U.S. Supreme Court Overrules Quill, But Leaves Many Unanswered Questions: South Dakota v. Wayfair Inc. 

By William Nelson
Smith Anderson
Jun 27, 2018

On June 21, the United States Supreme Court issued its long-awaited opinion in South Dakota v. Wayfair, Inc.[1] Overturning more than half a century of precedent, the Court ruled that a state may require a remote seller to collect the state’s sales tax on sales to in-state customers even where the retailer has no physical presence in the taxing state.

In lieu of physical presence, mere “economic presence” is now sufficient to subject a remote retailer to sales tax liability. Unfortunately, the Court offered little guidance on how much activity the retailer must have with in-state customers in order to establish the required economic presence.

The Wayfair decision will have an obvious and immediate impact on online and other remote sellers. These sellers will need to immediately begin collecting and remitting sales tax in states with sales tax statutes similar to the one at issue in Wayfair, and they will have to adapt to increased exposure to sales tax liability in other states until additional guidance is forthcoming in the form of further court decisions, state legislation or Congressional action.

The decision also offers the states a new source of revenue, conveniently collectible from non-voters. Just how much additional revenue may be forthcoming is unknown, but, if the amount is significant, states not committed to increased spending may be encouraged to reduce corporate or personal income tax rates as part of a general trend toward reliance on more predictable consumption taxes.

Commerce Clause Background

Section 8 of Article I of the United States Constitution enumerates eighteen specific powers granted to Congress. The third of these powers, behind only the power to tax and the power to borrow, is the power to regulate interstate commerce.

Since the early days of the Republic, the Supreme Court has asserted that Congress’s power to regulate interstate commerce implies a limitation on the power of the states to do so.[2] A state that imposes burdens on interstate commerce, the argument goes, is treading on a sphere of activity that the Constitution reserves to Congress. The Court has asserted the right to strike down state laws that burden interstate commerce even in areas of commercial activity where Congress has chosen not to exercise its regulatory power, i.e., where Congress’s Commerce Clause powers lie dormant.

At one time, the Court held that the dormant Commerce Clause doctrine prohibited the states from taxing purely interstate commerce at all.[3] In later decisions, the Court retreated from this position, holding that interstate commerce can be made to bear its fair share of state taxes. Under the Court’s holdings, a state may tax interstate commerce as long as certain requirements are met. One of these is that the state tax must “apply to an activity with a substantial nexus to the taxing state.”[4] This “substantial nexus” requirement was the subject of two prior Supreme Court sales tax cases as well as the Wayfair decision.

Bellas Hess and Quill

In 1967, the Supreme Court held, in National Bellas Hess v. Illinois,[5] that Illinois could not require an out-of-state mail-order retailer delivering goods to customers in Illinois by common carrier to collect Illinois use tax where the retailer had no physical presence in Illinois. To impose such a duty on the out-of-state retailer would place an undue burden on interstate commerce in violation of the Commerce Clause.

In 1992, the physical presence rule was challenged in Quill Corp. v. North Dakota.[6] Although that case involved facts similar to those in Bellas Hess, the North Dakota Supreme Court had upheld the state’s power to require an out-of-state mail-order retailer to collect North Dakota’s use tax on sales to North Dakota customers, reasoning that the massive growth in mail order sales since 1967 warranted abandoning the Bellas Hess physical presence requirement.

The taxpayer in Quill appealed to the United States Supreme Court. In its decision, the Court acknowledged the changes in the mail-order market but declined to disavow the bight-line physical presence rule. The Court acknowledged that the physical presence test was “artificial at its edges,”[7] but noted that the rule “firmly establishes the boundaries of legitimate state authority to impose a duty to collect sales and use taxes . . . , encourages settled expectations . . . [and] fosters investment by businesses.”[8] “Indeed,” the Court concluded, “it is not unlikely that the mail-order industry's dramatic growth over the last quarter century is due in part to the bright-line exemption from state taxation created inBellas Hess.”[9] The Court was expressly concerned that if the physical presence test were abandoned, the obligation to comply with the country’s thousands of taxing jurisdictions, with their varying and constantly changing exemptions and rates, would impose a substantial and unconstitutional burden on interstate commerce.[10]

Wayfair

The facts of Wayfair are essentially the same as those in BellasHess and Quill, except that the taxpayers in Wayfair were Internet rather than mail-order sellers. South Dakota had specifically drafted a law intended to challenge Quill. It required any retailer making more than $100,000 in sales into the state or more than 200 sales to in-state customers during the year to collect sales tax on all sales into the state.[11]

Specifically ruling that the physical presence test was “an incorrect interpretation of the Commerce Clause”[12] and expressly overruling both Bellas Hess and Quill, the Court declared that “the real world implementation of Commerce Clause doctrines now makes it manifest that the physical presence rule as defined by Quill must give way to the ‘far-reaching systemic and structural changes in the economy’ and ‘many other societal dimensions’ caused by the Cyber Age.”[13]

