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South Dakota v. Wayfair: The Physical Presence Rule - Outdated and Overturned

August 01, 2018

By: Trav Baxter

Category: Tax

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South Dakota v. Wayfair:[1]

Just about every State in the U.S. imposes a “sales tax” on the retail sale of goods and services in their State.[2] That sales tax is required to be collected and remitted by the seller of the goods or services; however, if the seller does not collect and remit the sales tax, then the purchaser is required to remit the tax.

One of the main issues that States have faced over the years is their inability to require out-of-state retailers to collect and remit sales tax on sales made to consumers within their State. This barrier to collection of sales tax from out-of-state retailers is the result of the holdings in two U.S. Supreme Court Cases, National Bellas Hess, Inc. v. Department of Revenue of Ill.[3] and Quill Corp. v. North Dakota,[4] under which the physical presence rule became the standard for whether an out-of-state retailer was required to collect and remit. The physical presence rule provides that a State may not require an out-of-state retailer to collect and remit sales tax if such retailer has no physical presence in the State. This inability to require such out-of-state retailers to collect and remit has increased many States’ revenue shortfalls, and with a dramatic increase in e-commerce it has only become worse. For example, it is estimated that the State of Arkansas would collect $35.4 million more in sales tax each year if it could require out-of-state retailers to collect and remit sales tax for their online sales to residents of Arkansas.[5]

As a result of the decrease in sales tax revenue in South Dakota, due to the increase in online sales to its residents, South Dakota enacted a law that required out-of-state retailers to collect and remit sales tax “as if the seller had a physical presence in [South Dakota].”[6] The South Dakota act did not apply to all out-of-state retailers, but only to those that on an annual basis either delivered more than $100,000 of goods or services into South Dakota, or engaged in 200 or more separate transactions for the delivery of goods or services into South Dakota.[7] After enactment, South Dakota filed an action in state court seeking declaratory relief against three large online retailers who had no physical presence in South Dakota, being Wayfair, Newegg and Overstock.[8] After adverse decisions from South Dakota courts in favor of the online retailers and pursuant to the physical presence test, South Dakota appealed to the U.S. Supreme Court.[9]

In taking up the issue of the validity of state taxation and whether or not the South Dakota law was constitutional, the court cited application of the Commerce Clause and the four-prong test in Complete Auto Transit, Inc. v. Brady.[10] Pursuant to the Complete Auto test, the validity of a state tax will be sustained if it (1) applies to an activity with substantial nexus with the taxing State, (2) is fairly apportioned, (3) does not discriminate against interstate commerce, and (4) is fairly related to the services the State provides.[11] In application of the Complete Auto test and overruling Bellas Hess and Quill, the Court held that an activity does not have to meet the physical presence test to satisfy the first-prong requirement of substantial nexus, and that South Dakota had clearly demonstrated sufficient nexus as “the [South Dakota] Act applies only to sellers who engage in a significant quantity of business in the State, and respondents are large, national companies that undoubtedly maintain an extensive virtual presence.”[12] The Court stated that “[m]odern e-commerce does not align analytically with a test that relies on the sort of physical presence defined in Quill[13] . . . and the Court “should not maintain a rule that ignores these substantial virtual connections to the State.”[14] The Court further stated that “[h]elping [Wayfair, Newegg and Overstock] customers evade a lawful tax unfairly shifts to those customers who buy from their competitors with a physical presence that satisfies Quill . . . an increased share of the taxes.”[15]

The Wayfair case opens the door for a more level playing field for retailers in a world where consumers are engaging in more and more e-commerce every day. It will be interesting to see how States respond.


[1] U.S. S. Ct., Dkt. No. 17-494 (June 21, 2018).

[2] Only five States do no impose a sales tax on the sale of goods and services: Alaska, New Hampshire, Delaware Montana and Oregon. See The Five States without a Statewide Sales Tax, at https://www.thebalance.com/states-without-a-sales-tax-3193305

[3] 386 U.S. 753 (1967)

[4] 504 U.S. 298 (1992)

[5] Arkansas Democrat Gazette, State to reap $35M in taxes, panel told, 1A, 5A (July 28, 2018).

[6] SDCL § 10-64-2.

[7] Id.

[8] 2017 WL 4358293 (S.D.Cir.).

[9] State v. Wayfair Inc., 901 N.W.2d 754, 2017 S.D. 56.

[10] 430 U.S. 274 (1977).

[11] Id. at 279.

[12] U.S. S. Ct., Dkt. No. 17-494, (Syllabus).

[13] U.S. S. Ct., Dkt. No. 17-494, pg. 14.

[14] Id. at 15.

[15] Id. at 17.

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