I. Introduction to State and Local Taxation
Inherent in the federalist structure of the U.S. government is the notion that the federal government is not the best authority to decide all the laws and regulations of each state. Thus, states carry out many activities that reflect those of the federal government but take place at a much more local level. Among those is financing various programs and infrastructure projects. For states to finance the services their populations need, they must be able to impose taxes to raise those funds. The states gain their power to tax within their own borders from the Constitution.1 Though many states have different taxing schemes, the primary revenue stream for most states falls into three tax categories: property tax, corporate/individual income tax, and sales/use tax.2
Though the states are given dominion over their own finances, their taxing power is limited by the due process and commerce clauses (and dormant commerce clause).3 The U.S. Constitution provides that “Congress shall have the power . . . to regulate Commerce with foreign nations, and among the several States, and with the Indian Tribes.”4 The U.S. Supreme Court has recognized the commerce clause not only as a grant of power to Congress to tax interstate commerce but also as a limitation on the states and their local governments to tax commerce outside their own borders.5
Many Supreme Court cases have been litigated to determine what interstate commerce is, but that is not the subject of this analysis. Rather, the focus of this paper is to propose a new method of determining whether a state has the authority to tax a company that has no physical presence within that state yet takes advantage of the state’s market to sell its goods. Section I provides a cursory look at state and local tax principles, including the constitutional bounds of state taxation and the current standing of the law for sales and use tax. Section II introduces how a “factor nexus standard” can be adapted from corporate income tax systems to be used for determining whether a state can require a company to collect and remit use tax. Section III advocates for the official switch from the physical presence requirement upheld in Quill Corp. v. North Dakota 6 to a factor nexus standard that includes both physical and economic presence thresholds. By showing the problems caused by the physical presence requirement and the tax gap — the difference between the amount of tax owed and what is actually paid — I argue that a factor-based nexus standard would allow states to use third-party out-of-state vendors to collect and remit use taxes more effectively than they currently can. That includes looking to states that have departed from the physical presence standard and examining other attempts for reform that could affect the sales and use tax regime. Section IV discusses whether Congress or the judiciary has the power to change the physical presence requirement, and which body should do so.
A. Overview of State and Local Taxation Principles
The first question is how to best address taxing commerce that, while clearly interstate, takes advantage of state markets. That problem can be addressed using the example of personal income taxes. What is a state to do when a resident of one state works full time or even part time in a second state? Which state has the authority to tax the individual’s income? Is it the state in which the individual resides? That state would have a claim because the individual primarily uses the services of that state — the individual lives there and presumably uses its healthcare, infrastructure, and schools. However, the second state also has a claim on taxing that individual’s income. The individual works in the second state and thus takes advantage of the market in the second state. Allowing the second state to tax the individual’s income would deprive the resident state of taxable income that otherwise would have stayed within the state. There are complex considerations that go into determining which state can tax what.
To address which state can tax what, the Court announced four factors that a state tax must meet to be considered constitutional under the commerce clause. Those factors were first announced in Complete Auto Transit Inc. v. Brady.7 Complete Auto Transit Inc., a Michigan corporation, was transporting cars into Mississippi to be distributed for sale. Mississippi imposed a tax on transportation companies for the privilege of doing business in the state.8The Court held that the tax was constitutional based on the following four factors: (1) the entity to be taxed must have a substantial nexus with the taxing state; (2) the tax must be fairly apportioned; (3) the tax must not discriminate against interstate commerce; and (4) the tax must have a fair relationship to the services provided by the taxing state.9
This paper focuses on the first factor, the substantial nexus requirement. That factor implicates both the commerce and the due process clauses. If a taxable entity does not have a substantial nexus with the taxing state, the state would violate the commerce clause. Also, without a substantial nexus, that same entity would be taxed contrary to its due process rights. Though the due process clause is necessary in determining which states can tax which goods and services, the nexus test for due process is a lower standard and is much easier to meet and apply than that of the commerce clause.10 Thus, there are usually very few issues with the due process clause that are not already addressed via the commerce clause’s higher burden for meeting the first of the Complete Auto factors.11
B. Basic Sales and Use Tax Principles
Forty-five states impose a sales tax on goods purchased in-state.12 The sales tax is second only to personal income taxes as the largest source of state revenue.13 Generally, the sales tax functions via consumers purchasing an item from a vendor, with the vendor charging the consumer the state’s prescribed sales tax rate on top of the purchase price. The vendor then remits the collected tax to the state government. The flip side of the sales tax is the use tax. It functions similarly to the sales tax but is assessed on out-of-state purchases of goods to be used within the state. For example, if an individual goes on a trip to another state and brings back something to use in their home state, they are obligated to pay a use tax on the item they returned with and will receive a credit for the sales tax they paid to the state they bought it in.
The U.S. Supreme Court ruled in Henneford 14 that the use tax is a permissible means of protecting both a state’s sales tax base and its in-state businesses:
The practical effect of a system thus conditioned is readily perceived. One of its effects must be that retail sellers in Washington will be helped to compete upon terms of equality with retail dealers in other states who are exempt from a sales tax or any corresponding burden. Another effect, or at least another tendency, must be to avoid the likelihood of a drain upon the revenues of the state, buyers being no longer tempted to place their orders in other states in the effort to escape payment of the tax on local sales.15
Justice Benjamin N. Cardozo’s analysis sheds light on the most important aspects of a sales and use tax regime, clarifying that sales and use taxes operating together impose a single tax on the purchase and use of tangible property. Purchases made in-state fall under the responsibility of the retailer, which is required to collect and remit the sales tax, whereas out-of-state purchases and the use taxes owed on them are the responsibility of the purchaser, who is liable for the tax payment. If not for the obligation on consumers under the use tax, sales taxes would systematically encourage state residents to make their purchases out of state to avoid the sales tax. One goal of the combined sales and use tax system is to put all retailers, in-state and out, on the same footing. Basically, the coordinated treatment of in-state and out-of-state vendors through sales and use taxes operates to minimize the revenue losses that would likely result without such a regime.16Most agree that sales and use tax regimes accomplish those goals and are an altogether good system for doing so. However, there are two major issues that keep the sales and use tax regime from being used to its full potential. The first is that states have long considered it impractical to enforce the use tax against individuals.17 The tax typically involves small amounts owed on numerous transactions for which the individual has not kept records, and the costs of collection could easily exceed the revenue collected.18 The more serious problem is one that all tax regimes have: compliance, or rather, a lack of thereof. That problem is far more pronounced in the use tax context. It is an inescapable truth of modern tax administration that taxation dependent on consumer reporting — that is, without third-party information reporting — is an unworkable system.19 When consumers are depended upon to report their own tax burdens, compliance, unsurprisingly, plummets.20 Combined, those two problems exacerbate one another. The more transactions in which a consumer participates but for which records are not kept, the more difficult it is for both the state and the consumer to calculate the applicable tax burden.
