A small, employee-owned New Hampshire outfit, Littleton Coin Company, sells currency through its website to collectors. After the Supreme Court ruled in its 2018 South Dakota v. Wayfair decision that such firms would henceforth have to pay sales taxes on transactions that they made in states where they weren’t physically present, Littleton Coin found itself potentially liable for levies in more than 12,000 state and local jurisdictions—“all with different laws, tax rates, filing processes, websites, registrations, product classifications, and exemptions,” CEO John Hennessey told a congressional hearing last June.
The bill is a whopper. The Court’s ruling predicted that the technical capabilities to deal with myriad tax laws would soon be in place at reasonable cost; but in 2018 alone, Littleton invested $225,000 to buy approved software to monitor its new tax liabilities. Since then, the business’s compliance costs—including engaging legal experts and technical staff—have added up to another $275,000 to track and pay proliferating obligations. Several states, meantime, have come, hand outstretched, for retroactive sales-tax payments—some for transactions made years before Wayfair. Worse still, Littleton is looking at unanticipated new levies based on states’ aggressive interpretation of the decision, written by now-retired Justice Anthony Kennedy. Three thousand miles away, California has demanded income taxes from Littleton Coin. And Littleton fears that this is “just the tip of the iceberg, of states reaching beyond these taxes into what could become an unlimited number of new areas,” Hennessey warned.
The Wayfair case dealt with a narrow South Dakota law that applied state sales taxes to goods sold by out-of-state firms to Dakotan customers. Wayfair, an online retailer of furniture and home products, challenged the law. The Court’s far-reaching decision, validating a new definition of tax “nexus”—the standard that a government uses to decide if a person or business is subject to its taxes—has created a counterproductive new American tax regime. Littleton is just one of millions of businesses nationwide trying to navigate a bewildering state and local tax landscape.
In a damning report, the nonpartisan Government Accountability Office (GAO) recently described the opaque and complicated post-Wayfair tax system as inequitable, overly expensive, and economically inefficient. Many of the worries that businesses expressed about Wayfair (several of which Chief Justice John Roberts highlighted in his dissent) have turned out to be justified. Even using the state-approved software to handle this complex environment, firms have found, has proved expensive and inadequate—sometimes leading to hefty penalties and interest costs.
Businesses have appealed to Congress for help, hoping that it can craft legislation that governs how states can apply their sales taxes, including requirements for simplification. Sensible reform would also address when and how states can apply other taxes—especially corporate income taxes—to firms with little or no physical presence in a state. Businesses, however, have pushed for just such legislation for several decades now, with little success. Now what was a mounting problem has become a crisis. “Four years after the Wayfair ruling, the state and local tax landscape for remote sellers in the United States continues to be overly complex, expensive, and burdensome,” Hennessey told Congress. “The future outlook of state and local tax obligations for small businesses is even more troubling.”
Among Congress’s constitutionally enumerated powers is the regulation of commerce among the states. As the Supreme Court has ruled in the past, this power allows the federal government to limit states’ ability to tax businesses or residents of other jurisdictions. And Washington has occasionally done so—for instance, when Congress passed the Interstate Income Act of 1959, which blocked states from slapping corporate income levies on out-of-state firms if they merely solicited orders within a particular state, without a physical presence there. The law responded to Minnesota’s attempt to tax an Iowa company that did some business with Minnesota firms. Several years later, Illinois tried to strong-arm a Missouri catalog retailer to collect sales taxes on items that it sold to Illinois customers. The Supreme Court reaffirmed in 1967 that states can’t make such demands on out-of-state companies.
As technology evolved, states launched new efforts at interstate taxation. In the early 1990s, North Dakota tried to force Quill, a business-supplies firm with offices in California, Illinois, and Georgia, to collect sales taxes on transactions within its borders. By mailing floppy disks of its product offerings to customers within North Dakota, the state contended, Quill had established a presence there. Though the Supreme Court denied North Dakota that power in Quill v. North Dakota (1992), it also noted that, as technological innovations changed how businesses operated, Congress would need to craft new laws that clarified and updated the tax-nexus idea.
For decades, Congress has demurred, though, failing to find common ground on various bills that would answer the nexus question. States have filled this vacuum, claiming the right to tax out-of-state firms based on loopholes in outdated legislation. The Interstate Income Act, for instance, applies only to firms selling tangible property, excluding modern products like cloud computing services, which customers access via online portals, or software that firms deliver to customers over the Internet. California, New York, and Connecticut, among other states, have imposed income taxes on out-of-state firms that sell such digital products, claiming that they have established an “economic” presence within their borders, even if the firms have no employees or offices there.
