S.B. 106, any appeal from the Circuit Court goes directly to the South Dakota Supreme Court and then, potentially, to the U.S. Supreme Court to challenge Quill's physical presence standard.

A number of other states have similar sales tax economic nexus provisions that directly challenge the physical presence requirements. These states face similar court challenges. The South Dakota Circuit Court's ruling illustrates the progression of state economic nexus developments.

Cookie nexus

Massachusetts recently took a different position than other states addressing how to tax internet sellers. The commonwealth, through Directive 17-1 issued on April 3, 2017, and effective July 1, 2017, stated its intention to provide clarity and administrative simplicity by adopting an administrative bright-line rule regarding sales by out-of-state internet vendors. The bright-line rule for internet vendors is based on a dollar and transaction threshold and is similar to many states' economic nexus standards for sales and use tax. However, unlike other states that have directly challenged Quill's physical presence standard, Directive 17-1 states that the internet vendors' economic activity invariably creates contacts (e.g., software and cookies) with the state that constitute an in-state physical presence.

This position is not like other states' economic nexus stance. Directive 17-1 went on to explain that there are five ways to establish in-state presence for an internet vendor. These include:

  • Using software downloaded and used by in-state customers to facilitate or increase the vendor's in-state sales;
  • Using internet cookies to facilitate in-state sales;
  • Accelerating delivery of website content through the use of content-distribution networks (CDNs) in the state;
  • Selling via in-state online marketplaces/marketplace providers; and
  • Using delivery services that offer more than using a mail/common carrier to create a presence (e.g., logistics, order fulfillment, storage, etc.).

This is the first time a state has attempted to expand the definition of physical presence to include the use of in-state internet cookies or CDNs. To no one's surprise, this directive immediately was challenged by NetChoice, a trade association of internet companies and organizations dedicated to advancing the interests of e-commerce businesses and online consumers, and the American Catalog Mailers Association, with the plaintiffs advancing two arguments in their suit.14

First, according to the plaintiffs, regulations and other public written statements promulgated by the Massachusetts Department of Revenue (DOR) are subject to the state's Administrative Procedure Act (APA). The APA defines a "regulation" as "includ[ing] the whole or any part of every rule, regulation, standard or other requirement of general application and future effect, including the amendment or repeal thereof, adopted by an agency to implement or interpret the law."15 The plaintiffs assert that Directive 17-1 meets the definition of a "regulation" and, therefore, the DOR must give notice of a proposed regulation at least 21 days before issuing the regulation and give interested persons "an opportunity to present data, views, or other arguments" in response to the proposed regulation, among other requirements.16 Since the DOR issued Directive 17-1 on April 3, 2017, without any prior notice, the APA requirements were violated.

Second, the federal Internet Tax Freedom Act (ITFA), P.L. 105-77, bars a state tax on the sale of goods over the internet if those sales are treated differently from sales made by other means, e.g., in a retail store, by catalog, or over the phone. Because Directive 17-1 focuses solely on internet vendors, the plaintiffs claim that ITFA prohibits the imposition of sales and use taxes specified in the directive.

Based on these challenges, the state has since withdrawn Directive 17-1 (with the issuance of Directive 17-2 on June 28) but plans to go through the proper channels to enact regulations adopting similar language.

Notably, Ohio enacted language similar to Massachusetts DOR Directive 17-1, effective Jan. 1, 2018, as part of its budget bill.17

Marketplace provider nexus

Another strategy to increase sales tax collection is to enact what are known as "marketplace provider" provisions. Minnesota was the first state to enact a marketplace provider nexus law.18 Many other states, including New York, have attempted to enact similar provisions.

With the enactment of Minnesota H.F. 1, Minnesota expanded the definition of "retailer maintaining a place of business in this state" to include having a marketplace provider or other third party operating in the state under the authority of the retailer or its subsidiary, for any purpose, including facilitating or processing sales, whether or not the retailer, subsidiary, or affiliate is authorized to do business in Minnesota. H.F. 1 provides that a retailer is represented by a marketplace provider in Minnesota if the retailer makes sales in the state facilitated by a marketplace provider that maintains a place of business in the state.

A marketplace provider is defined as any person who facilitates a retail sale by a retailer by (1) listing or advertising for sale by the retailer in any forum, tangible personal property, services, or digital goods that are subject to tax; and (2) ­either directly or indirectly through DMA agreements or arrangements with third parties, collecting payment from the customer and transmitting that payment to the retailer regardless of whether the marketplace provider receives compensation or other consideration in exchange for its services.

Direct challenges to physical presence

With sales tax revenue representing a large percentage of total state tax collections, states for years have lamented the fact that the physical presence requirement stymies their efforts at collecting tax from ever-increasing remote sales made over the internet. While the Quill court invited Congress to resolve the issues surrounding the physical presence standard, attempts at enacting federal legislation have not been successful. Without federal legislation, states have begun enacting laws and promulgating regulations that expand what is considered a physical presence. And, after Justice Kennedy's concurrence in the Colorado DMA case, states have gone even further by enacting laws that directly challenge the physical ­presence standard.

The result is that remote sellers have to continuously monitor states' myriad activities and decide whether to comply with or challenge legally questionable positions.  


1McNichol and Waxman, Center on Budget and Policy Priorities, "Many States Face Revenue Shortfalls" (March 30, 2017), available at


3Walczak, Tax Foundation, "Unpacking the State and Local Toolkit: Sources of State and Local Tax Collections" (June 20, 2017), available at

4See Jensen and Thurber, "The Evolution of Sales Tax Nexus Expansion Laws," The Tax Adviser (April 2012).

5Quill Corp. v. North Dakota, 504 U.S. 298 (1992).

6N.Y. Tax Law §1101(b)(8)(vi). LLC v. New York State Dep't of Tax. and Fin., 20 N.Y.3d 586 (2013), cert. denied, No. 13-259 (U.S. 12/2/13).

8Colo. Rev. Stat. §39-26-102(3)(b).

9Colo. Rev. Stat. §39-21-112(3.5).

10Direct Marketing Ass'n v. Brohl, No. 13-CV-34855 (D. Colo. 2/22/17) (settlement agreement).

11Vermont H.B. 516, Laws 2017, effective June 13, 2017, and Washington H.B. 2163, Laws 2017, effective July 7, 2017.

12Direct Marketing Ass'n v. Brohl, No. 13-1032 (U.S. 3/3/15).

13South Dakota v. Wayfair, Inc., No. 32CIV16-000092 (S.D. Cir. Ct. 3/6/17).

14American Catalog Mailers Ass'n v. Heffernan, No. 1784CV01772 (Mass. Sup. Ct. 6/9/17) (suit filed).

15Mass. Gen. Laws ch. 30A, §1(5).

16Mass. Gen. Laws ch. 30A, §3.

17Ohio H.B. 49.

18Minn. H.F. 1.



Jennifer Jensen is a director with PwC in Washington in State and Local Tax, focusing on indirect taxes. She is also the chair of the AICPA State & Local Tax Technical Resource Panel. For more information about this column, contact


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