Supreme Court Asked To Overturn Quill's Physical Presence Standard With South Dakota's Economic Nexus Tests For Imposing Sales Tax On Out-Of-State State Retailers

By: Jerald David August

State of South Dakota v. Wayfair, Inc. et al

In what portends to be the next landmark Supreme Court decision on a state’s constitutional power to impose state sales tax on interstate commerce the Court recently heard oral arguments in South Dakota v. Wayfair, Inc., et al, cert granted, 138 S.Ct. 735 (1/12/2018).  The issue before the Court is whether South Dakota sales tax scheme can satisfy the requirement under the Commerce Clause by imposing sales and use tax collection on a remote seller without such seller’s having a physical presence in South Dakota.

The fact that there is a judiciable controversy before the high court at this time does not mean the lost state revenues and other economic impacts associated with the impact of the physical presence test on internet based platform retailers are newly discovered. They clearly are not. The massive proliferation of internet platform sales in states by retailers who can side-step state sales and use tax burdens has long been recognized as generating an unfair tax advantage for the remote seller over the in-state seller or retailer. It also costs states millions if not hundreds of millions of dollars annually in foregone revenues.

In Wayfair, supra, the State of South Dakota asserted in its petition for certiorari that the “physical presence” standard previously announced by the Supreme Court in its 1992 decision in Quill Corp. v. North Dakota, 504 U.S. 298, is outdated and unworkable. This is because such standard must inquire into the physical presence of employees, affiliates or company websites on smart phones results in physical presence to the out-of-state vendor. An out-of-state seller may unknowingly trigger the physical presence standard and fail to collect and remit millions in dollars in sales tax liabilities. On the other hand, it is common knowledge that internet sellers not having physical presence in a state have long generated millions of dollars of sales revenues without being subject to state sales tax. This outcome disadvantages in-state retailers and other sellers having a physical presence in South Dakota as compared with remote based sellers. Still, internet based shopping is the rage and therefore why should owning or leasing bricks and mortar, maintaining warehouse or commission based sales forces, etc., be the touchstone for sales tax? Protecting the remote seller would be more logical if the annual sales in state were few and the revenues low.  But such is clearly not the case with large internet sales companies and is not the factual setting before the Court in Wayfair.

Since South Dakota has replaced physical presence with economic presence for imposing its sales tax, it must ask the Court to overturn its decision in Quill Corp., supra. South Dakota’s petition for cert. contends that the various factors that the Supreme Court has identified in determining whether it should follow or overturn its existing precedent, which in this case is Quill Corp., supra, justifies the Court in this case to abandon its physical presence test for state sales and use tax. Instead, South Dakota’s argues that its economic nexus test is a far better standard to apply with respect to the dormant Commerce Clause given the proliferation of on-line sales. [1]

It has been reported from individuals present at the  oral argument that the Supreme Court justices seemed impressed with the arguments advanced by the solicitor general’s opinion and responses to questions that some justices had asked. One report states “it’s likely there will be at least five votes in favor of allowing states to compel online retailers beyond their borders to collect use tax”. This is a quote is attributed to legal counsel to South Dakota.

This case presents what some consider to be the “perfect” set of facts from which the Supreme Court can exit its Quill standard of physical presence in order to adopt a more up-to-date economic nexus standard for approving a state sales tax scheme that does not violate the “dormant” Commerce Clause.

South Dakota’s Adoption of the Economic Nexus Standard for State Sales Tax: South Dakota v. Wayfair, Inc.

South Dakota implemented an economic nexus standard on May 1, 2016 with the intent of not only protecting in-state business but in presenting a challenge to mail-order and out-of-state retailers in serving up a case for Supreme Court review. S.D. Codified Laws § 10-64-1 (Supp. 2016). This “invitation” to adopt a standard other than “physical presence” for the purpose of the Court’s revisiting Quill is sourced from quotes from Justice Kennedy’s DMA Marketing concurring opinion. [2]

South Dakota's version of the economic presence standard for sales tax nexus standard sets forth two independent sales tax triggers that are measured using the current or prior calendar year.  First, remote sellers that derive over $100,000 of annual gross revenue from in-state sales are required to collect sales tax. Second, remote sellers entering 200 or more annual in-state sales transactions are required to collect sales tax.