The explosion of online selling frustrated states because previous Supreme Court decisions had specifically banned localities from collecting sales taxes on such transactions. The rise of online retailing behemoths like Amazon also spurred doubts in the minds of some of the Court’s justices. In a concurring opinion on a 2015 case involving digital marketing, Justice Kennedy noted that the Court should reexamine its prior tax rulings with the e-commerce landscape in mind.
Several states, including South Dakota, promptly enacted laws demanding sales taxes from online retailers, hoping to produce a court case that might upend legal precedents. They got their payoff in the Wayfair decision, which overturned the doctrine that a physical presence was necessary to create a tax nexus in a state. Instead, the Court accepted the constitutionality of a South Dakota tax bill that said a business established an “economic” nexus if it executed 200 transactions or did $100,000 worth of business in the state. That was enough “to satisfy the substantial nexus requirement” of previous court cases, Kennedy wrote in his opinion for the Court, though without explaining why just 200 transactions would be considered “substantial.” Overturning Quill was necessary, Kennedy argued, because it was “unfair and unjust” to allow online retailers to evade sales taxes—even though the biggest of them, like Amazon, were already paying them because of the warehouses and offices that they were opening in most states.
Wayfair is a powerful example of the dangers of legislating from the bench. Kennedy’s decision revolved around a narrowly tailored state law, but it unleashed chaos by overturning the physical-presence requirement, without substituting a comprehensive alternative—some new parameters that could apply to every state and to the new economy. For example, though Kennedy praised South Dakota for pledging in its law not to seek sales taxes retroactively, several states subsequently have done just that, forcing firms either to pay up or fight a costly court battle to clarify whether Wayfair bans that practice. Similarly, though South Dakota has a population of just 900,000 and a tiny economy, much larger states, including Florida and Illinois, have passed sales-tax laws using Wayfair’s low thresholds for establishing a “substantial nexus requirement.” Kansas went further still, claiming that just a single transaction by an out-of-state firm triggers sales-tax requirements.
The 200-transactions limit is proving particularly burdensome for low-margin companies selling inexpensive products. The owner of one small New Jersey firm, Kevin Mahoney of specialty retailer FindTape.com, told a congressional hearing that he would make an average profit of just $169 on the 200 transactions that trigger the nexus requirement. In the first two years after Wayfair, Mahoney said, “We have spent $183,500 to collect just $79,423 in sales tax across 32 states. This equates to $2.31 for every $1.00 of sales tax collected.” Such problems are widespread. The GAO, in its report, noted that one firm was spending $1,500 a month in compliance costs to pay $500 in sales tax.
Anticipating complaints about Wayfair’s potential administrative costs, Kennedy’s opinion said that states could band together to minimize differences in how they imposed sales tax and that state-approved software was available to help firms manage the complexities and protect them from audit liabilities. The reality has been far different. Lacking any federal legislation that requires or motivates states to cooperate, many have passed sales taxes for remote sellers that suit their state’s particular interests. And the software has been glitchy, justifying Chief Justice Roberts’s concern in his dissent that this entire field was in its “infancy” and filled with “inadequacies.” The GAO reported that it had spoken with numerous businesses that had sustained big expenses trying to institute approved software. One firm, the GAO said, “told us it incurred a cost of almost $250,000 beyond taxes owed due to an error in the software code.” It took 80 employee hours to identify the problem, which affected sales taxes in multiple jurisdictions and forced the company to file “350 amended tax returns for the period in question and remit back taxes with accrued interest and penalties.”
Another firm, Halstead Bead of Prescott, Arizona, said that it joined the consortium of states cooperating on sales-tax administration and brought in an approved firm to track and pay its taxes. The firm, though, failed to forward to the states the taxes that Halstead Bead had collected. Halstead Bead was hit in 2019 with 35 notices of delinquency from tax authorities. Tennessee threatened to seize the company’s property over $38.22 in penalties, while Wyoming warned that it would put a lien on the firm’s assets because of an unpaid $100 tax bill. Trying to find out what had happened to the collected tax money, Halstead Bead’s finance chief, Bradley Scott, says that one tax department told him that he had no right to any information about transactions between the state and the certified software provider that the firm had hired to manage its taxes. “Each notice [of delinquency from states] induced a combination of panic and fear,” Scott informed Congress.
