In a closely watched 5 to 4 decision authored by retiring Justice Kennedy in South Dakota v. Wayfair, 585 U.S. ___ (2018), the U.S. Supreme Court reversed decades of Supreme Court precedent, giving state and local governments the right to collect sales taxes from out of state retailers on online sales made into the local jurisdiction.

The case involves Wayfair, a furniture and home company which sold products over the Internet into the state of South Dakota.  The law in question required the payment of a 4.5% sales tax by out-of-state retailers that make at least 200 sales or sales totaling at least $100,000 in South Dakota.

Prior to the Wayfair case, the standard, from two Supreme Court cases named Bellas Hess and Quill, was that a company had to have a physical presence in the state in order to be required to pay local tax.  A “physical presence” was something like a retail outlet, employees or property in the jurisdiction.

The Supreme Court stated, overruling decades of precedent, that the physical presence rule is unsound and incorrect. The Court noted that the rule has become removed from economic reality as technology has advanced.  The Court stated that the physical presence rule creates market distortions and puts local businesses and others at a competitive disadvantage given the new online marketplace.

The court concluded that, if a retailer establishes a substantial nexus with a state, that state can tax the sales in that state.  In this case, they concluded that the South Dakota law’s requirements of number of sales or total value satisfies the substantial nexus requirement.

This case has attracted much attention. Nonetheless, it is not surprising. Readers of this blog might recall that several years ago, the Supreme Court refused to hear an appeal of an Iowa law that required the collection of income taxes from franchisors on royalties for the use a franchisor’s intangible intellectual property by its franchisees within the physical confines of the state of Iowa.  The US Supreme Court let stand a ruling that such use presents “a sufficient connection to Iowa to justify the imposition of income taxes.” To us, this sounds an awful lot like the new “substantial nexus” test for the imposition of sales taxes.

Given that so many states rely on sales tax revenue for huge portions of their budgets and state governments have a strong aversion to new income taxes, this green light from the Supreme Court means that other states are likely to take a hard look at their laws and consider the enactment of laws calling for the collection of online sales taxes like the one in South Dakota. At the same time, for the franchise world, the related issue of whether the presence of franchisees in a state constitutes a substantial nexus for taxes on royalties will be closely watched by the franchise industry.

This information does not constitute legal or tax advice.  You should, of course, consult an attorney or tax adviser regarding any taxation issues you might have, as each situation is unique.

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