These two independent bases for economic presence have been subject to litigation pre-dating the effective date of May 1, 2016. In this case, South Dakota sought a declaratory judgment in a state circuit court to compel Wayfair Inc., Overstock. com, Inc., and Newegg Inc. to collect sales tax.  South Dakota v. Wayfair Inc., No. 3:16-CV-03019-RAL,(D.S.D. Jan. 17, 2017).This action was removed to the United States District Court for the District of South Dakota Central Division and then remanded back to state court for further proceedings. In a second state circuit court action, American Catalog Mailers Association and NetChoice sought a declaratory judgment against South Dakota's economic presence standard.

The Wayfair case worked its way through to the Supreme Court of South Dakota. 901 N.W.2d 2017. In review of a summary judgment order in favor of the sellers and court ordered injunction preventing South Dakota from enforcing its economic nexus legislation of 2016, the Supreme Court of South Dakota affirmed the sellers’ motion and entered a judgment in its favor.  

Although the South Dakota Supreme Court acknowledged Justice Kennedy’s comment in Direct Marketing, supra, expressing that he would welcome reconsideration of Bellas Hess, supra, and Quill, supra, and further understood what the new legislation enacted by the State was designed to do, the Court held that Quill had not been overruled by the U.S. Supreme Court and remains the applicable precedent on the Commerce Clause limitations on interstate collection of sales and use tax.

South Dakota would next file a writ for certiorari which was granted and oral arguments by the parties were presented to the U.S. Supreme Court on April 17, 2018.

Due Process and Commerce Clauses:

For many years the widely accepted rule has been that in the absence of a physical presence by a seller of property in-state, the state in which the sale occurs (performance or delivery) is without authority to impose a sales tax. See Quill Corp. v. North Dakota, 504 U.S. 298 (1992). For state taxes, in general the starting point, the Due Process Clause, asks whether there is “some definite link, some minimum connection, between a state and the person, property or transaction it seeks to tax.” See Scripto, Inc. v. Carson, 362 U.S. 207 (1960).  The Due Process inquiry concerns “fundamental fairness” with respect to minimum contacts with the market in-state and concerns of proper “notice” and “fair warning”.  

The Commerce Clause, often referred to as the “dormant” Commerce Clause, requires that a state tax scheme not burden interstate commerce and further that there must be the required degree of “nexus” or connection between the sales tax states and the out-of-state seller.

South Dakota statute’s newly enacted standard based on economic nexus presents a case of first impression for the Supreme Court to address. Indeed, the Supreme Court has never held that a state may impose the duty of use tax collection and payment upon a seller whose only connection with customers in the State is by common carrier or the United States mail.  Congress, in the Court’s view, has the ultimate power to resolve the competing principles involved in a state tax nexus case under the Commerce Clause. In this regard, there is a legislative proposal, S.B. 976, the Marketplace Fairness Act of 2017, that would give state and local governments the ability to collect taxes from out-of-state retailers. [3]

Quill Corporation v. North Dakota: The Physical Presence Test

In its landmark National Bellas Hess, Inc. v. Department of Revenue, 386 U.S. 753 (1967), the United States Supreme Court set forth the requirements for state taxation under the Due Process and Commerce Clauses.  The Court held that before a state can impose sales and use tax collection duties on a mail-order seller, the Due Process and Commerce Clauses require the mail-order seller to maintain a physical presence in the taxing state. After Bellas Hess, supra, the Supreme Court has consistently equated Due Process Clause nexus with Commerce Clause nexus, treating the two as one and the same for determining the validity of state taxes. [4]

In Quill Corp. v. North Dakota, 112 S.Ct. 1904 (1992), the Court held that while the Commerce Clause bars a state from enforcing use tax collection duties against a mail-order seller who has no physical presence in the taxing state, the Due Process Clause does not. By holding that the Commerce Clause requires physical presence to satisfy tax nexus while the Due Process Clause requires something less, for the first time the Court held that the minimum contacts  under the Due Process clause were less than under the Commerce Clause and that physical presence was not required.

