Initial perspectives on Wayfair

Editor: Howard Wagner, CPA   On June 21, 2018, the U.S. Supreme Court issued its decision in South Dakota v. Wayfair, Inc., No. 17-494 (U.S. 6/21/18), which overturned 50 years of precedent and dealt with fundamental questions of state tax jurisdiction and the regulation of interstate commerce. This decision is the most significant state tax case in the past 25 years and raises new and fundamental issues.

Facts and significance of the case

Wayfair is an internet retailer without a physical presence in South Dakota, which enacted a law targeting out-of-state retailers for sales and use tax collection. The issue decided in Wayfair was whether the Court should overturn its holding in Quill Corp. v. North Dakota, 504 U.S. 298 (1992), that physical presence is necessary for a state to require an out-of-state mail-order company to collect sales and use tax under the Commerce Clause (Quill, 504 U.S. at 314). Quill upheld the Court’s 1967 decision in National Bellas Hess, Inc. v. Department of Revenue of Ill., 386 U.S. 753 (1967).

The physical presence requirement under Quill was a “bright-line rule” (Quill, 504 U.S. at 316). Although the decision in Quill was clear and pointed, 23 years later, in Direct Marketing Association (DMA) v. Brohl, 135 S. Ct. 1124 (2015), Justice Anthony Kennedy wrote a concurring opinion inviting a challenge to Quill:”Given 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” (135 S. Ct. 1124, concurring opinion (internal citation omitted)). South Dakota heeded the call and passed a law directly challenging Quill. Wayfair subsequently filed suit.

DMA dealt with the legality of a Colorado law requiring out-of-state sellers to provide information about in-state customers’ total purchases so that they could calculate their sales and use tax liability. Justice Neil Gorsuch was a member of the Tenth Circuit Court of Appeals that issued a decision in DMA. In Wayfair, the Court referred to this: “The physical presence rule has ‘been the target of criticism over many years from many quarters.’ Direct Marketing Assn. v. Brohl, 814 F.3d 1129, 1148, 1150-1151 (CA10 2016) (Gorsuch, J., concurring).”

The Wayfair Court held that “the physical presence rule of Quill is unsound and incorrect” and declared the Court’s decisions in Quill and National Bellas Hess overruled (Wayfair, slip op. at 22).

Due Process Clause precedent and its application in Wayfair

The Due Process Clause of the Fifth and Fourteenth Amendments of the U.S. Constitution requires fairness in the operation of law, including jurisdiction. Under the Constitution, the Supreme Court is empowered to make determinations about whether a law or action passes or violates the Due Process Clause. Although the Court’s case law on due process and jurisdictional issues dealt with tax cases in the past, Wayfair provided only a cursory analysis of the due process issues, in particular, whether Wayfair had minimum contacts with South Dakota under International Shoe Co. v. Washington, 326 U.S. 310 (1945), and Miller Brothers Co. v. Maryland, 347 U.S. 340 (1954).The former case dealt with an out-of-state corporation with in-state sales people and the collection of unemployment taxes. Although not cited in Wayfair, in International Shoe, the Court introduced the well-known “minimum contacts” standard for jurisdiction — “sufficient contacts or ties” are needed to establish jurisdiction, as long as it is “reasonable and just according to our traditional conception of fair play and substantial justice.” In Miller Brothers, which dealt with a mail-order business and use tax, the Court held “that due process requires some definite link, some minimum connection, between a state and the person, property or transaction it seeks to tax.”

Four later cases dealing with due process and personal jurisdiction were decided in the 1980s. In each case, the Court applied the minimum-contacts standard, with varying outcomes: World-Wide Volkswagen Corp. v. Woodson, 444 U.S. 286 (1980) (personal injury case arising out of a car accident; insufficient contacts — foreseeability alone not enough for personal jurisdiction); Helicopteros Nacionales de Colombia, S.A. v. Hall, 466 U.S. 408 (1984) (involving Texas long-arm statute and a helicopter crash in Peru; defendant’s business-related activities in the forum state were not “continuous and systematic general business contacts” to allow the state to exercise general jurisdiction); Burger King Corp. v. Rudzewicz, 471 U.S. 462 (1985) (involving Florida long-arm statute and a breach-of-contract claim; defendant had sufficient contacts — “purposeful availment”); and Asahi Metal Industry Co., Ltd. v. Superior Court, 480 U.S. 102 (1987) (personal injury case arising out of a motorcycle accident in California and California’s long-arm statute; insufficient contacts — no purposeful availment, and stream of commerce not enough; focus on the burdens placed on out-of-state defendant).