Since Wayfair, many state tax departments have engaged in “fishing” expeditions, barraging out-of-state businesses with letters demanding that they fill out questionnaires about their local sales to determine whether they owe money. That has added administrative burdens even for firms that have no business in a state. “It is incredibly stressful to open up your mail and see a stack of letters from a state you have no real presence in,” FindTape.com’s Mahoney told Congress. Some letters carry implied threats that the business is presumed to owe the state taxes—and had better pay them. “In some instances, audit staff for the state simply wish to make an assessment and force the company to fight the assessment in appeals,” two Florida-based state tax experts, David J. Brennan, Jr. and Joseph C. Moffa, wrote after Wayfair. “To say the least, many states have been emboldened by Wayfair,” they observe.
“States have begun applying the new nexus precedent to their business-activity taxes—all the taxes and fees that firms may have to pay to operate in a state.”
Wayfair is proving massively unfair to online sellers—exactly contrary to the situation that Kennedy claimed prevailed before the decision, in which physically located firms were supposedly disadvantaged. “An accepted principle of equity is that similarly situated taxpayers should receive similar treatment,” the GAO maintained. But post-Wayfair, the GAO said, remote sellers “must grapple with the patchwork of different requirements across the taxing jurisdictions with which they have economic nexus, whereas brick-and-mortar sellers generally must grapple only with the requirements of the jurisdictions in which they are physically located.”
According to the GAO, the tax regime that has emerged since the court’s ruling undermines economic efficiency. Ideally, government should raise revenues in a way that creates the least economic distortion. Instead, the GAO says, the confusing jumble of tax jurisdictions has forced many businesses to change how they operate. “[R]emote sellers made behavioral changes arising from the need to divert resources away from business operations and investments and toward tax compliance, such as limiting the number of states into which they sell or the amount of sales into some states,” the GAO observes. News stories have included examples of firms saying that they will close because of the onerous new sales-tax regime, and others shifting their business models.
Wayfair’s most troubling outcome may be its impact on other kinds of taxes. States have begun applying the new nexus precedent to their business-activity taxes—that is, the income taxes, corporate registration fees, and franchise taxes that firms may have to pay to operate in a state. Previous court rulings, as well as the Interstate Income Act, accepted the idea that if a business wasn’t physically present in a state, it wasn’t making use of the services that government provided and thus shouldn’t have to pay income or other corporate taxes there. The new economic nexus precedent maintains that states create their local economy and that businesses that tap into it should pay for the privilege. That ignores a key fact: in a modern economy of more than 2 million remote-selling businesses, state treasuries already benefit when their own in-state firms sell to remote customers, bringing those revenues back home. Under the new theory, states want to have their cake and eat it, too—that is, they profit from the remote economy that local firms utilize and tax out-of-state firms.
Without waiting for clarification after Wayfair, several states moved quickly to apply the economic-nexus standard to corporate income taxes. Hawaii was first, establishing the same standard used in Wayfair—200 transactions, or $100,000 in sales—to trigger income-tax requirements. California and New York followed soon after with their own version of economic nexus, using the sales-tax data that firms now had to file to begin dunning companies for corporate taxes. California demanded back income taxes from 2019 from Littleton Coin after it registered with the state to pay sales tax. Many others have since lined up. “These taxes we pay out of our own pocket as they are not taxes collected and remitted from customers. We currently pay $40,000 per year in these taxes,” Littleton CEO Hennessey told Congress. Texas similarly has demanded that VIM & VIGR Compression Legwear, a Montana-based employer that sells online, pay its $3,000-a-year franchise tax—essentially a licensing fee to do business in the state—though the company has no connection to it, other than customers. “Several other states, including Hawaii, Idaho, and Pennsylvania are doing the same,” the firm’s founder, Michelle Huie, said in testimony before the Senate Finance Committee. FindTape.com has been hit with corporate income taxes in California, with Washington State’s business and operation tax, and Nevada’s annual business registration fee—all without any physical connection to these locations.
Changes accelerated by the Covid pandemic have also made firms increasingly vulnerable to interstate taxation. Telecommuting, which exploded during Covid lockdowns, has persisted, even as firms reopened their offices. Many experts have praised this transformation because it gives businesses more flexibility in hiring and cuts real-estate costs. However, the downside is also becoming apparent: companies are now finding that telecommuting workers make them targets for state tax authorities. In a Bloomberg survey, 37 states said that they would consider an employee working remotely in their state for an out-of-state company as grounds to tax the firm’s profits. That’s on top of other obligations that firms already incur from remote workers—including paying withholding taxes and unemployment insurance in those states. Many states suspended these obligations during the pandemic to accommodate the lockdowns, but they are now targeting remote workers. Particularly vulnerable are companies that have gone entirely to a telecommuting model—up to one in six firms, by some estimates. They potentially face corporate income tax and other business-activity levies in every state where their remote employees live. The issue is so serious that “companies may need to consider creating ‘blacklist states’—states where employees are prohibited from working remotely,” several state tax experts recently advised firms.