The Court noted the following considerations in support its decision:

  • The physical presence test is inappropriate in a market that is now dominated by online retailers.[14]
  • The massive growth of the online retail market protected by the physical presence rule has dramatically increased the revenue loss to the states.[15]
  • The physical presence test no longer serves as an efficient, reliable bright line. In particular, digital transactions present peculiar difficulties in applying the test. For instance, does a retailer’s placement of cookies on a customer’s hard drive create a physical presence in the state (so-called “cookie nexus”). These uncertainties substantially undercut the reliance interests that have grown up around the rule, making it easier for the Court to justify overturning its prior decisions.[16]
  • The physical presence test granted competitive advantages to remote sellers vis-à-vis their local counterparts.[17]
  • The physical presence test encouraged businesses to avoid otherwise economically efficient investment location decisions merely to avoid tax.[18]
  • The physical presence test produced absurd results highlighted by the hypothetical case of two businesses with warehouses located on either side of a state line. The business with an in-state warehouse would have to collect tax on all sales to in-state customers, whether or not involving the warehouse, while the business with the warehouse just across the state line would not have to collect any tax on sales to in-state customers, even if it maintained a “pervasive Internet presence” in the state.[19]
  • In what may have been the decisive factor for the Court majority, the physical presence rule was found to constitute an “extraordinary imposition” by the judiciary on state sovereignty by limiting the states’ taxing power, an imposition exacerbated by the massive growth in e-commerce.[20]

Economic Presence Threshold

Elimination of the physical presence test leaves open the question of what kind and amount of activity is necessary to create the “substantial nexus” required by the Commerce Clause. The Court’s answer to this question is not terribly helpful. Specifically, the Court stated that substantial nexus is estab­lished when the taxpayer “avails itself of the substantial privilege of carrying on business”[21] in the state. Note that the term “substantial” in the Court’s language modifies the privilege granted by the state to the remote seller, not the level of the remote seller’s business activity in the state. This suggests that any activity that constitutes “carrying on business” in a state will suffice to create substantial nexus.

The Court did not explain what it meant by “carrying on business” but was convinced that the Wayfair taxpayers were carrying on business in South Dakota. South Dakota imposed its tax only on sellers that made sales of more than $100,000 into South Dakota or engaged in 200 or more separate transactions with in-state customers. “This quantity of business could not have occurred” the Court concluded “unless the seller availed itself of the sub­stantial privilege of carrying on business in South Dakota. And respondents are large, national companies that un­doubtedly maintain an extensive virtual presence. Thus, the substantial nexus requirement . . . is satisfied in this case.”[22]

The Court’s language leaves several questions unanswered:

  • Does the $100,000/200 transaction threshold represent the lower limit of the economic presence test? I.e., would the result have been different if the South Dakota statute had a $50,000/100 transaction threshold? Some states will no doubt be inclined to probe beneath South Dakota threshold.
  • Are there in-state activities so fundamental or important that they constitute “carrying on business” even if they do not generate a certain level of sales or transactions?
  • Are businesses that exceed the threshold but that are not “large, national companies” or that do not maintain an “extensive virtual presence” nevertheless liable to collect sales taxes?
  • What is a “large national business” and what is an “extensive virtual presence”?

Limitations on the Economic Presence Test

The Court acknowledged that without the physical presence test, some, especially smaller, taxpayers may be faced with unduly burdensome compliance costs and that states that push the economic presence test too far may still run afoul of the Commerce Clause. The Court suggested four ways such pitfalls might be avoided:

  • First, the $100,000/200 transaction threshold should protect many smaller businesses from disproportionate compliance burdens.[23] This suggests that lowering the threshold might be unconstitutional for smaller firms. This could lead states to adopt a tiered threshold system depending on firm size.
  • Second, the Court noted that the South Dakota statute, by its terms, could not be applied retroactively.[24] Although the Court did not state, as it sometimes does when it overrules older precedent, that its decision has only prospective effect, it suggested that retroactive application of the economic presence test might in some cases be unconstitutional.[25] It is hoped this warning from the Court will deter retroactive application of the economic presence test by the states.
  • Third, the Court suggested that the compliance burdens might be kept to acceptable levels in states that have joined the Streamlined Sales and Use Tax Agreement.[26] This is a multistate agreement that attempts to standardize taxes to reduce adminis­trative and compliance costs and provides sellers access to sales tax administration software paid for by the states.[27] The Wayfair decision may encourage more states to become parties to the agreement.
  • Finally, the Court invited Congress to exercise its Commerce Clause powers and establish safe harbors or other clear rules.[28] Taxpayers should not place too much hope in this invitation. The Court included a similar invitation in its Quill opinion to no avail.[29]

Taxpayers should also note that a remote seller’s ability to argue for relief from the economic presence standard based on compliance burdens may be short-lived. The Court noted that “eventually,” and perhaps “in a short period of time,” software improvements may make compliance manageable even for small businesses.