Compliance is a problem across all forms of taxes and all levels of government. For example, at the federal level, the Government Accountability Office estimates noncompliance at 56 percent when there is little or no third-party reporting.21 That figure emphasizes the compliance problem; when there is little or no information reporting, more than half of taxpayers fail to comply with the law.22 In contrast, when information reporting is paired with withholding, as is the case with federal taxes on employee wages, compliance is nearly universal, with only a 1 percent noncompliance rate, according to GAO estimates.23Cases involving information reporting but no withholding see noncompliance rates ranging from 8 to 11 percent.24 It should be clear why information reporting is effective. There is an informational asymmetry between the government and the taxpayers when the taxpayers are more familiar with their own activities.25 Thus, the government must gain that information after the fact, either directly from those taxpayers or indirectly from third parties.26 Because the government is not going to obtain very much information from the taxpayer, third-party reporting is the best option.
The use of third-party reporting to promote tax compliance is not a recent idea. In fact, withholding for the federal income tax was introduced during World War II.27 That practice is now standard in all states with an income tax when companies are required to withhold the taxable portion of their employees’ income and remit it to the government.28 Since third-party reporting was put into place, tax compliance in those areas is, unsurprisingly, almost universal, with only a 1 percent noncompliance rate.29 Because of the demonstrated effectiveness of third-party reporting, the method is being used on a global scale. The federal government has recently begun to employ that technique in some international transactions.30 Also, the widespread international use of the VAT shows the use of successful third-party reporting through its reporting requirement at each level of business.31 There is ample evidence that third-party reporting spurs compliance.32
The advantages of relying on third parties to assist in tax collection through withholding and reporting are not limited to income taxes. The modern retail sales tax has always relied on third parties because the sales tax has always been collected by vendors.33 That kind of a system has long been accepted by the Supreme Court.34 It has never been the responsibility of individual taxpayers to calculate and remit their sales taxes on a transaction-by-transaction basis as they must for a use tax.35
C. Quill and the Physical Presence Requirement
In 1992 the Supreme Court decided Quill, which set the precedent for states requiring out-of-state vendors to collect and remit use tax from their in-state customers.36 In Quill, North Dakota tried to force Quill Corp., an out-of-state mail-order office supplies retailer, to collect and remit a North Dakota use tax on Quill merchandise to be used within North Dakota.37Quill was a Delaware corporation with offices and warehouses in Illinois, California, and Georgia.38 None of its employees worked or lived in North Dakota, and its ownership of tangible property in that state was either insignificant or nonexistent.39 Quill sold office equipment and supplies; it solicited business through catalogs and fliers, advertisements in national periodicals, and telephone calls. Its annual national sales exceeded $200 million, of which almost $1 million was attributable to about 3,000 customers in North Dakota.40 It was the sixth largest vendor of office supplies in North Dakota at the time. Quill delivered all its merchandise to its North Dakota customers by mail or common carrier from out-of-state locations.41
In Quill’s predecessor case, Bellas Hess,42 the Court overturned a similar law in Illinois as a violation of both the due process and commerce clauses. In Quill, however, the Court admitted that over time, subsequent cases have allowed for more flexibility than Bellas Hess.43 Nevertheless, the Court maintained that this evolution does not suggest a rejection of Bellas Hess.44 The Court determined that North Dakota’s imposition of the use tax did not constitute a breach of the due process clause because Quill had sufficient contact with the state’s residents and benefited from the state’s tax revenue.45 However, the Court found the use tax to be unconstitutional because it interfered with interstate commerce, rendering it a violation of the commerce clause.46 Consequently, the Court reversed the North Dakota Supreme Court’s decision by ruling in favor of Quill.47
The Court’s decision in Quill figuratively defanged the due process protections against taxation of out-of-state corporations.48 The Court moved away from Bellas Hess’s physical presence test required to satisfy the “minimum contacts” standard of the due process clause, instead invoking a “reasonable contacts” test, relying on the fact that Quill had purposefully directed its sales to North Dakota residents.49 Thus, the due process consideration theoretically should be met by any out-of-state company trying to take advantage of a given state’s market through directed sales. However, Quill reaffirmed the physical presence requirement in terms of satisfying the commerce clause. Since the Quilldecision, the definition of physical presence has been litigated many times.50 The commerce clause is thus the main hurdle for states to overcome in the use tax arena.51
In Quill, the Court put forth a persuasive reason to affirm the physical presence requirement of the substantial nexus prong of Complete Auto. The Court wrote that the physical presence requirement is animated by “structural concerns about the effects of state regulation on the national economy.”52 The Quill Court recognized that state taxes can quickly burden the national economy to the point of destruction. Those structural concerns date back to the Articles of Confederation in which “state taxes and duties hindered and suppressed interstate commerce.”53 The physical presence requirement supports the commerce clause as a “cure for these structural ills.”54 Though those concerns are still valid, the United States has come a long way from the times of the Articles of Confederation, and it’s possible that the problems the physical presence requirement causes outweigh the structural protections it affords.
