Extracted from Law360
The U.S. Supreme Court issued its decision in South Dakota v. Wayfair Inc. on Thursday. The South Dakota law under review was the result of an intentional effort by South Dakota to pass a law with an “economic nexus” threshold for use tax collection purposes that would conflict with the “physical presence” standard imposed by the Supreme Court’s 1992 decision in Quill Corp. v. North Dakota. By design, South Dakota lost before its state supreme court and appealed to the U.S. Supreme Court. South Dakota’s gambit worked: in its decision, the court explicitly overruled Quill (and National Bellas Hess before it) and held that because of the taxpayers’ “economic and virtual” connections with South Dakota, the “substantial nexus” requirement was satisfied, notwithstanding the taxpayers’ lack of physical presence in the state.
South Dakota’s challenge to Quill was inspired by Justice Anthony Kennedy’s concurrence in Direct Marketing Association v. Brohl, in which he contended that modern e-commerce rendered the Quill physical presence standard unworkable. He asked for the states to bring a case to the court that would act as a vehicle to review Quill.
South Dakota heeded Justice Kennedy’s request, passing legislation, S.B. 106, in 2016 to challenge the physical presence standard and to replace it with an “economic nexus” standard under which out-of-state sellers with either $100,000 in sales into the state or 200 sales to South Dakota customers are required to collect and remit South Dakota use tax on those sales. South
Dakota’s direct challenge to Quill in turn invited an immediate challenge by Wayfair and other remote sellers, and the fast-track appeal mechanism included in S.B. 106 allowed the case to reach the court quickly.
The Decision — Commerce Clause Background
The court’s modern precedents include two principles that govern a state’s authority to regulate interstate commerce. States may not discriminate against interstate commerce, and they may not impose “undue burdens” on interstate commerce. The court’s four-part test in Complete Auto Transit Inc. v. Brady, used those principles to define the specific requirements that a state tax must meet to satisfy the Commerce Clause. A state tax must:
- Apply to an activity “with a substantial nexus” with the state;
- Be fairly apportioned;
- Not discriminate against interstate commerce; and
- Be “fairly related to the services” provided by the state.
The court’s 1992 decision in Quill affirmed that under the “substantial nexus” prong of Complete Auto, a state could require remote sellers to collect use taxes on sales into the state only if the seller had physical presence there. The justices recognized certain deficiencies in the physical presence standard but cited to the “benefits of a clear rule” and the reliance interests that the rule had engendered in affirming it. The Quill court also acknowledged the possibility that the bright-line standard had helped to promote the growth of the mail order industry at issue in that case. In a concurrence, Justice Scalia riffed on the “special force” that attaches to stare decisis in the context of a commerce clause rule made by the judiciary, which Congress has the power to overrule or change.
The Decision — Majority’s Reasoning
The opinion of the five justices in the South Dakota v. Wayfair majority was written against that backdrop. In an analysis of the oral argument of this case, we had projected that the justices’ view of the “harms” inflicted by the physical presence rule would be crucial to their decision: if they believed that the alleged harms of the physical presence rule outweigh the uncertainty of throwing out that standard, they would be much more likely to rule for South Dakota. The majority opinion reveals that the five justices found the harms caused by the physical presence rule to be very compelling.
First, the court found that the physical presence rule is a “poor proxy” for making sure that the compliance costs of use tax collection are borne only by businesses that are engaged in substantial business in the state, for a large business could avoid the obligation by structuring its operations to ensure it lacked physical presence, while a smaller business could trigger a use tax collection obligation through a small warehouse or a number of employee visits into the state. That disconnect led to the second harm cited by the majority, which is that the physical presence rule created “market distortions” by putting some local businesses at a “competitive disadvantage” against large remote sellers that did not collect taxes. The majority was also persuaded that the physical presence rule continues to yield significant revenue shortfalls for states — though in something of a contradiction, the majority surprisingly suggested that the physical presence rule is “proving unworkable” because of states’ efforts to work around the rule (e.g., the “cookie nexus” regulation proposed in Massachusetts and the notice/reporting requirements imposed by Colorado and other states).
In light of those cited reasons, the majority held that the physical presence rule was “unsound and incorrect”; accordingly, it overruled National Bellas Hess and Quill. It went on to note that the sales volumes of the taxpayers in the case “could not have occurred unless the seller availed itself of the substantial privileges of carrying on business in South Dakota,” so it held that South Dakota’s economic nexus thresholds had satisfied the “substantial nexus” prong of Complete Auto.
The majority did not hold, however, that South Dakota’s law was constitutional. Rather, it remanded the case to the state court to consider whether the state tax scheme had satisfied the other three prongs of Complete Auto. Oddly, though, the court strongly suggested that the state’s scheme would pass constitutional muster because “several features” of the state’s scheme went toward preventing any discrimination or “undue burdens” on interstate commerce. Specifically:
- The economic nexus thresholds created a “safe harbor” for those who transact only limited business in the state;
- The law prohibited retroactive application;
- The state’s adoption of the Streamlined Sales and Use Tax Agreement utilized uniform definitions, “simplified tax rate structures,” and a single-level administration
- that reduced burdens on multistate businesses; and
- The state provided access to free compliance software, the use of which would yield immunity from audit liability.
