Is Illinois’s sales tax playing field really level?

Editor: Mary Van Leuven, J.D., LL.M.

Since the U.S. Supreme Court’s decision in South Dakota v. Wayfair, Inc., 138 S. Ct. 2080 (2018), a few lawsuits have alleged that the sales tax collection and remittance obligations imposed by a state or locality post-Wayfair were unduly burdensome. A recent suit, filed with the Illinois Tax Tribunal, is PetMed Express, Inc. v. Illinois Department of Revenue, No. 23 TT 104 (Ill. Indep. Tax Trib. 11/28/23) (petition filed). PetMed Express, also known as PetMeds, a Florida-based remote retailer of pet medications, asserts that the Leveling the Playing Field for Illinois Retail Act (35 Ill. Comp. Stat. 185/5-1) violates the Commerce Clause of the U.S. Constitution and the Uniformity Clause of the Illinois Constitution. The lawsuit also asserts a separate Taxpayer Bill of Rights issue stemming from the procedure of the audit. This discussion focuses on PetMeds’ Commerce Clause argument, which contends that the act discriminates against remote retailers compared to retailers that have a physical presence in Illinois.

Illinois’s sales tax is called the retailers’ occupation tax (ROT) and consists of a state-level ROT and locally imposed ROTs. A separate state use tax applies, but local use taxes generally do Not exist (Chicago is the exception). Prior to the act, remote retailers with economic nexus were required to collect the flat 6.25% state use tax, while in-state retailers collected not only the 6.25% state ROT rate but also local ROT. This allowed consumers to purchase goods more cheaply from remote sellers because there was a higher tax rate for sales by in-state retailers. The act was intended to correct this disparity.

Effective Jan. 1, 2021, the act requires the following:

• In-state retailers: Collect ROT at the origin rate.
• Remote retailers (i.e., retailers with no physical presence in Illinois): Collect ROT at the destination rate, assuming the retailer has economic nexus.
• Out-of-state sellers with physical presence in Illinois: If selling activities occur in Illinois for the particular transaction, collect ROT at the origin rate. Otherwise, collect the 6.25% state use tax rate.

In its lawsuit, PetMeds argues primarily that requiring remote retailers to use destination sourcing is an unfair burden because sellers with a physical presence in Illinois can use much simpler origin sourcing.

For background, “origin sourcing” requires retailers to collect the tax rate for a particular transaction based on the seller’s in-state location or ship-from location. “Destination sourcing” requires retailers to collect the tax rate based on the location where the customer takes possession of the item sold, which is generally the customer’s ship-to location. Most U.S. state sales taxing jurisdictions implement destination sourcing for all retailers.

PetMeds’ position

PetMeds sells pet medications, food, supplements, and other items that are shipped from out of state via common carrier directly to customers in Illinois. For Illinois ROT purposes, PetMeds is considered a remote retailer. Pursuant to the act, PetMeds was required to collect and report ROT based on each Illinois local jurisdiction where products were delivered to customers. PetMeds stated in its petition that it delivered goods to over 900 destinations in Illinois and incurred significant expenses by engaging a third-party software provider to assist with the calculation and remittance of Illinois local ROT. From a local ROT compliance perspective, remote retailers are required to: (1) identify the location code for each destination to which a taxable sale is delivered; (2) register each individual location code onto the taxpayer’s MyTax Illinois account; and (3) remit the local ROT for each jurisdiction on a separate form (Form ST-2, Multiple Site Form) from the tax return form (Form ST-1, Sales and Use Tax and E911 Surcharge Return). Identification of location codes requires manually inputting the address of each purchaser and validating the address with a nine-digit ZIP code to conduct a location code inquiry, according to the petition.

Count I of the petition addresses the Commerce Clause challenges, and, at heart, PetMeds is asserting that it is treated unfairly under the act as compared to retailers that have some Illinois presence. First, PetMeds alleges that the act discriminates against interstate commerce by imposing destination-based sourcing on sales by remote retailers and origin-based sourcing on sales by similarly situated retailers with an Illinois presence (minimal or otherwise). This disparate treatment, PetMeds alleges, discriminates against remote retailers by imposing a different and more onerous scheme than is imposed on retailers with physical presence.

PetMeds likewise asserts that the act imposes undue burdens on remote retailers as compared to similarly situated in-state retailers. Specifically, as noted above, PetMeds is required to separately determine and report local ROT for over 900 Illinois jurisdictions. In contrast, retailers with some amount of in-state presence are required to do so only for one or significantly fewer local tax jurisdictions under the origin-based sourcing rules.