II. How the Factor Presence Nexus Standard for Corporate Income Tax Can Be Adapted for Use Tax
Given the difficulties associated with the physical presence requirement, this paper advocates for its replacement with a factor-based nexus standard, which would provide uniformity in state policies by creating a template for states and businesses to follow that considers both physical and economic presence within a state, eliminating the hodgepodge of standards states currently use to determine physical presence. Such a regime would closely resemble the factor presence nexus standard proposed by the Multistate Tax Commission in 2002 as an attempt to unify the standards by which states collect corporate income tax nationwide.55 That would involve implementing four thresholds to determine whether a vendor has physical or economic presence within a given state.56
The factor presence nexus standard articulates four ways in which a business can have substantial nexus with a state57 — a set dollar amount of property, payroll, or sales, or a percentage of those. Under the Multistate Tax Commission standard, if a business meets or exceeds any of the following four threshold amounts during the taxing period, it is liable to taxation by that state58: (a) $50,000 of property; (b) $50,000 of payroll; (c) $500,000 of sales; or (d) 25 percent of total property, total payroll, or total sales.59 That standard has been adopted in some form or another by eight states to determine whether they can tax a corporation’s income.60
This paper advocates the adoption of a four-factor template such as the factor presence nexus standard. It is possible to apply a similar threshold factor nexus standard to the sales and use tax regimes of the states. If an out-of-state vendor sells products for use within a state, that state would be able to tax the vendor if it meets any of four threshold factors. The first two factors, thresholds for physical property or payroll in the state, embody the spirit of the standard’s physical presence requirement. The second two factors — amount of sales into the state and percentage of overall business in the state — represent an economic presence requirement. Overall, the effect of a factor nexus standard would be to replace the Quill physical presence requirement with uniform indicators of physical presence supplemented by uniform indicators of economic presence. It is important that both the physical presence and the economic presence indicators be represented in a unified use tax regime to give states the most latitude to recoup their uncollected use tax revenue.
Though the main substance of the four factors would be uniform throughout the states, the proposed factor nexus standard can be tailored according to what makes the most sense for each state. That individualization is important because state markets differ, and what constitutes a substantial economic presence in one might be too low or too high of a threshold in another. Under a factor nexus regime, that question is left for each state legislature to decide, within reason. It would be outside the spirit of the reform for states to create unreasonable low thresholds to tax out-of-state vendors, and the market would likely punish any state that made such a choice. Overall, switching standards would bring consistency, not only in how states collect use taxes, but also in ridding tax law of the unwieldy divide between the collection of sales/use taxes and the collection of all other taxes.61
III. The Physical Presence Requirement
There are numerous problems with the physical presence requirement. Following are several, with a discussion of how they could be addressed with a factor presence nexus standard.
A. Lost Revenue
Since the Quill decision, the physical presence requirement has been litigated many times but it has not been changed. However, since 1992 commerce in the United States has changed drastically. While some mail-order companies, such as Quill, have long been an enigma for state taxation purposes, the tax gap has increased exponentially with the advent and continuing popularity of online electronic sales. The internet became publicly available in 1991, only a year before Quill.62 It was not foreseeable that the internet would substantially change how commerce operates. And yet it has. In 2007, 66 percent of adults had reported purchasing some tangible goods online.63 As the number of people purchasing goods on the internet increases, so does the revenue of the industry. The amount of revenue generated from e-commerce in the United States has increased consistently year after year, and even quite a bit from quarter to quarter. For example, the U.S. Census Bureau announced in December 2016 that the estimate of U.S. retail e-commerce sales for the third quarter of 2016, adjusted for seasonal variation but not for price changes, was $101.3 billion.64 That is an increase of 4 percent from the second quarter of 2016, which increased 0.9 percent from the first quarter in 2016.65
Given the growth of online sales just in 2016, it’s likely that online business will continue to grow. That projection is especially likely given the possibility of continued advancements in technology leading to increased production quality while simultaneously decreasing production costs. Basically, technology will allow more goods to be available for sale overall, and internet sales have been the dominant method of selling those products. Take for example, the increase in accessibility and ownership of personal computers and mobile smartphones,66 which gives buyers near-instantaneous access to retailers, enabling businesses to have a significant presence in a state without that presence being physical in the traditional sense.67
The enormous amounts of money generated via e-commerce often go untaxed. In fact, the total use tax collection gap facing the states collectively in 2012 is estimated to be more than $11 billion.68 That means that states are missing out on millions of dollars of revenue because they cannot depend on their residents to report and pay their legal use tax burden. That money could be used for vital state programs or infrastructure projects. With the combined state debt around $1.18 trillion in 2016, the states could use the use tax revenue — especially since it is tax revenue they are already owed.69 In practice, abiding by the physical presence requirement is effectively being complicit in mass consumer tax evasion.
The tax gap could be addressed by adopting a factor nexus standard over the physical presence requirement to satisfy the substantial nexus prong of Complete Auto, because it would allow states to require out-of-state vendors to withhold and remit use taxes based on how much business they do within that state. No longer would an actual physical presence of that vendor within that state be required. Instead, each state would pass legislation determining how much revenue is required within that state market to constitute a substantial economic presence. States with larger markets may require a higher threshold than those with smaller markets. As previously discussed, third-party reporting in conjunction with withholding is the single most effective way to collect tax revenue.70 If third-party reporting and withholding were introduced into the use tax realm, compliance would undoubtedly increase and so would each state’s use tax revenue.
B. Unfair Competition
The continued growth of e-commerce means the revenue gap for states will continue to grow as well. But states’ inability to require out-of-state vendors to collect and remit use tax without nexus is more than just a revenue problem. Recalling the analysis by Cardozo in Henneford, we can see how the sales and use tax systems no longer function together to create one consistent tax. Without the use tax, more consumers will choose to buy their goods via out-of-state online retailers to avoid paying the sales tax required had they purchased the item in-state. That gives out-of-state online vendors a significant market advantage over in-state bricks-and-mortar vendors, and even in-state online retailers. For example, take two online retailers that are almost identical, except that one has a sales office or warehouse in-state and the other does not. The in-state business is not at all different from the out-of-state online vendor, yet because of its in-state warehouse, it is subject to the state’s requirement to collect and remit sales tax. That extends to online vendors that do collect use tax, whether voluntarily or under the direction of a state law. That obligation theoretically puts them in the same position as an in-state vendor that always had to collect sales tax. When, for some reason, an online vendor begins to collect and remit use tax from its purchasers, it can lead to a decline in sales from the company and an increase in sales to a competitor who doesn’t collect use tax.71 For example, a study found that when Amazon first began to collect use tax in only some states, there was a 19.8 percent increase in purchases at competing online retailers that do not collect the use tax.72That demonstrates that consumers will change their behavior to avoid paying use tax on their online purchases, and it showcases the competitive disadvantage of in-state retailers.