As to the facts in Quill Corporation, supra, North Dakota brought a declaratory judgment proceeding against an out-of-state retailer and asked the court to rule whether it had the power to collect and remit applicable state use tax against the retailer.  The retailer won on motion for summary judgment and the state appealed. The North Dakota Supreme Court reversed.

Quill, a Delaware corporation, had its offices and warehouse facilities Illinois, California, and Georgia. None of its employees worked or resided in North Dakota, and its ownership of tangible property in North Dakota was insignificant at best. It business involved the sale of office equipment and supplies and solicited business by mail-order. For the years in issue, its annual national sales exceeded $200 million, of which approximately $1 million were made to about 3,000 customers in North Dakota. It was reported to be the sixth largest retailer in North Dakota and shipped the purchased goods by mail or common carrier from out-of-state locations. Based on the definition of retailer under the North Dakota statute and administrative regulation, a mail order company engaging in a regular or systematic solicitation of sales order business in state was considered to be a retailer for purposes of collecting and remitting sales and use tax. [5]

On petition for writ of certiorari by North Dakota, which relief was granted, the Supreme Court, per Justice Stevens, held: (i) that an out-of-state mail order seller did not need to have a physical presence in state in order to permit the state to require the business to collect use tax from its in-state customers based on its sufficient contacts with the state for due process clause purposes, but (ii) physical presence in state was required, however, for such business to have “substantial nexus” for a taxing state to impose sales tax without violating the commerce clause.  The “physical presence” test was the appropriate standard in the view of the Court as a “means for limiting state burdens on interstate commerce” and established boundaries of state authority to impose a duty to collect sales and use taxes and reducing litigation concerning those taxes. The Supreme Court therefore found in favor of Quill Corp. and invalidated the use tax collection procedure devised by North Dakota to collect use tax from resident customers purchasing property from out-of-state retailers having no physical presence.

For Commerce Clause purposes, beyond a direct and visible in-state presence of the seller, the so-called “bright-line” physical presence requirement may also be satisfied where the business activities of an affiliate, related entity or unrelated agent conducting activities on behalf of a remote seller satisfy the nexus requirement. In attribution nexus cases, “the crucial factor governing nexus is whether the activities performed in th[e] state on behalf of the taxpayer are significantly associated with the taxpayer's ability to establish and maintain a market in th[e] state for the sales.” Tyler Pipe Indus., Inc. v. Wash. State Dep't of Revenue, 483 U.S. 232, 250 (1987). Attribution nexus “is simply the nature and extent of the activities,” whether performed by an employee, independent contractor, agent, or related entity. The formal contractual status of the attribution actors is “without constitutional significance. There are also “click-through” nexus standards where the physical nexus standard is satisfied by a commissioned agent or affiliate clicking through a sale to a remote seller. [6]

The Internet Tax Freedom Act of 1998

Congress, which has the inherent power to legislate on matters concerning the Commerce Clause, enacted The Internet Tax Freedom Act (“IFTA”), P.L. No. 105-277, §1101 (1998) in 1998 in telling the states’ to effectively back off from imposing sales and use tax on out-of-state retailers. The IFTA prohibits state and local taxation on electronic commerce that does or could result in multiple states’ taxation of the same electronic transaction without curative credits. Discriminatory taxes cover taxes on electronic commerce that are not also imposed on other means of commerce for the same types of transactions such as by setting forth differential rates for electronic commerce. Discriminatory taxes could also extend to using the accessibility of a remote seller's out-of-state computer server based website as a factor in determining a collection obligation. On February 24, 2016, Congress made the Internet Tax Freedom Act's state and local taxation limitations permanent in the Trade Facilitation and Trade Enforcement Act of 2015. See Trade Facilitation and Trade Enforcement Act of 2015, P.L. No. 114-125, §922.  While this legislation may have had a temporary chilling effect on states seeking to impose sales tax on out-of-state retailers and mail-order sellers, the states have constantly adapted other basis for getting to tax parity between internet based retailers and local retailers.