Emboldened states are pushing the envelope even further. Legislators in many locales have considered a digital-advertising tax. As proposed in various states, the tax would apply to online ads clicked on by residents of a state and to the revenues that a site earned from them. The levy applies regardless of where the website operator or advertising company is physically headquartered. That means taxing out-of-state firms whose only nexus is that residents of a state are clicking on their ads.
Over the veto of now-departed governor Larry Hogan, Maryland has already passed such a tax, a charge ranging from 2.5 percent to 10 percent of the gross revenues generated by these ads. A Maryland court subsequently deemed the tax unconstitutional because it violated the Commerce Clause, but at least 25 states have proposed similar measures and await potential appeals of the Maryland ruling. A New York bill would apply a 5 percent tax to any company that uses the data of state residents to generate income. That could potentially mean, for instance, that a business that you’ve purchased something from in the past could be taxed if it subsequently sent you solicitations for similar merchandise and you responded by buying something.
The latest state overreach finds at least part of its rationale in what underlies Wayfair. Legislators in seven states have proposed a wealth tax on the rich, which would apply not to the income of individuals but to their assets, including unrealized capital gains. To confront the inevitable exodus of the wealthy from these states under such a tax, the legislation also proposes to keep taxing these individuals after they’ve left the state. Such an exit tax has long been thought to violate the Commerce Clause, in part because the levy applies to individuals not deriving any benefits from a state government because they are no longer physically present in a jurisdiction. But the justification for the exit tax—that these people generated their wealth in a state’s economy and therefore should keep paying taxes on it, even when they have moved themselves and their assets elsewhere—is related to the argument in Wayfair that a business that benefits from customers in out-of-state economies should pay for the privilege.
If Justice Kennedy and the other concurring Supreme Court justices meant to spur Congress into action with the Wayfair decision, the strategy has yet to work—and the consequences of the ruling are piling up. Congress now has two tasks. One is legislation that specifically addresses the Wild West landscape in remote sales tax. The GAO report recommends that Congress work with the states to create national parameters for a remote sales-tax system. That should include guidelines on the amount of contact that firms must have with a state’s economy before the tax nexus kicks in. Merely allowing much larger states to adopt the standard in the Wayfair precedent ignores the “substantial nexus requirement” that Kennedy used to justify the South Dakota tax. Similarly, Congress should ban retroactive taxation and aim for a simplified system for remote sellers that requires states to use standardized definitions of taxable items and procedures. Such legislation should also consider liability protection for firms that adopt the software recommended by states. Any legislation should also make clear that these parameters apply only to state sales taxes—states should not be free to apply them as justification for other kinds of taxes on out-of-state firms.
Congress needs to go further, however, and also address the issue of tax nexus in the digital age for business levies, especially corporate income and franchise taxes. For nearly a decade, Congress considered a Business Activity Simplification Tax Act that would have closed some of the loopholes that exist in interstate taxation. That law would have prevented a tax authority from claiming that a firm has a physical presence in a state merely if an employee visits the state on business. It also prohibited states from claiming that an out-of-state firm that leases software or provides other remote services to clients within a state would be considered to be physically present and therefore subject to corporate taxes. But Congress has failed to agree on any such measure. Congress should provide a federal definition of what constitutes nexus for business activity taxes and offer some parameters that the states must follow to levy such taxes on businesses based elsewhere. That legislation should probably address the growing question of remote workers and the obligations that businesses incur from them. Otherwise, the entire momentum of telecommuting might come undone.
Individual workers now face similar tax liability from states like New York, which claims that an out-of-state worker telecommuting for a New York firm is essentially present in the state for the purposes of individual income taxes. That arrangement would either require the employee’s home state to provide the worker with a credit on the income taxes that he is paying to another state, or it would result in double taxation—either way, an unacceptable form of multistate taxing. A proposed Mobile Workforce Simplification Act would limit such taxes if a worker spends most of his time outside a state imposing them—an especially important principle in an age of remote work.
The digital economy has provided dazzling choices to consumers, opened exciting opportunities for entrepreneurs, and helped both employers and workers figure out how to connect in better ways. Yet states’ aggressive efforts to squeeze tax revenues out of this online economy threaten to undermine many of its advantages. It’s up to Washington to fix the mess.
Top Photo: More than 2 million American businesses that sell goods online are potentially liable for taxes in up to 12,000 state and local jurisdictions, many with their own distinctive forms and filing requirements. (MICHAEL MACOR/THE SAN FRANCISCO CHRONICLE/HEARST NEWSPAPERS/GETTY IMAGES)