The burden on in-state vendors is more than the mere existence of the sales tax and the widespread evasion of the use tax. Imposition of a sales tax requires more than simply adding a percentage to the base costs of a product. On the contrary, the calculation can become rather complicated. For example, in Colorado, some goods are excluded from the sales tax, requiring73 vendors to catalog each sale individually to determine whether sales tax is owed.74
Predictably, some states have tried to improve their use tax collection rates.75 One method is to include a use tax line on the state income tax return.76 Use tax collection in Illinois, Louisiana, Massachusetts, and Michigan all increased in the year following the implementation of a use tax line item, despite remaining low overall compared to the total owed.77 California is perhaps the best example of unsuccessful attempts to collect use tax. Despite implementing a slew of initiatives to assist in increasing use tax compliance, such as providing use tax reference tables on its personal income tax form, compliance is still low.78California estimated in 2012 that it collected only about 4 percent of use taxes from purchases by residents from out-of-state vendors.79 That means the estimated tax gap in California for sales and use taxes alone is more than $2 billion.80 Colorado has tried to implement notice and reporting obligations on vendors that don’t collect sales tax.81Information reporting alone, however, does little to solve the problem of consumer noncompliance. Other states have responded by raising the sales tax to recoup that lost revenue and have found, not surprisingly, that this further pushes consumers to purchase goods from out of state.82 If the commerce clause was intended to put businesses on an even playing field, the physical presence requirement has had the opposite effect by giving out-of-state sellers a significant competitive advantage over in-state vendors.83
The adoption of a factor nexus standard would mitigate many of those concerns. By allowing a state to require out-of-state vendors to collect and remit a use tax when they have the requisite physical or economic presence in that state’s market, the state would be able to level the playing field between in- and out-of-state retailers. Consumers would not have the option of paying fewer taxes by purchasing their products online because the use tax obligation on out-of-state purchases would equal the sales tax obligation on in-state purchases, as was originally intended. Moreover, in-state vendors who are required to keep detailed records of sales to determine which incur sales tax would no longer be the only vendors required to do so. That would make it much easier for in-state vendors to compete with their out-of-state counterparts because it would take away the competitive disadvantage that burdens them.
Some practitioners argue that it is unfair to put the burden of collecting and remitting the use tax on out-of-state vendors when it is the consumer’s duty to pay it. That argument has theoretical merit. That system is in place even for an individual with one job, when calculating the tax burden would not be difficult or complicated. For consumers required to pay use taxes, the calculation involves all the out-of-state purchases they have made that year, and consumers often do not keep complete records.84 Since the calculation of the tax burden is much more complicated in the use tax realm than it generally is for income tax, and we already use withholding for income tax, it makes sense to use withholding for the more complex use tax collection. Chances are there would be more, and more accurate, tax information if the obligation of tabulating and reporting fell on entities with greater bookkeeping infrastructures than consumers.85
C. No Consensus on the Definition of Physical Presence
Because the Supreme Court has not taken a case on the physical presence requirement in the context of sales and use tax since Quill, the states have been left to litigate their own definitions of what physical presence requires.86 Those definitions have varied widely and have led to an overall lack of conformity nationwide.87 The situation is confusing for businesses trying to structure themselves to minimize their tax burdens, and it is also a burden for states because it is unclear when they can enforce collection obligations on a certain business. For example, in Overstock,88 the New York Court of Appeal extended the U.S. Supreme Court’s interpretation of independent contractors as employees such that Amazon and Overstock would have attributional physical presence in New York. Although neither company had sales forces, warehouses, or physical operations within New York, many residents were providing links to Amazon or Overstock on their personal websites and receiving commissions if those links were used.89 The court of appeal concluded that those individuals were acting as independent contractors for Overstock and Amazon, which it felt was enough to establish attributional physical presence within New York if sales resulted in a certain threshold amount.90 Since 2008, Arkansas, California, Connecticut, Georgia, Florida, Illinois, North Carolina, Rhode Island, and Vermont have pursued compliance through similar practices.91 That inconsistency leads to uncertainty and undue complexity for businesses.
There is also confusion in the Tenth Circuit. Colorado tried to require out-of-state vendors to report the amount of use tax owed by consumers, but did not require the vendors to collect the tax.92 The Tenth Circuit upheld the Colorado district court in ruling that Quillapplied to the information reporting requirement even though no tax collection or remission was required.93 That contradicted another Tenth Circuit holding decided 15 years before.94 In part because of the confusion caused by the physical presence requirement, some states have refused to extend the physical presence standard to any taxes other than sales and use taxes.95
Using a factor-based nexus test of four threshold factors, states would be on the same page in terms of their constitutional reach. Moreover, it would bring greater consistency to businesses when trying to plan their tax strategies. It would dispel much of the uncertainty that permeates sales and use tax regimes if both states and businesses have concrete indicators to work with.
Though states would likely adopt different thresholds for what reaches a substantial economic presence within their state for the second two factors, there would be uniformity on the method used to determine whether the state has the authority to tax a business. Although the initial switch between regimes would disrupt the reliance interests of those companies who are used to doing business in a state without being required to collect and remit use tax, any reliance interests at stake are slight because “it is unreasonable for companies . . . to invoke a ‘settled expectation’ in conducting affairs without being taxed.”96
D. States That Have Implemented a Substantial Economic Presence Approach
Spurred to action by the tax gap and the unsuccessful initiatives to improve compliance, some states have tried sidestepping the physical presence requirement altogether by imposing some form of economic presence threshold, either for reporting purposes or for collection and remittance obligations. However, none of those enactments is as effective as the proposal herein for a modified factor nexus test.
