Much attention has been paid to the Marketplace Fairness Act currently under consideration in Congress. Understandably, that coverage has focused on whether the bill, which would permit states to require out-of-state businesses to collect and remit sales taxes on goods sold over the Internet, will gather enough political support to become law. Little attention has been paid to the more interesting legal question—would the law be constitutional? Recent decisions from the federal courts suggest the question is open to serious debate.
Two constitutional provisions are implicated when a state attempts to collect sales tax on interstate transactions: the Due Process Clause of the Fourteenth Amendment and the Commerce Clause (or, in this instance, the Clause’s implied prohibition against certain state actions that burden interstate commerce, known as the “Dormant Commerce Clause”). As the Supreme Court explained in Quill Corp. v. North Dakota, 504 U.S. 298 (1992), these Clauses serve different purposes and thus while “a State may ... have the authority to tax a particular taxpayer” under one of these constitutional provisions, "imposition of the tax may nonetheless violate the” other Clause.
Quill Corp. explained that under the Due Process Clause, a state may tax transactions with any foreign business that “purposefully avails itself of the benefits of an economic market in the forum State.” Under the Dormant Commerce Clause, however, a state may only tax such transactions if the business has a “substantial nexus with the taxing State,” which generally requires some sort of physical presence there. Quill Corp. itself illustrated the difference between these constitutional tests: the mail-order office supply company involved in that case had solicited enough business in North Dakota to permit the state to tax its transactions under the Due Process Clause, but it lacked the sort of in-state presence necessary for that tax to be constitutional under the Dormant Commerce Clause.
Of course, the Marketplace Fairness Act would be a federal law, and not a state statute. But that might not be sufficient to make the law constitutional. As Quill Corp. explained, “while Congress . . . may authorize state actions that burden interstate commerce,” Congress “does not similarly have the power to authorize violations of the Due Process Clause.” It is this distinction that might prove fatal to the Marketplace Fairness Act, should it become law.
Only once before has Congress enacted a law that requires retailers to collect and remit state and local taxes on Internet sales: the Prevent All Cigarette Trafficking Act (“PACT Act”). Intended to end the practice of selling tax-free cigarettes over the Internet, the PACT Act requires Internet tobacco sellers to comply with “all State, local, tribal, and other laws generally applicable to sales of cigarettes or smokeless tobacco” in the states where they ship their products, including laws imposing tobacco excise taxes. That law was immediately challenged by Internet cigarette sellers who argued, among other things, that it violated the Due Process Clause because it did not ensure that these retailers had sufficient “minimum contacts” with the states into which they ship their products.
Thus far, two district courts have agreed, enjoining the PACT Act on the ground that it impermissibly “broaden[ed] the jurisdictional reach of each state and locality without regard to the constraints imposed by the Due Process Clause.” Red Earth LLC v. United States, 728 F. Supp. 2d 238 (W.D.N.Y. 2010); Gordon v. Holder, 826 F. Supp. 2d 279 (D.D.C. 2011). One district court has disagreed, holding that the PACT Act’s taxation requirement “is not being imposed by a state, acting unilaterally, but by Congress, and the legislative due process analysis must reflect the federal character of the legislation.” Musser’s Inc. v. United States, No. 10-4355 (E.D. Pa. Sept. 26, 2011). No federal Court of Appeals has squarely addressed the merits of this constitutional question to date; the U.S. Court of Appeals for the Second Circuit affirmed the Red Earth decision without deciding whether the PACT Act was constitutional, and the U.S. Court of Appeals for the D.C. Circuit has yet to issue its decision in Gordon. [Disclaimer: The author of this article previously worked for the U.S. Department of Justice and in that role defended the constitutionality of the PACT Act, including by arguing both Red Earth and Gordon in the U.S. Courts of Appeals].
The Marketplace Fairness Act might similarly be susceptible to attack under Quill on the ground that it attempts to “authorize violations of the Due Process Clause.” The bill pending in Congress creates no federal enforcement mechanisms, but simply provides that states would be “authorized to require all sellers not qualifying for the small seller exception . . . to collect and remit sales and use taxes.” Presumably, any legal actions to enforce this provision would occur under state law.
To be sure, the Marketplace Fairness Act does have a “small seller exception” for any retailer whose remote sales total $1 million or less per year. As a practical matter this exception might negate many potentially unconstitutional applications of the law, because sellers with that volume of business may well have sufficient minimum contacts with all of the states into which they sell their goods. This exception might not be enough to save the law from all Due Process challenges, however. Presumably, the law still would permit a state to tax even a single sale by an Internet retailer that sold over $1 million worth of goods to the residents of all other states combined. Under current constitutional standards, however, a single remote sale might not be enough to justify taxation by a foreign state under the Due Process Clause.
Should this law pass Congress, we can expect these issues—and many more—to be litigated in federal and state courts in the coming years. The political battle might be just the beginning of the movement to collect taxes on all Internet sales.