The Decision — Dissent
The dissenting opinion — authored by Chief Justice John Roberts and joined by Justices Stephen Breyer, Elena Kagan, and Sonia Sotomayor — conceded the error of the physical presence rule, but it emphasized that the harms created by the rule should be addressed by Congress, rather than the court. Like the majority in Quill, the dissent emphasized that overruling a precedent requires “special justification,” and it noted that an even more “heightened” form of stare decisis applies in the commerce clause context. Noting that the court had already heard and rejected one challenge to the physical presence rule, the power of stare decisis “should be an even greater impediment to overruling precedent now,” especially given that Congress was in the process of evaluating potential legislative solutions.
The dissenting justices were dismayed by the majority’s “breez[y] disregard” for the potential burdens that the decision would impose on sellers who will now be subjected to a use tax collection obligation in many new states — a burden that “will fall disproportionately on small businesses.” For that reason, and because Congress was better positioned to “consider the competing interests at stake” and provide a “nuanced answer” to the complex issues in the case, the dissenting justices would have affirmed Quill and left the matter for resolution by Congress.
Considerations and Concerns
In a close decision, a 5-4 majority prioritized its perceived need for “correcting the error” of Quill over the benefits of a bright-line physical presence rule and threw out that rule rather than defer to Congress to reset the status quo. The exchange between the majority and the dissent shows that the crux of the dispute turned on respect for stare decisis: the dissent viewed Congress’s ability to craft a complete response to the issues as a strong basis to let the physical presence rule stand, while the majority ultimately determined that it must be “vigilant” in correcting the court’s 50-year-old error.
One of the ironies of the decision is that the majority criticized the physical presence rule for becoming “unworkable,” but it threw out that bright-line rule for no rule at all. While many states will choose to track the constitutionally-blessed economic nexus thresholds in the South Dakota law, there is nothing in the language or reasoning of the decision that would prevent another state from asserting that a much lower standard satisfies the “substantial nexus” prong.
Indeed, at oral argument, the state asserted that a single sale into a state may satisfy the substantial nexus prong under Complete Auto; while it is highly unlikely that the court would uphold such a standard, the court did not reject that possibility.
A somewhat unexpected aspect of the decision is the court’s discussion of the other “features” of South Dakota’s sales and use tax scheme that the state court should consider on remand. The majority praised those features (e.g., a prohibition on retroactive application, centralized administration, uniform definitions and simplified rates) as parts of a scheme that is likely to survive constitutional scrutiny because it does not discriminate against, or impose “undue burdens” on, interstate commerce. It will be interesting to see whether any state agency or court interprets that discussion to give rise to a “sliding scale” for constitutionality, in which South Dakota’s low economic nexus thresholds are deemed sufficient for a “simple” state tax scheme, whereas a higher sales threshold is constitutionally required for a more complicated regime (e.g.., a home-rule jurisdiction with multiple levels of administration and inconsistent definitions at the state and local levels).
Finally, while of course circumstances change and laws must evolve, this decision triggers an uncomfortable possibility. While the majority opinion mentions the need to respect precedent, it seems more concerned with “correcting an error” perceived to exist by five justices than with actually applying a heightened level of deference to long-standing precedent. If states needed any encouragement to craft state laws or regulations to bring fast-track, targeted challenges to other controversial constitutional decisions with which they disagree, this is it.
Conclusion: Other Implications and Salutary Effects
Before we go, we wanted to offer a few concluding thoughts. First, by rolling back the protections of the “substantial nexus” prong under the Complete Auto test, this decision likely gives renewed importance to the due process clause as a valuable protection for multistate businesses. This may be particularly true for service providers, and especially cloud service providers, who have much less control and direction over the location of the use of their services than, say, a seller of tangible personal property who fills an order and ships property to a purchaser’s address.
Second, taxpayers should press arguments that a state tax system that may otherwise pass constitutional muster is nevertheless made unconstitutional if it imposes multiple burdens on a remote seller or asserts nexus based on physical and economic factors. For example, if we assume that South Dakota proceeds to enforce nexus based on S.B. 106, South Dakota should not also require noncollectors to submit to the type of notice and reporting requirements that were at issue in Direct Marketing Association v. Brohl. Nor should states impose tax under an economic nexus standard and aggressively pursue nexus based on “click-through nexus” or other broad attributional nexus concepts; instead, states should have to pick a lane in order to avoid imposing heightened burdens on taxpayers. Forcing taxpayers to track and navigate multiple nexus thresholds would impose additional burdens that have not been constitutionally blessed, and taxpayers should be “vigilant” (to borrow a term from the majority) in pushing back against such undue burdens. Finally, taxpayers may rejoice in one thing — that the court’s emphasis on the “simplified” features of South Dakota’s tax scheme may have the salutary effect of encouraging states to simplify their sales and use tax administration to reduce the burdens on multistate businesses.
Disclaimer: The firm represented Americans for Tax Reform in its amicus curiae brief in support of respondents in this case.
 No. 17-494
 135 S. Ct. 1124 (2015).
 430 U.S. 274 (1977).