Colorado, for example, employs sales and use tax systems that complement one another, like most states.97 To improve use tax compliance, Colorado adopted an information reporting requirement for vendors who were not otherwise obligated to collect and remit the state’s sales and use tax.98 The statute requires three notices to be provided by any out-of-state vendors who sell $100,000 worth of products to be used in Colorado.99 First, a seller must send a notice to a purchaser for each purchase that incurs use tax.100 Second, the seller must send a notice at the end of each year to anyone who purchased more than $500 in goods that year.101 Finally, an annual notice must be sent to the Colorado Department of Revenue detailing all purchases made by Colorado residents and all purchases sent into Colorado that year.102 There are no collection obligations imposed; the burden of paying the use tax is still on Colorado consumers, though it is easier to collect consumer tax burdens when the Department of Revenue is aware of them.103 That measure was challenged by Direct Marketing Association (now Data & Marketing Association) on the grounds that it is outside the state’s power to impose such a reporting requirement under the commerce clause.104 The U.S. Supreme Court denied cert in DMA on December 12, 2016.105 Since the law was upheld by the Tenth Circuit, several other states have started to adopt reporting measures. Louisiana requires reporting both to the state and to the consumer. Oklahoma and Vermont require businesses to inform their customers of their use tax obligations, but they do not require them to report to the states.106
Alabama in January 2017 implemented an economic presence test for out-of-state vendors.107 For businesses to be required to collect and remit use tax to Alabama, they must have retail sales of tangible personal property sold into the state exceeding $250,000 per year and conduct some in-state activities.108 In May 2016, South Dakota and Vermont adopted an economic presence test requiring out-of-state vendors to collect and remit use taxes if they surpass the annual sales threshold of $100,000 or 200 separate transactions within the state.109
None of those enactments are as effective as the modified factor nexus standard proposed herein. The states that require reporting still put the use tax burden on the consumers whose compliance is still at issue. The laws in South Dakota and Vermont are especially troubling because requiring as a threshold a specific number of transactions will disproportionately affect smaller businesses. Take Etsy.com, for example. Etsy allows artisans and others to sell their wares, many of which cost only $1 or less. By allowing a 200-transaction threshold, South Dakota and Vermont are imputing the use tax collection and remittance obligations onto individual sellers or small businesses that may not otherwise approach the $100,000 threshold in either state. That inconsistency would be avoided under a factor nexus standard that does not include a specific transaction threshold of in-state transactions for determining use tax obligations.
States that have opted for economic nexus standards for determining use tax collection and remittance obligations on out-of-state vendors have forgone the physical presence requirement entirely. Though a standard solely based on economic nexus would likely capture more use tax revenue than a physical presence requirement would, both methods are needed for comprehensive use tax reform. With only an economic presence requirement, companies that would be taxable under the physical presence requirement but that do not transact enough business in the state under the threshold would be exempt from tax. That is the flip side of the problem we face now. A factor-based nexus standard would encapsulate both the physical and the economic nexus indices, giving states the most latitude to collect use tax revenue.
E. Other Attempts at Reform
The closest initiative to a unified reform of sales and use tax is the Streamlined Sales and Use Tax Agreement, created through the cooperation of 44 states and the District of Columbia.110 It encourages out-of-state vendors selling goods over the internet and by mail order to collect tax on sales to customers living in the states that have signed the agreement.111 The SSUTA tries to minimize costs and administrative burdens on retailers that collect sales tax by means of uniform tax definitions, a uniform and simpler exemption administration, rate simplification, state-level administration of all sales taxes, uniform sourcing (where the sale is taxable), and state funding of the administrative costs.112Though the SSUTA is a great idea in theory, it attacks the use tax problem from the wrong angle. The SSUTA cannot enforce obligations on businesses to pay use taxes any more than the states themselves can.113 Instead, the SSUTA relies on the goodwill of corporations that are willing to register and take on the burden of collecting and remitting use taxes.114 Since 2000, only 1,400 retailers have collected use tax for states signed the agreement, totaling $700 million in use taxes collected.115 The goal of the SSUTA was likely not to create a uniform system; rather, it was likely to get Congress to notice the reform if enough states signed on.116 The idea was that if enough states expressed interest in the reform, Congress would be more willing to pass legislation allowing states to require out-of-state vendors to collect and remit use tax.117 That initiative demonstrates how at least 44 states and the District of Columbia see the need for reforming and unifying the sales and use tax regime.
IV. Congress or the Court: Who Should Spearhead the Change?
A. Congress Is Better Equipped To Make the Change
The Court has acknowledged that Congress is the appropriate body to determine whether states may extend use taxes to out-of-state vendors. In Bellas Hess, the Court stated that “under the Constitution, [use tax] is a domain where Congress alone has the power of regulation.”118 In Quill, the Court stated that the issue of expanding the scope of use taxes “is not only one that Congress may be better qualified to resolve, but also one that Congress has the ultimate power to resolve. No matter how we evaluate the burdens that use taxes impose on interstate commerce, Congress remains free to disagree with our conclusions.”119
The commerce clause gives Congress the power to regulate interstate commerce.120 That is more than an affirmative grant of power. Without any action by Congress, that clause “by its own force” prohibits some state actions that interfere with interstate commerce.121 Under that constitutionally enumerated power, Congress is better qualified to determine whether a state may require out-of-state vendors to collect use taxes for goods to be used in-state. Congressional action is preferred to a judicial determination because the application of a use tax requires burdens to be allocated among different parties, and “the precise allocation of such burdens is better resolved by Congress rather than this Court.”122 The Court cannot make those considerations because of its limited fact-finding powers. Congress should implement the legislative change advocated for in this paper because of the uniformity considerations. If Congress were to pass a template such as the one discussed here, states could easily tailor it to their needs.
