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U.S. Supreme Court overturns physical presence rule, opens the door for states to require online retailers to collect sales tax

on Thursday, 12 July 2018 in The Closer - M&A, Securities & Corporate Counsel: Kevin P. Tracy, Editor

On June 21, 2018, the U.S. Supreme Court handed down its decision in South Dakota v. Wayfair,1 with significant tax consequences for the future of e-commerce. The Court overturned the “physical presence rule” required by a previous case, holding that a physical presence in a taxing state is no longer required to establish a “substantial nexus” between the state and a retailer.2 An economic nexus is now sufficient for the state to require a retailer to collect and remit sales tax.

Physical Presence Precedent

The physical presence rule was first established by the U.S. Supreme Court in Bellas Hess3 on due process and Commerce Clause grounds. Several decades later, the Court reexamined the physical presence rule in Quill, overturning Bellas Hess’ due process holding.4 However, the Court in Quill reaffirmed the physical presence rule on Commerce Clause grounds, “[d]espite the fact” that Bellas Hess “linked due process and the Commerce Clause together” in establishing the physical presence rule in the first place.5

Sales tax on internet sales is nothing new. However, under the physical presence rule, states were required to rely on state residents to pay the use tax owed on their purchases from out-of-state sellers. Consumer compliance rates with these laws are “notoriously low.”6 The inability to collect sales tax from online retailers leads to substantial revenue losses to many states each year. States have long struggled with “the complexities of defining physical presence in the Cyber Age”7 in their efforts to avoid revenue losses without running afoul of Quill’s constitutional requirements.

Conflicting approaches “embroil courts in technical and arbitrary disputes about what counts as physical presence.”8 For example, some states have enacted laws defining physical presence based on making apps available to be downloaded by in-state residents and placing cookies on residents’ web browsers.9 Some states have enacted “click through” nexus statutes, which define nexus to include out-of-state sellers that contract with in-state residents who refer customers for compensation. Other states have imposed notice and reporting requirements on out-of-state retailers which – in effect – “fall just short of actually collecting and remitting the tax.”10

South Dakota Challenge

In 2016, South Dakota enacted S.B. 106, providing for the collection of sales tax from any remote seller with a certain level of commercial activity in the state, “as if the seller had a physical presence in the state.”11 Because South Dakota’s law could not survive under U.S. Supreme Court precedent in Bellas Hess and Quill, South Dakota sought a declaratory judgment upholding the law’s validity, as well as an injunction requiring online retail giants Wayfair, Inc.,, Inc., and Newegg, Inc. – none of which have employees or real estate in South Dakota – to comply. The retailers were granted summary judgment at the trial level, which was affirmed by the South Dakota Supreme Court. The U.S. Supreme Court granted certiorari to reconsider the “scope and validity of the physical presence rule.”12

Supreme Court Opinion

Justice Kennedy, authoring the Opinion of the Court, reaffirmed that a state can only tax activities having a substantial nexus with the taxing state under the Commerce Clause doctrine. However, a physical presence is no longer required to establish this nexus. Bellas Hess and Quill were thus both overturned on due process and Commerce Clause grounds.

The Court reasoned that the physical presence rule places an unfair burden on brick-and-mortar retailers, in effect serving as a “judicially created tax shelter” for online retailers.13 Additionally, each year, the physical presence rule becomes “further removed from economic reality,”14 and has proved “unworkable.”15 Specifically, “it is not clear why a single employee or a single warehouse should create a substantial nexus,”16 but pervasive “virtual connections” – such as a virtual showroom which can show “far more inventory, in far more detail, and with greater opportunities for consumer and seller interaction than might be possible for local stores” – should not.17 While Congress could be tasked to fix the problem, it is not Congress’ job to correct a “false constitutional premise of (the) Court’s own creation.”18

Chief Justice Roberts dissented, joined by Justices Breyer, Sotomayor, and Kagan. The Dissenters argued under stare decisis that any inhibition on e-commerce should be undertaken by Congress, which is better equipped to consider the competing interests at stake. The Dissent expressed concern that the Court’s decision will place the greatest burden on small online businesses with a small volume of sales to customers in many states.

Conversely, Justice Kennedy reasoned that other aspects of the Court’s Commerce Clause doctrine could “protect against any undue burden on interstate commerce, taking into consideration the small businesses, startups, or others who engage in commerce across state lines.”19

Likely Fallout from South Dakota v. Wayfair

We believe it likely that the following will occur in light of the Wayfair decision:

  • States should be expected to more aggressively enforce sales tax collection from online retailers under existing laws that were formerly constitutionally constrained by Quill, thereby expanding revenues immediately.
  • Many states will look to their legislatures to take action to further expand their sales tax bases to include online retailers selling into their respective states. The U.S. Government Accountability Office predicted that Nebraska may expect revenue gains between $67 million and $95 million per year with expanded tax collection authority on remote sales.20 Iowa may expect revenue gains between $104 million and $146 million per year.21
  • Wayfair opens the door for states to tax more services, even if the service provider never physically steps foot in the taxing state.
  • Finally, businesses should anticipate legislative action at the federal level as a way to impose some uniformity requirements on the various states.

Online retailers, service providers, and their tax advisors will need to diligently monitor changes at both the federal and state level to keep abreast of the sea change in sales tax laws that Wayfair will cause.


Kevin P. Tracy


1 585 U.S. ___ (2018).
2 Complete Auto Transit, Inc. v. Brady, 430 U.S. 274 (1977).
3 Nat’l Bellas Hess, Inc. v. Dep’t of Rev. of Ill., 386 U.S. 753 (1967).
4 Quill Corp. v. North Dakota, 504 U.S. 298 (1992).
5 Wayfair, 585 U.S. at 8.
6 Id. at 2.
7 Id. at 19.
8 Id. at 20.
9 See id. at 19-20.
10 Id. at 20.
11 2016 S.D. Sess. Laws ch. 70 § 1 (S.B. 106).
12 Wayfair, 585 U.S. at 1.
13 Id. at 13.
14 Id. at 10.
15 Id. at 19.
16 Id. at 15.
17 Id. at 17.
18 Id. at 18.
19 Id. at 21.
20 U.S. Gov’t Accountability Off., States Could Gain Revenue from Expanded Authority but Businesses Are Likely to Experience Compliance Costs, p. 48 (Nov. 16, 2017),
21 Id.

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