On June 21, 2018, in a five to four majority decision deciding the case of South Dakota v. Wayfair, the US Supreme Court overturned 50 years of precedent. Businesses now face a new landscape for sales and use tax with the decision significantly expanding the authority states have to impose transaction taxes upon out of state companies of all types.
To understand what happened on that day, one first has to understand what power a state has to tax out of state businesses to begin with. In its most basic form, nexus is the connection or link with a jurisdiction that must exist for that jurisdiction to be able to impose tax on the activities of a business. There are different nexus standards for different types of taxes. For sales and use tax, physical presence had to exist within a jurisdiction for it to be able to require an out of state seller to collect and remit use tax on sales delivered to customers within the jurisdiction. Physical presence could take the form of property, an employee, or agent operating on behalf of the seller. Without a physical presence, there was no requirement on the seller to collect tax on transactions delivered into a jurisdiction.
The Wayfair decision reversed the physical presence requirement and upheld a state law that said use tax nexus could be created based solely on the sales activity of a company, regardless of physical presence. Under Wayfair, the Court ruled that a test based on sales revenue or number of transactions (in the case of South Dakota it was $100,000 in sales or 200 separate transactions) could be sufficient to establish nexus for use tax. It should be noted that the Court only accepted the reasonableness of the South Dakota threshold and did not spell out what the threshold for economic nexus actually should be.
The states have reacted in a variety of ways after Wayfair with regard to how they are addressing the new nexus. Almost universally they are pushing forward to either adjust their current laws or put new laws and regulations in place that impose economic nexus on out of state taxpayers. As of February 15; thirty eight states have either adopted or are in the process of adopting economic nexus rules based on sales and/or number of transactions.
Does this matter to manufacturers?
The Wayfair decision came about due to states believing there were billions of dollars of online transactions occurring where use tax was not being collected and feeling frustrated that a federal solution had not been created to address their concern. However, this decision has a far broader reach than just online and e-commerce type businesses. Manufacturers and wholesalers, who have traditionally been exempt from the need to collect tax because they sell for resale or are otherwise exempt from sales and use tax, now have to consider if the decision impacts them. To make that determination, businesses will only need to answer two questions: Do they sell something and do they sell it to out of state customers? If the answer to both questions is “yes”, then Wayfair may likely have an impact.
The impact will be felt by manufacturers and wholesalers, and must be addressed by taxpayers lest they face increased risk of use tax exposure. Issues manufacturers need to consider in the new use tax environment include:
- Use tax exposure: How much use tax exposure already exists for the business? The Wayfair case was decided in June 2018 and, at that time, there were a few states that already had the law on their books. While the case was decided on a prospective basis and the states have apparently embraced that, it still means there were some states where it became effective almost immediately. Additionally, there were other states that enacted or began enforcing economic nexus within just a few months of the decision. Companies just now looking at the impact of use tax rules could find they already have significant exposure in a number of jurisdictions.
- New filing requirements: The new nexus rules do not look exclusively at retail sales. In some states, the threshold is measured on gross revenue, or something similar, which can result in taxpayers now having to register and file in potentially numerous jurisdictions. Businesses who typically didn’t file many use tax returns may now find themselves facing a new administrative burden if they suddenly have many states to deal with.
- Exemption certificates: When a seller has a requirement to collect use tax on a sale into a jurisdiction, they are obligated to do so unless they receive an exemption or resale certificate from the buyer. Previously, when manufacturers only had physical presence nexus where they had a physical presence, they were only required to collect certificates in that limited number of states. Due to new economic nexus standards, they are now being required to collect tax in a growing number of states. These businesses will also need to obtain proper certificates in those new states or face increased exposure in the event of an audit. Without the exemptions, an auditor will assess the seller for the use tax on their transactions so it’s critical for a seller to have properly completed exemptions on hand. Not only will taxpayers now have more certificates they need to collect, they will also be facing the issue that the states are not uniform on their certificates, either with what certificate is required or how long the expiration date is for an exemption. Both of these can lead to the need for more effort in order to collect and maintain this aspect of sales and use tax compliance.
- Vendor impact: Manufacturers, and other businesses, will likely now have vendors that are also being impacted by the Wayfair case. Vendors may now have economic nexus in states where they didn’t in the past and may begin to charge tax on sales they hadn’t in the past. Manufacturers will need to remain vigilant in determining whether sales tax is being properly charged and watch out for transactions where they would have automatically accrued taxes in the past. They may now find the vendor is assessing tax on that purchase, and if not careful, could end up paying the tax twice.
- State nexus: Businesses, including manufacturers, will likely see an increase in the number of notices they receive from states, particularly with regard to nexus. With income tax having different nexus rules than sales tax, there may be states where an entity only has to report for one type of tax. However, it’s likely that states will use these discrepancies to automatically generate non-filing notices. For example, when a state sees an amount exceeding its economic nexus threshold in the sales factor box of an income tax return, for which they do not have a use tax registration on file, there may be notices generated for that taxpayer asking them to explain why they have sufficient revenue to meet the use tax economic nexus threshold but have not registered to collect tax. There may be a reason why no registration has been done, but time and effort will still need to be expended to respond to the notice.
- Tax on services: Manufacturers that sell tangible personal property may not be used to charging tax on services, such as installation, because it’s not taxable in their home state. But with the new economic nexus laws, they may now have transactions in new states where installation activity is taxable, and they will need to tax this appropriately.
Summary of complicating issues sellers face
One of the premises behind the Wayfair case being the vehicle sought by the states for bringing economic nexus before the Court was that the tax didn’t impose an unreasonable burden on the taxpayer. Additionally, that simplicity was one of the bases for which the Court sided with the state of South Dakota. But, in this case, the law of unintended consequences has reared its head again, and the states have managed to make the issue overly complex for the small business given how each has implemented economic nexus in their own manner. Some of the areas of concern are:
- When is the economic nexus threshold achieved? Depending on the state, it can be based on prior calendar year sales, current calendar year sales or a rotating quarterly basis, among others.
- What type of activity does the “sales” threshold include? This can be defined by the states to be different things, including retail sales, gross revenue, sales of tangible personal property, sales of tangible personal property and taxable services and gross sales, among others.
- The thresholds are not consistent in dollar amount or number of transactions between the states. It currently ranges between $10,000 all the way up to $500,000.
- What is the definition of a “transaction?” Does the definition of a transaction mean a single shipment, what’s on a single invoice, an individual item, etc.?
- What is the impact of “home rule” municipal taxes? Do the thresholds of a state apply to individual cities that impose their own use tax or does that threshold need to be met within the city itself to allow for the municipality to also impose use tax? In “home rule”, the municipality doesn’t follow the states rules, however, if they want to only require the threshold be met at the state level for sales into that city, then that’s contrary to how “home rule” works.
Manufacturers may not consider Wayfair to be particularly important since what they sell is generally treated as an exempt transaction but since the vast majority of manufacturers ship out of state, it’s certainly something that needs to be considered. Manufacturers must figure out previous year sales on a state to state basis to see if they meet the economic thresholds in states imposing these regulations. The Wayfair decision holds a lot more weight for manufacturers than it would seem, and there is a certain degree of complexity with policies varying state to state and some states not imposing economic nexus. Discussing how the decision will impact your organization with a UHY Advisors state and local tax professional is critical as the decision is relatively recent, and it may help limit accrued tax exposure. As with most new tax regulations, it is better to address concerns sooner rather than later to avoid tax liabilities.