However, Congress has failed to act in the 25 years since Quill was decided. Although there has been legislation before Congress addressing the issue, it has not been made law.123Though those attempts by Congress to put together some comprehensive legislation to address that issue showcase Congress’s legitimate concern for the ever-increasing tax gap and the effect of the physical presence requirement on the states, its failure to definitively act matters more. As the amount of lost revenue from uncollected use taxes continues to increase substantially each year, states cannot afford to delay a decision any longer. Because of those circumstances, it seems the burden of that change falls on the Court. Justice Anthony Kennedy urged “the legal system [to] find an appropriate case for that Court to reexamine Quill and Bellas Hess.”124
B. The Judiciary Created the Physical Presence Test
As with any legal precedent, the Court has the power to overturn or depart from its prior decisions. While the doctrine of stare decisis is fundamental to the U.S. legal system, it “is not an inexorable command.”125 When reexamining a prior holding, the Court’s “judgment is customarily informed by a series of prudential and pragmatic considerations designed to test the consistency of overruling a prior decision with the ideal of the rule of law.”126 Thus, several factors are examined when that Court considers departing from a prior decision, including: (1) the antiquity of the precedent; (2) whether the prior decision was well reasoned; (3) whether the precedent provides a workable standard; and (4) the reliance interests at stake.127 Although vastly important in our legal system, stare decisis cannot justify a rule that now inflicts more harm than good. Quill, “a case questionable even when decided . . . now harms states to a degree far greater than could have been anticipated earlier.”128
1. The Antiquity of the Precedent: Does It Still Provide a Workable Standard?
When Quill was decided, it was necessary for a remote seller to have some form of physical presence, such as a warehouse, office, or salesperson, within a state to generate substantial business in that state.129 Now a vendor no longer needs a physical storefront from which to sell its products and generate substantial business within a state, and relying on such a requirement is unworkable.130 With the advent of the internet and proliferation of devices that can access it, commerce has drastically changed. Technology not only allows for expediency in production and sale, but it also changes how companies advertise. Gone are the days of Quill in which out-of-state companies sent catalogs or other materials through the mail. Now internet vendors are employing personally targeted ads on most websites, including social media, news sites, and Google searches. Consumers once could throw away catalogs; now they are now bombarded with ads in their emails or while messaging friends. Internet advertising has made it much easier for companies both to target specific people and to reach a much broader audience than was possible before. Not only is the physical presence standard preventing states from implementing the most efficient means of collecting the use taxed owed to them, it is losing the states billions of dollars.131 That standard is unworkable because it exempts many out-of-state vendors who are selling products for use into a state and depends entirely on consumer compliance. Given the climate of e-commerce and how it is carried out, it is not difficult to see how much times have changed since the Quill decision. Therefore, the Quill precedent is no longer workable.
2. Whether the Prior Decision Was Well Reasoned
The Court has recognized the rule in Bellas Hess was flawed.132 The holding was based on questionable rationales, has artificial boundaries, and likely would have been decided differently were it to be looked at under contemporary commerce clause jurisprudence.133In reaffirming Bellas Hess, the Court relied on stare decisis to uphold a rule when “contemporary commerce clause jurisprudence might not dictate the same result.”134 While stare decisis is fundamental to the success and health of our legal system, complying with it cannot take priority over the proper functioning of the states. Stare decisis may have justified upholding the Bellas Hess rule in Quill, but it does not justify upholding a rule that causes states to lose billions in revenue each year.135 Further, the Court acknowledged that the physical presence requirement was artificial at its edges.136 Specifically, a state’s ability to require an out-of-state seller to collect and remit sales or use taxes may turn on the presence of a small sales force, plant, or office in-state.137 Thus, an out-of-state vendor with one salesperson in a state soliciting business from in-state residents and $1,000 in annual sales would have use tax collection responsibilities since that salesperson constitutes a physical presence within the state. However, absent that one salesperson, a vendor cannot be compelled to collect a use tax, despite directly advertising to in-state residents and deriving enormous amounts of sales in that state. Those artificialities are no longer workable.
Nevertheless, the Court reaffirmed the Bellas Hess rule in Quill because the convenience in having a bright-line rule would firmly establish the boundaries of a state’s authority to impose a duty to collect sales and use taxes and reduce litigation.138 Although the Court believed a bright-line rule would reduce litigation, by declining to define what constitutes a physical presence, the decision has instead led to substantial litigation regarding the ways states and courts have tried to avoid extending Quill’s holding.139 The Court recognized in its more recent commerce clause jurisprudence a preference for flexible balancing analyses rather than strict bright-line tests.140 This is clear in that the Court has not adopted a similar bright-line physical presence rule for any other type of tax and in the fact that state courts have limited the physical presence requirement to sales and use tax regimes.141 Given that subsequent development, the Court admitted that Bellas Hess would likely have been decided differently but was upheld in Quill because of stare decisis.142 It is only logical that sales and use taxes be analyzed under the more flexible balancing analyses applied to every other tax type. Therefore, although that Court’s decision in Quill may have been well reasoned when it was decided, it is evident the reasons for upholding the physical presence standard no longer apply.
3. The Reliance Interests at Stake
Any reliance interests at stake are slight because “it is unreasonable for companies such as Quill to invoke a ‘settled expectation’ in conducting affairs without being taxed.”143 First, implementing collection and remittance requirements would not be as much of a burden as it would have been when Quill was decided. “Modern technology has rendered feasible the once seemingly burdensome task of calculating and remitting sales taxes for the country’s many state and local jurisdictions.”144 While Bellas Hess and Quill were decided during a time when the sales tax for each jurisdiction had to be calculated manually, numerous third-party companies now provide software that makes it easy for sellers to calculate and collect sales taxes by automatically calculating the tax rate based on a consumer’s shipping location.145 Any burdens imposed on out-of-state sellers would mirror those already imposed on in-state retailers for collecting use tax and would level the playing field for in- and out-of-state vendors.146 Some argue that it is unfair to place any burden on vendors when it is the consumers who are liable for the use tax. However, given the reality of consumer noncompliance with the use tax, any additional requirements on vendors are outweighed by the revenue states would collect.
The physical presence requirement articulated in Quill is no longer feasible. The growth of e-commerce without a concurrent update in the law has kept states from effectively collecting use tax revenue owed. Implementing a factor-based nexus standard nationally for states to customize is the best way to address the use tax gap and update the law for today’s market.
1 U.S. Const. Article I, section 8, cl. 3 (dormant commerce clause).
2 Walter Hellerstein et al., State and Local Taxation: Cases and Materials 5 (2014).
3 M. David Gelfand, Joel A. Mintz, and Peter W. Salsich Jr., State and Local Taxation and Finance 16, 19-20 (2007).
4 Supra note 1.
5 Supra note 3.
7 430 U.S. 274, 276 (1977).