Expansion of Nexus For State Sales Tax  Based on Overall Economic Presence

In continuing to fight back to impose state sales tax on out-of-state retailers, various jurisdictions have adopted a standard of “economic nexus” based on the total sales receipts or sales transactions. At least four states have been implementing an economic nexus test. Direct Mktg. Ass'n v. Brohl, 135 S. Ct. 1124, 1135 (2015) (Kennedy, J., concurring and calling for the reexamination of the physical presence standard for sales tax nexus). Alabama, for example, requires sellers with over $250,000 of in-state tangible personal property sales in a prior calendar year to collect sales tax. This requirement applies to sellers without a physical presence. The Alabama model requires the sales threshold level to be combined with at least one other traditional seller activities, i.e., business registration, agents, targeted advertising and tradename use. See Alabama Dept. of Rev. (ADOR) Rule 810-6-2.90.03 (2016). [7]

In 2016, Alabama issued a final assessment against a remote online retailer, Newegg Inc. Notice of Appeal at 1, Newegg, Inc. v. Ala. Dep't of Revenue No. S. 16-613 (Ala. Tax Trib.), filed June 8, 2016. The sales tax was for January and February 2016 in the amount of approximately $150,000 of tax and over $30,000 in penalties and interest. In challenging the final assessment to the Alabama Tax court, Newegg asserted that Alabama’s adoption of the “economic presence standard” violates the bright-line physical presence rule and the corporation does not otherwise have a physical presence in Alabama. Newegg Inc. is seeking a cancellation of the assessment, attorney's fees and costs, and equitable relief. Alabama is seeking the collection of the final assessment and “a proper case [for] the U.S. Supreme Court to consider ... Quill's harsh effects.” Newegg Inc.'s Alabama Tax Tribunal appeal is pending based on the fact that the Wayfair case is also pending before the Supreme Court. [8]

Tennessee, Vermont and South Dakota have also adopted the economic nexus standard.

What Will the Supreme Court Decide?

Tax lobbyists must be really busy on this issue. A decision in favor of South Dakota invites all states to adopt economic nexus as the sales tax standard to help in-state retailers and small business. That means that larger internet based sellers will need political cover to enact Federal legislation to prohibit economic nexus as the appropriate test. There are billions of dollars of state sales tax revenues at stake as well.

On the other hand there are members of Congress who are determined to come to the aid of small in-state businesses who are disadvantaged by the remote seller. Again, states suffering from budgetary issues and problems also want this source of lost or forfeited revenue to be collected.  There are several legislative vehicles that would provide such protection and revenues respectively. In the Marketplace Fairness Act, which was introduced by a bipartisan group of senators in 2013 and 2015 and failed to be enacted each time, would allow states meeting certain requirements to require remote sellers that do not fall within a “small seller exception” to collect (and remit) state and local sales and use taxes. See S.976 introduced by Senator Michael Enzi (R-WY). In 2017, another bipartisan group of lawmakers introduced the Remote Transactions Parity Act of 2017 . It had also been unsuccessfully introduced in 2015. As with the Marketplace Fairness Act, the legislation would impose sales and use tax collection obligations on remote sellers but with a different definition of a remote seller.

From yet another perspective conservative groups, such as Heritage Action, The Competitive Enterprise Institute and the National Taxpayers Union, have stated their opposition to the Marketplace Fairness Act of 2017 based on the fact that it would impose unfair burdens on small businesses with the obligation to collect sales and use taxes for nearly 10,000 jurisdictions (states, local and municipal taxing districts) across the country.

