The South Dakota v. Wayfair Decision Explained

The 2018 Supreme Court decision in South Dakota v. Wayfair altered sales tax obligations for businesses across the United States, particularly for companies that sell products to customers in states where they have no physical offices or property. The case addressed the challenges state governments faced in collecting sales tax revenue in an economy dominated by online retail. The ruling replaced a long-standing physical presence rule with a new standard based on economic activity, reshaping how remote sellers approach their tax responsibilities.

The Physical Presence Standard

For decades, the requirement for a business to collect sales tax was determined by the “physical presence” standard, solidified by the 1992 Supreme Court case Quill Corp. v. North Dakota. Under this rule, a state could only compel a business to collect sales tax if it had a sufficient physical connection, or nexus, to that state. A company without a tangible footprint like an office or employees within a state’s borders had no collection obligation.

A physical presence was defined by tangible connections, such as having an office, a warehouse, or a storefront. Employing individuals who worked within the state, owning property, or storing inventory in a third-party facility also created a physical nexus. For example, a mail-order company that only shipped goods to customers from an out-of-state facility was exempt from collecting that state’s sales tax. While customers were responsible for paying a corresponding use tax, compliance was low.

This standard created a clear test. If a company had no property or personnel in a state, it had no sales tax collection duty there. The presence of customers alone was not enough to establish the required nexus under the Commerce Clause of the U.S. Constitution.

The rise of e-commerce exposed the limitations of this rule. As online retail grew, states saw their sales tax revenues decline. Remote sellers could offer goods without charging sales tax, giving them a price advantage over local brick-and-mortar stores. This disparity prompted states to seek a new legal standard that reflected the modern digital economy.

The Supreme Court’s Ruling

The challenge to the physical presence standard came from a 2016 South Dakota law designed to confront the Quill precedent. The law required remote sellers to collect sales tax if they met specific economic thresholds. The obligation was triggered if a seller had gross revenue from sales in the state exceeding $100,000 or engaged in 200 or more separate transactions with South Dakota residents within a calendar year.

Before the Supreme Court, South Dakota argued that the physical presence rule was outdated and harmful in the age of e-commerce. The state contended that a business could have a substantial economic presence without a physical one. It pointed to significant revenue losses and the unfair advantage given to online retailers as direct consequences of the old rule.

The defendants, including online retailers like Wayfair, argued that overturning Quill would impose an excessive burden on interstate commerce. They highlighted the complexity of the nation’s sales tax system, with thousands of different state and local taxing jurisdictions, each with its own rates and rules. They asserted that navigating this complex web would be costly for businesses, especially small ones, and that this was a matter for Congress to resolve.

In a 5-4 decision, the Supreme Court sided with South Dakota, overturning Quill. The Court reasoned that the physical presence rule distorted the market and was not a necessary interpretation of the “substantial nexus” requirement from the Commerce Clause in the modern digital marketplace. The ruling established that a substantial economic connection to a state was sufficient to create a sales tax collection obligation.

Understanding Economic Nexus

The Wayfair decision replaced the physical presence standard with “economic nexus.” This standard allows a state to impose a sales tax collection duty on a business based on its economic activity within that state, regardless of physical location. A company’s sales volume or number of transactions can now be the sole basis for establishing a tax obligation.

The foundation for economic nexus is a set of thresholds for sales or transaction volume. A remote seller establishes economic nexus by meeting a state’s specific criteria, most commonly a minimum amount of gross sales or a certain number of transactions over a 12-month period. The thresholds validated by the Court were considered substantial enough to avoid burdening small sellers with minimal activity in the state.

Following the decision, nearly every state with a sales tax enacted its own economic nexus laws. While many states adopted thresholds similar to South Dakota’s, there is no uniform federal standard. States have chosen different sales thresholds, and some have eliminated the transaction count, requiring businesses to monitor their sales activity on a state-by-state basis.

The implementation of economic nexus means any business selling across state lines must be aware of its sales footprint in every state. The seller is responsible for tracking its revenue and transaction volume to determine where it has a collection obligation. Nexus is no longer tied to a physical map but to a company’s sales data.

Steps for Sales Tax Compliance

For businesses selling across state lines, compliance involves several steps:

• Determine nexus: The first step is to conduct a nexus study, which is a review of a company’s sales activities. This study analyzes sales data against the economic nexus thresholds of every state to identify where the business has a tax collection obligation. The analysis should also account for any physical nexus triggers, such as remote employees or inventory.
• Register for permits: Once a business identifies the states where it has nexus, it must register for a sales tax permit in each of those jurisdictions. This is handled through the state’s Department of Revenue. Failing to register in a state where nexus exists can lead to penalties and liability for uncollected back taxes.
• Calculate and collect tax: With permits, a business must accurately calculate and collect sales tax on all taxable transactions. This is complex, as tax rates vary by state, county, and city. Many businesses use automated sales tax software to manage this complexity and calculate the correct rates at the point of sale.
• File returns and remit taxes: The final step is to file sales tax returns and remit the collected funds to the state authorities. Each state has its own filing schedule, which can be monthly, quarterly, or annually, depending on the volume of tax collected. Businesses must submit a return detailing total sales and the tax collected.