8 Id. at 278.
9 Id. at 274.
10 Quill, 504 U.S. 298 (“The ‘substantial nexus’ requirement is not, like [the] due process ‘minimum contacts’ requirement, a proxy for notice, but rather a means for limiting state burdens on interstate commerce. Accordingly, contrary to the State’s suggestion, a corporation may have the ‘minimum contacts’ with a taxing State as required by the Due Process Clause, and yet lack the ‘substantial nexus’ with that State as required by the Commerce Clause”); and Tax Commissioner v. MBNA America Bank N.A., 220 W. Va. 163, 172, 640 S.E.2d 226, 235 (2006) (“The Due Process Clause requires merely some minimum connection between a state and the person, property or transaction it seeks to tax. In contrast, a substantial nexus under the Commerce Clause requires that an entity’s contacts with the taxing state be more frequent and systematic in nature. Also, an entity’s exploitation of the market must be greater in degree than under the Due Process standard so that its economic presence can be characterized as significant or substantial. In sum, although a substantial economic presence standard is by nature more elastic than the bright-line physical presence test, we are convinced that when properly applied, a greater nexus is required under the substantial economic presence standard [than] under the minimum contacts analysis”).
11 Supra note 3.
12 Nina Manzi, “Use Tax Collection on Income Tax Returns in Other States,” Minnesota House of Representatives Research Department Policy Brief (2012).
14 Henneford v. Silas Mason Co., 300 U.S. 577 (1937).
16 Darien Shanske et al., “Brief of Interested Law Professors in Direct Marketing Association v. Brohl (10th Circuit)” UC Davis Legal Studies Research Paper No. 429; Stanford Public Law Working Paper No. 2608807 (May 19, 2015).
17 Supra note 12.
19 Supra note 16.
21 U.S. Government Accountability Office, “Tax Gap: Sources of Noncompliance and Strategies to Reduce It,” GAO-12-651T (2012).
25 Leandra Lederman, “Reducing Information Gaps to Reduce the Tax Gap: When Is Information Reporting Warranted?” 78 Fordham L. Rev. 1733 (2010).
27 Current Tax Payment Act of 1943, P.L. 78-68, ch. 120, section 2(a), 57 Stat. 126 (1943). The current version is codified at 26 U.S.C. section 3402 (2014).
28 Most states have some withholding and information reporting requirement. See, e.g., Cal. Rev. & Tax. Code section 18662 (authorizing withholding); see also RIA, “All States Tax Guide 227” (2014).
29 Supra note 21, at 5-6.
30 Foreign Account Tax Compliance Act, 26 U.S.C. sections 1471-74 (2014).
31 Sijbren Cnossen, “A VAT Primer for Lawyers, Economists, and Accountants,” Tax Notes, Aug. 17, 2009, p. 687 (150 countries have a VAT, including all other members of the OECD).
32 See, e.g., Dina Pomeranz, “No Taxation Without Information: Deterrence and Self-Enforcement in the Value Added Tax,” Harvard Business School Working Paper 13-057 at 24 (2013) (“This paper investigates the effectiveness of the Value Added Tax in facilitating tax enforcement . . . and shows that in line with a growing recent literature, information reporting plays a crucial role for effective taxation”).
33 Shanske et al., supra note 16.
34 The Sales Tax, 47 Harv. L. Rev. 860, 869 (1934) (early survey of modern American retail sales tax); and General Trading Co. v. Tax Commission of Iowa, 322 U.S. 335, 338 (1944) (“To make the distributor the tax collector for the State is a familiar and sanctioned device”).
36 Quill, 504 U.S. 298 (1992).
38 Id. at 302.
42 National Bellas Hess Inc. v. Department of Revenue, 386 U.S. 753 (1967).
43 Quill, 504 U.S. 298.
48 Gelfand, Mintz, and Salsich, State and Local Taxation and Finance 19 (2007).
49 Id.; Quill, 504 U.S. at 311.
50 Gelfand, Mintz, and Salsich, supra note 48.
51 Id. at 20.
52 Quill, 504 U.S. at 312.
55 Multistate Tax Commission, Policy Statement 02-02, “Factor Presence Nexus Standard for Business Activity Taxes” (Oct. 17, 2002).
56 American Institute of CPAs State and Local Taxation Technical Resource Panel, “State Tax Nexus Guide” (2014).
57 Supra note 55.
60 Charles Britt, Kevin Eberhardt, and Zachary Myatt, “Factor Presence Nexus Standards and Market-Based Sourcing: A Tough Combination for Service Businesses,” The Tax Adviser (Apr. 1, 2016).
61 Supra note 1.
63 Consumer Choice Data Set, Pew Research Center’s Internet and American Life Project (Sept. 2007) (showing questionnaire answers from 2,400 adults older than 18).
64 U.S. Department of Commerce, U.S. Census Bureau News: Quarterly Retail E-Commerce Sales 3rd Quarter 2016 (2016).
66 Mobile Commerce Data Set, Pew Research Center’s Internet and American Life Project (Jan. 2012) (showing questionnaire answers from 4,300 adults ages 18 and up in which 88 percent reported having cellphones and 24 percent reported using their cellphones to check product prices).
68 Donald Bruce, William F. Fox, and Leann Luna, “State and Local Sales Tax Revenue Losses from E-Commerce,” State Tax Notes, May 18, 2009, p. 537.
70 Supra note 21, at 6.
71 See Brian Baugh et al., “The ‘Amazon Tax’: Empirical Evidence From Amazon and Main Street Retailers,” National Bureau of Economic Research, Working Paper No. 20052, *3 (2014) (studying how consumers reacted in the small number of states in which Amazon.com has begun to collect the use tax and, among other things, finding “a 19.8 percent increase in purchases at the online operations of competing retailers [that do not collect the use tax]”); see also Liran Einav et al., “Sales Taxes and Internet Commerce,” 104 Am. Econ. Rev. 1, 4 (2014) (“We estimate that on average, the application of a 10 percent sales tax [on the vendor] reduces purchases by 15 percent among [eBay] buyers who have clicked on an item”); and David R. Agrawal, “The Internet as a Tax Haven? The Effect of the Internet on Tax Competition” (Feb. 1, 2015) (“For the large jurisdictions containing more than 95% of the population, an increase in Internet penetration has strong negative effects on local tax rates”).