The Court in Quill reviewed several of these decisions and applied them, holding that physical presence is not required under the Due Process Clause. The Court was explicit: “Thus, to the extent that our decisions have indicated that the Due Process Clause requires physical presence in a State for the imposition of duty to collect a use tax, we overrule those holdings as superseded by developments in the law of due process” (Quill, 504 U.S. at 298).

In 2011, the Court issued two decisions on personal jurisdiction dealing with personal injury cases — J. McIntyre Machinery, Ltd. v. Nicastro, 131 S. Ct. 2780 (2011), and Goodyear Dunlop Tires Operations, S.A. v. Brown, 131 S. Ct. 2846 (2011). In both cases, the Court ruled that state courts were barred from exercising personal jurisdiction over foreign manufacturers, based on due process, because there were insufficient contacts; limited sales into the jurisdiction were not enough. According to a law review article, “the Court embraced a more general doctrine that limits general jurisdiction over corporations to places where they are ‘at home’ — their places of incorporation, principal places of business, and, perhaps, places where they engage in such substantial, continuous, and systematic activity that those places are comparable to principal places of business” (Hoffheimer, “General Personal Jurisdiction After Goodyear Dunlop Tires Operations, S.A. v. Brown,” 60 Kansas L. Rev. 551 (2012)).

In 2014, the Court continued its trend of limiting jurisdiction over out-of-state parties and applied the “at home” standard. In Daimler AG v. Bauman, 134 S. Ct. 746 (2014), the Court held that the out-of-state party must have continuous and systematic contacts within the state to make it “essentially at home in the forum State.” In Walden v. Fiore, 134 S. Ct. 1115 (2014), the Court held that “our ‘minimum contacts’ analysis looks to the defendant’s contacts with the forum State itself, not the defendant’s contacts with persons who reside there” and “we reiterate that the ‘minimum contacts’ inquiry principally protects the liberty of the nonresident defendant, not the interests of the plaintiff.”

The Wayfair Court concluded that Wayfair had sufficient minimum contacts with South Dakota, despite its lack of physical presence in the state. “It is settled law that a business need not have a physical presence in a State to satisfy the demands of due process. Burger King Corp. v. Rudzewicz, 471 U.S. 462, 476 (1985)” (Wayfair, slip op. at 11). The Court in Quill also specifically ruled that physical presence is not required under the Due Process Clause. However, the Court in Quill specifically acknowledged that “[o]ur due process jurisprudence has evolved substantially in the 25 years since Bellas Hess, particularly in the area of judicial jurisdiction.” Likewise, the Court’s due process cases have evolved since Quill and appeared to provide more constitutional protection to out-of-state retailers than existed under prior cases, including Quill. Regardless, the Wayfair Court reasoned:

[T]here is nothing unfair about requiring companies that avail themselves of the States’ benefits to bear an equal share of the burden of tax collection. Fairness dictates quite the opposite result. Helping respondents’ customers evade a lawful tax unfairly shifts to those consumers who buy from their competitors with a physical presence that satisfies Quill — even one warehouse or one salesperson — an increased share of the taxes. It is essential to public confidence in the tax system that the Court avoid creating inequitable exceptions. This is also essential to the confidence placed in this Court’s Commerce Clause decisions. Yet the physical presence rule undermines that necessary confidence by giving some online retailers an arbitrary advantage over their competitors who collect state sales taxes. [Wayfair, slip op. at 17]

Leveling the playing field between interstate commerce and local interests

The Wayfair Court mainly focused on the Court’s Commerce Clause jurisprudence in reaching its decision, citing “the now-accepted framework for state taxation in Complete Auto Transit, Inc. v. Brady, 430 U.S. 274 (1977)” (Wayfair, slip op. at 7).

The Commerce Clause deals with Congress’s power to regulate interstate commerce (U.S. Const. art. I, §8, cl. 3). In Complete Auto,the Court ruled that a tax involving interstate commerceis valid if it meets a four-part test: (1) It is applied to an activity having a substantial nexus with the taxing state; (2) it is fairly apportioned; (3) it does not discriminate against interstate commerce; and (4) it is fairly related to the services provided by the state.

In Quill, the Court separately analyzed the physical presence requirement with respect to the Due Process Clause and the Commerce Clause. It held that for purposes of due process, physical presence within a state was not a prerequisite to the legitimate exercise of state power. The court further held, however, that substantial nexus under the Commerce Clause requires physical presence. As stated above, the physical presence requirement, in the Court’s own words, is a “bright-line rule” (Quill, 504 U.S. at 316).