Potential State Responses

Approximately eighteen states have already enacted economic presence statutes similar to South Dakota’s. Now that Wayfair has been decided, these statutes can be enforced immediately unless by their terms they have a delayed effective or enforcement date. States without economic presence statutes can be expected to move quickly to enact them.[30]

How much additional sales tax revenue the states will raise from the elimination of the physical presence test is an open question. Assuming significant revenue materializes, states will have to decide how to spend it. While state legislatures rarely have trouble finding spending opportunities, additional sales tax revenue may enable states to reduce other business or personal taxes. States such as North Carolina have been aggressively moving to reduce reliance on income taxes, because they are a volatile and unreliable source of revenue and because they discourage in-state investment. More sales tax revenue could pay for further reductions in income tax rates.

Use Taxes

The Wayfair decision raises an interesting question of whether use taxes are needed any longer as a corollary to the sales tax. Older Supreme Court cases had drawn a formal distinction between taxes imposed on the sale of goods and taxes imposed on the purchaser’s use and enjoyment of the goods after the sale. The older decisions were clear that a state had no jurisdiction to tax a sale consummated outside its territory, although it could tax the purchaser’s subsequent in-state use of the goods.[31] Thus, the taxes at issue in Bellas Hess and Quill were use taxes imposed on the purchasers’ in-state use of the goods in question, which the states were attempting to require the remote sellers to collect.

In Wayfair, however, South Dakota was attempting to require the remote seller to collect its sales tax on sales consummated outside the state where the goods were then delivered to in-state customers. The Court’s decision does not address this distinction and, in fact, hardly seems to acknowledge it. The Court noted that the sale of goods or services “has a sufficient nexus to the State in which the sale is consummated to be treated as a local transaction taxable by that State.”[32] The Court went on to state, however, that “[g]enerally speak­ing, a sale is attributable to its destination.”[33] The Court’s decision thus appears to give the destination state the constitutional right to tax an out-of-state sale to an in-state consumer as well as the consumer’s in-state use of the property at issue. At least in those cases where the substantial nexus requirement has been satisfied, the use tax seems to have no function except to give the state the option of collecting the tax from either the buyer or the seller, which also could be achieved by making both parties jointly liable for the sales tax.

Taxable Services

Many states have expanded their sales taxes to cover the sale of specified services as well as tangible goods. Some services, such as digital services, can be rendered and sold from a remote location without the need for local sales offices or distribution centers. As a result, providers of such services particularly benefited from the physical presence rule and may be especially affected by its elimination.

One difficulty providers of taxable services will face in a post-Wayfair environment is determining where their services should be taxed. In many states, the general sourcing rule for services is the place where the customer can first make use of the service.[34] This can be difficult to determine for business services that are not rendered face-to-face where the customer has multiple locations. The possibility for confusion, multiple taxation and future constitutional litigation in this area may be particularly strong.


[1] Slip Op.; 585 U.S. __ (2018).

[2]See Gibbons v. Ogden, 9 Wheat. 1 (1824).

[3]See Freeman v. Hewitt, 329 U.S. 249 (1946).

[4]See Complete Auto Transit, Inc. v. Brady, 430 U.S. 274 (1977).

[5] 386 U.S. 753 (1967).

[6] 504 U.S. 298 (1992).

[7] 504 U.S., at 315.

[8] 504 U.S., at 315.

[9] 504 U.S., at 316.

[10] 504 U.S., at 313, n.6.

[11] S. 106, 2016 Leg. Assembly, 91st Sess. (S.D. 2016).

[12] Slip Op., at 10.

[13] Slip Op., at 18.

[14] Slip Op., at 18-19.

[15] Slip Op., at 19.

[16] Slip Op., at 19-20.

[17] Slip Op., at 13.

[18] Slip Op., at 13.

[19] Slip Op., at 14.

[20] Slip Op., at 17.

[21] Slip Op., at 22, quoting Polar Tankers, Inc. v. City of Valdez, 557 U.S. 1, 11 (2009).

[22] Slip Op., at 23.

[23] Slip Op., at 21.

[24] Slip Op., at 21.

[25] Slip Op., at 21-22.

[26] Slip Op., at 21.

[27] North Carolina is a party to the agreement.

[28] Slip Op., at 21.

[29] 504 U.S., at 318.

[30] In North Carolina, an economic presence bill (S81) modeled on the South Dakota statute was introduced in the 2017 North Carolina General Assembly, where it passed the Senate but was still in committee when the legislature adjourned. Presumably, the bill or a similar one will be taken up again at an early opportunity.

[31]See McLeod v. J.E. Dilworth Co., 322 U.S. 327 (1944).

[32] Slip Op., at 10 quoting Oklahoma Tax Comm’n v. Jefferson Lines, Inc., 514 U.S. 175, 184 (1995).

[33] Slip Op., at 10 quoting C. Trost & P. Hartman, Federal Limitations on State and Local Taxation 2d §11.1, p. 471 (2003).

[34]See, e.g., N.C. Gen. Stat. §105-164.4B(a).