PetMeds persuasively cites the U. S. Supreme Court case Associated Industries of Missouri v. Lohman, 511 U. S. 641 (1994), for the proposition that the burdens on interstate and intrastate commerce must be equal. While not the main focus of its petition, PetMeds is also required, at times, to collect a higher rate of tax as compared with in-state retailers that collect a lower origin rate, or as compared with out-of-state retailers with a physical presence in Illinois that are required to collect the flat 6. 25% use tax rate only. This type of difference in rate collection was the crux of the inequality addressed in Associated Industries of Missouri.

How to resolve this issue

Although this case is in its infancy, the question arises as to how Illinois’s ROT regime could be fixed if PetMeds is successful. Ultimately, this is a question for the legislature; however, a couple of possible solutions come to mind.

The first option: Reimplement the 6.25% use tax collection for remote retailers. This is a potential temporary solution; however, the result would be disparate treatment against in-state retailers, which was what the act was intended to fix in the first place. While disparate treatment against in-state retailers does not violate the Commerce Clause, it is problematic nonetheless. At the time of this writing, the average local ROT rate in Illinois is approximately 8. 82%, in comparison with the 6.25% use tax rate remote retailers used to be required to collect. This would again prompt Illinois consumers to make their purchases online.

A second option is to implement destination sourcing for all retailers making sales in Illinois, whether they be in-state, out-of-state (with physical presence in Illinois), or remote retailers. This would mean that retailers with a physical presence would no longer look to the location of selling activities as the means of sourcing a sale, which would preclude them from planning where their “selling activities” occur to avoid collection of the local use tax. This option, of course, would not remove the compliance burdens identified in PetMeds’ petition; instead, it would impose the same burdensome rule on all sellers. Arguably, the compliance burden felt by in-state sellers may be of no actual effect, particularly in scenarios of brick-and-mortar retail stores lacking an e-commerce platform and not making deliveries. In these scenarios, sales under destination sourcing would still be sourced to the taxpayer’s store location (i.e., where the customer takes possession of the item sold), which is the same result as with origin sourcing.

In conjunction with option 2, a third option would be a wholesale overhaul and simplification of Illinois’s overall sales tax regime. The current regime has been referred to by the executive director of the Illinois Chamber of Commerce’s Tax Institute as “incomprehensible” (Staats, Illinois CPA Society, “Illinois’ Incomprehensible Sales Tax Law,” Insight (Fall 2019)).

What are the potential implications stemming from this decision?

In Wayfair, the U.S. Supreme Court observed that although the physical presence requirement was repealed, “other aspects of the Court’s Commerce Clause doctrine can protect against any undue burden on interstate commerce. ”The Court did not set forth any particular test for determining when a state’s taxing regime would be unduly burdensome, and the application of the “undue burdens” test in this context is untested. However, the Court cited with approval several aspects of South Dakota’s sales tax regime that it believed alleviated any concerns with respect to the situation at hand. Since Wayfair, the question many sales tax practitioners have raised is: When will compliance with a state or local tax regime be unduly burdensome so that the Commerce Clause is implicated? The PetMeds dispute may provide guidance on this important question.

The case may also raise awareness as to when differential treatment of in-state retailers and out-of-state retailers may be unconstitutional. PetMeds’ suit should be monitored closely by states that apply differing sales or use tax sourcing regimes for in-state versus out-of-state or remote retailers, such as California, Tennessee, Texas, Utah, and Virginia. Similar to Illinois, these states require in-state retailers to collect tax based on the origin of the sale, while remote retailers must collect tax based on the destination of the sale. In sum, to the extent that these state regimes favor in-state retailers, the state similarly runs the risk of lawsuits.

Texas offers an election for remote retailers to collect a single local use tax rate of 1.75%; this removes a remote retailer’s compliance burden. However, one could point out that this is disadvantageous for certain remote retailers because some Texas local jurisdictions have a zero local use tax rate, a benefit for in-state retailers in such jurisdictions.

Wrapping it up

Unequal treatment of remote retailers potentially violates the Commerce Clause. Under the complex sales and use tax sourcing regimes implemented in Illinois and some other states, questions arise about equal treatment of remote retailers, flipping the concerns raised in Wayfair about equal treatment of in-state retailers. Remote retailers are, in fact, treated differently in these states, which the Court in Wayfair noted could potentially have the effect of discriminating against interstate commerce.

Editor notes

Mary Van Leuven, J.D., LL.M., is a director, Washington National Tax, at KPMG LLP in Washington, D.C. Contributors are members of or associated with KPMG LLP. For additional information about these items, contact Van Leuven at mvanleuven@kpmg.com.