The Quill Court invited Congress to regulate and legislate a different standard than the bright-line physical presence test. One year later, the Court sent the same message to Congress when it decided an unclaimed property dispute between two states. In Delaware v. New York, 507 U.S. 490, 492 (1993), the Court held that “[i]f the States are dissatisfied with the outcome of a particular case, they may air their grievances before Congress. That body may reallocate abandoned property among the States without regard to this Court’s interstate escheat rules. Congress overrode Pennsylvania by passing a specific statute concerning abandoned money orders and traveler’s checks, . . . and it may ultimately settle this dispute through similar legislation.”

The Court in Wayfair was faced with the same situation as in Delaware v. New York: whether it should overturn its own long-established precedent. The Court overturned its decision and chose not to wait for Congress. The Court held:

Each year, the physical presence rule becomes further removed from economic reality and results in significant revenue losses to the States. These critiques underscore that the physical presence rule, both as first formulated and as applied today, is an incorrect interpretation of the Commerce Clause. [Wayfair, slip op. at 10]

In rejecting the physical presence standard, the Court cited the importance of a level playing field between in-state and out-of-state retailers (Wayfair, slip op. at 12—13, 17) and believed that “Quill has come to serve as a judicially created tax shelter for businesses that decide to limit their physical presence and still sell their goods and services to a State’s consumers — something that has become easier and more prevalent as technology has advanced” (Wayfair, slip op. at 13).

The Wayfair Court also addressed the concerns that its holding would harm small business, arguing that the South Dakota law at issue:

affords small merchants a reasonable degree of protection. The law at issue requires a merchant to collect the tax only if it does a considerable amount of business in the State; the law is not retroactive; and South Dakota is a party to the Streamlined Sales and Use Tax Agreement. [Wayfair, slip op. at 21]

Left unresolved is how a state’s being a party to the Streamlined Sales and Use Tax Agreement provides protection to small businesses. Also left unresolved is whether a state that is not a party to the Streamlined Sales and Use Tax Agreement would be viewed as imposing an unreasonable burden on business.

The Wayfair holding raises a number of important issues. Foremost, there is no longer a bright-line rule to follow for sales tax purposes. Instead, states and businesses will need to litigate to determine what level of in-state activity is reasonable and consistent with Wayfair. Is the threshold in South Dakota the new standard that every state must follow, i.e., delivering more than $100,000 of goods or services into, or engaging in 200 or more transactions for the delivery of goods and services into the state annually? Or can states craft their own thresholds — as little as a single sale or $1 of revenue annually? Second, is the Court’s holding limited to sales taxes or does it broadly apply to all state taxes, including income tax? Third, after Wayfair, is there even a functional difference between the due process nexus standard and the Commerce Clause nexus standard and, if so, how are they to be applied?

Also left undecided is whether states will attempt to retroactively pursue out-of-state retailers for uncollected sales and use tax, as well as unpaid income taxes of a business if the state has adopted economic nexus standards (and most states have done so). Nexus under the economic presence standard for income tax purposes is generally triggered when a business directs economic activity in the state or derives income from a state’s local market by making sales to customers in the state. Such a standard appears to be valid underWayfair.

Small businesses beware

While the Quill Court invited Congress to regulate this issue, the Wayfair Court invited more litigation:

And, if some small businesses with only de minimis contacts seek relief from collection systems thought to be a burden, those entities may still do so under other theories. These issues are not before the Court in the instant case; but their potential to arise in some later case cannot justify retaining this artificial, anachronistic rule that deprives States of vast revenues from major businesses.” [Wayfair, slip op. at 22]

Wayfair may be the beginning of a long line of cases on state tax jurisdiction.

As a practical matter, remote sellers should take these immediate actions:

• Examine and prioritize their sales tax posture in jurisdictions that currently allow for taxation of remote sellers that do not have a physical presence in the jurisdiction;
• Determine whether their systems and processes can identify taxable transactions; and
• Consider their potential exposure in states that have enacted similar laws prior to the Wayfair decision and implement proactive courses of action (e.g., prospective registration and voluntary disclosure agreements).

EditorNotes

Howard Wagner is a partner with Crowe LLP in Louisville, Ky.

For additional information about these items, contact Mr. Wagner at 502-420-4567 or howard.wagner@crowe.com.

Unless otherwise noted, contributors are members of or associated with Crowe LLP.