The Supreme Court is expected to render its decision in this case during the present term. It is also reasonable to expect that a decision in this area will also be made by Congress, perhaps before the Supreme Court’s decision is issued.


[1] The factors the Supreme Court has identified in determining whether to continue to follow its prior opinion on a particular issue, i.e., the doctrine of stare decisis, include whether  (i) the prior case was decided on constitutional or statutory grounds; (ii) the prior decision has engendered legitimate reliance interests; (iii) the prior precedent has been undermined by changed circumstances; (iv) the prior decision has been consistently criticized, and is now seen as sufficiently inconsistent with other doctrine that it is a detriment to coherence in the law; and (v) the prior case has proven ‘unworkable‘ and/or outdated.

[2] See Direct Marketing Ass'n v. Brohl, 135 S. Ct. 1124 (2015) (Kennedy, concurring). One such quote is the following: ‘Given these changes in technology and consumer sophistication, it is unwise to delay any longer a reconsideration of the Court's holding in Quill. A case questionable even when decided, Quill now harms States to a degree far greater than could have been anticipated earlier. There may be a Tenth Amendment issue present in the case as well based on the argument that the Quill's physical presence rule is cannot be derived from the express language under the constitution and thus presents a separation of powers problem by ‘seiz[ing] a power from the states‘since the states would be permitted to craft their own nexus rules absent the judicially crafted physical presence rule”.

[3] Note the change in position taken by Congress within a relatively short period of time if this new bill finds its way into the law. Under the Trade Facilitation and Trade Enforcement Act of 2015, the Congress made the Internet Tax Freedom Act’s state and local taxation limitations permanent.

[4] In Complete Auto Transit, Inc. v. Brady, 97 S.Ct. 1076 (1977) the Court announced a four-part test which continues to govern the validity of state taxes under the Commerce Clause. In expressing its view that Bellas Hess, supra, was not overruled by Complete Auto, supra,  Justice Stevens in writing for the Court, explained that the former case concerns  the first part of the Complete Auto test and stands for the principle that a vendor whose only contacts with the taxing state are by mail or common carrier lacks the “substantial nexus” required by the Commerce Clause. In other words, “a mail order house may have the ‘minimum contacts’ with a taxing State as required by the Due Process Clause and yet the “substantial nexus” with the State required by the Commerce Clause”. These requirements are not identical.

[5] See N.D. Cent. Code §57-40.2-07 (Supp. 1991); N.D. Admin. Code §81-04.1-01-03.1(1988).

[6] See, e.g., Overstock.com, Inc. v. New York State Dept. of Taxation and Finance, Nos. 33 and 34 (NY, March 28, 2013) (affirmed NY sales tax statute under so-called “amazon” law whereby an out of state retailer with no physical presence in the state, as with an online retailer, is obligated to collect New York sales tax on sales to New York customers where it: (i) maintains links on website operated by New York residents; and (ii) pays commissions on sales made through those links.

[7] In its Answer, the ADOR addressed Newegg’s argument that  Quill Corp. v. North Dakota, supra, exempts it from having to collect and remit use tax because it lacks physical presence within the state. The ADOR asked the Alabama Tax Tribunal to adopt a new “substantial nexus” framework, per Complete Auto,  that an expansive “economic presence” rule is more appropriate for contemporary society.  The ADOR further argued that its economic nexus rule, when combined with the list of nexus-creating activities specified in Ala. Code §40-23-68, causes Newegg to have “substantial nexus.” . (Ala. Code § 40-23-68(b)(10)).

[8] See Holderness, “Questioning Quill”, 37 Va. Tax Rev. 313 (Winter, 2018)(“Though the ‘Kill Quill’ movement has succeeded in getting a challenge to the rule before the Supreme Court, the case for overturning the physical presence rule remains cloudy”).


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