72 Baugh, supra note 71.
73 See, e.g., Colo. Rev. Stat. section 39–26–704(4) (2015) (“All sales made to schools, other than schools held or conducted for private or corporate profit, shall be exempt from taxation . . .”).
75 DMA, 135 S. Ct. at 1135.
76 Manzi, supra note 12.
78 California State Board of Equalization, Addressing the Tax Gap (undated); and Laura Mahoney et al., “States See Little Revenue From Online Sales Tax Laws, Keep Pressure on Congress,” Bloomberg BNA, Jan. 6, 2014, at J-1; see also supra note 12.
79 California State Board of Equalization, supra note 78; see also “Revenue Estimate: Electronic Commerce and Mail Order Sales,” 7 tbl.3 (2013) (comparing estimate of total remote sales with estimate of total sales on which use tax was paid).
80 California State Board of Equalization, supra note 78.
82 Michael D. Smith and Erik Brynjolfsson, “Consumer Decision-Making at an Internet Shopbot: Brand Still Matters,” 49 J. Indus. Econ. 541, 549 (2001). (“Consumers are . . . approximately twice as sensitive to changes in sales tax as they are to changes in item price”).
83 Quill, 504 U.S. at 329 (White, J., concurring in part and dissenting in part).
84 Manzi, supra note 12.
85 Lederman, supra note 25.
86 Supra note 56.
88 Tyler Pipe Industries Inc. v. Washington Department of Revenue, 483 U.S. 232 (1987); and Overstock.com Inc. v. N.Y. Department of Taxation and Finance, 20 N.Y.3d 586, 597 (2013).
89 Overstock, 20 N.Y.3d at 591-592.
90 Id. at 597.
91 Lederman, supra note 25; in 2013, the Illinois Supreme Court held in Performance Marketing Association Inc. v. Hamer that the state’s original click-thru nexus statutes in P.A. 96-1544 (H.B. 3659), Laws 2011, were void and unenforceable because of the federal prohibition against discriminatory state taxes on e-commerce in the Internet Tax Freedom Act. 998 N.E.2d 54 (Ill. 2013). In response, Illinois approved legislation that amended the state’s sales and use tax click-thru nexus statutes. P.A. 98-1089 (S.B. 352), Laws 2014, effective Jan. 1, 2015.
92 DMA, 814 F.3d at 1129.
94 American Target Advertising Inc. v. Giani, 199 F.3d 1241, 1255 (10th Cir. 2000) (“The Utah Act imposes licensing and registration requirements, not tax burdens. The Bellas Hess/Quillbright-line rule is therefore inapposite”).
95 See MBNA, 220 W.Va. 163, 171.
96 Quill, 504 U.S. at 331.
97 Colo. Rev. Stat. sections 39-26-104(1)(a), -106(1)(a)(II) (2015); and sections 39-26-202(1)(b), -204(1) (2015).
98 Colo. Rev. Stat. section 39-21-112(d)(I)(A) (2010).
99 1 Colo. Code Regs. section 201-1:39-21-112.3.5(1)(a)(iii) (2015) (definition of a retailer that does not collect Colorado sales tax).
100 Colo. Rev. Stat. section 39-21-112(3.5)(c)(I) (2015).
101 Colo. Rev. Stat. section 39-21-112(3.5)(d)(I)(A) (2015); and 1 Colo. Code Regs. section 201-1:39-21-112.3.5(3)(c) (2015) (defining a de minimis Colorado purchaser).
102 Colo. Rev. Stat. section 39-21-112(3.5)(d)(II)(A) (2015).
103 Colo. Rev. Stat. section 39-21-112(d)(I)(A) (2010).
104 See DMA, 814 F.3d at 1129, 1132.
106 William H. Gorrod, “States Fight to Enforce Online Sales and Use Taxes,” CFO.com (July 6, 2016).
107 Ala. Reg. 810-6-2-.90.03.
108 Ala. Reg. 810-6-2-.90.03(1)(a) and (b); and Ala. Code section 40-23-68.
109 S.D. S.B. 106; and Vt. H.B. 873.
110 Supra note 13.
112 Streamlined Sales Tax Governing Board, “How Does the Agreement Simplify Sales Tax Administration?” (undated).
114 Supra note 13.
115 Supra note 113.
116 Supra note 13.
118 Bellas Hess, 386 U.S. at 760.
119 Quill, 504 U.S. at 318.
120 Supra note 1.
121 Gibbons v. Ogden, 22 U.S. 1, 9 (1824).
122 Quill, 504 U.S. at 318 n.10.
123 See Marketplace Fairness Act of 2013, S. 743, 113th Cong. (2013) (Although the Senate passed the MFA with bipartisan support, it has not been enacted).
124 DMA, 135 S. Ct. 1124, 1135.
125 Planned Parenthood of Southeastern Pennsylvania v. Casey, 505 U.S. 833, 854 (1992).
127 Citizens United v. FEC, 558 U.S. 310, 362-363 (2010).
128 DMA, 135 S. Ct. at 1135.
129 See MBNA, 220 W. Va. 163, 171.
130 Id. (“The development and proliferation of communication technology exhibited . . . by the growth of electronic commerce now makes it possible for an entity to have a significant economic presence in a state absent any physical presence there”).
131 Supra note 68.
132 See Quill, 504 U.S. at 311 and 315.
134 Id.; see also DMA, 135 S. Ct. at 1134 (“Three Justices . . . stat[ed] their votes to uphold the rule of Bellas Hess were based on stare decisis alone”).
135 Supra note 68.
136 Quill, 504 U.S. at 315.
138 See Quill, 504 U.S. at 315.
139 See Overstock, 20 N.Y.3d 586 (2013); see also DMA, 814 F.3d at 1129, and MBNA, 220 W. Va. at 163, 171.
140 See Quill, 504 U.S. at 314.
141 Quill, 504 U.S. at 317; see also MBNA, 220 W. Va. 163.
142 See Quill, 504 U.S. at 311.
143 Quill, 504 U.S. at 331.
146 See Baugh and Agarwal, supra note 71.