By: Eli Noff, Partner & Mary Lundstedt
On June 21, 2018, the Supreme Court delivered its highly anticipated decision in South Dakota v. Wayfair, Inc., et al. The 5-4 decision discards the antiquated “physical presence rule” – a rule which has allowed retailers lacking a physical presence in a state to avoid any obligation to collect and remit sales taxes. Significantly, the Court overruled the long-standing interpretation of the Commerce Clause, finding that “the physical presence rule of Quill is unsound and incorrect,” and that virtual and economic contacts may indeed satisfy the necessary substantial nexus requirement.
The Commerce Clause in the U.S. Constitution empowers Congress to regulate interstate commerce; however, it does not function as an express limitation on the states’ ability to regulate commerce. Almost from its very beginning, the Supreme Court’s interpretation of the Commerce Clause has been necessary for determining “its meaning, its reach, and the extent to which it limits state regulations of commerce.”
Most states have a sales tax applicable to the retail sales of goods and services. Typically, the seller must collect and remit the sales tax. As a backstop, if the seller fails in its duty, then the in-state consumers are typically supposed to pay a use tax at the same rate.
Over the years, the Supreme Court has considered various cases requiring interpretation of the Commerce Clause in the circumstance of an out-of-state retailer and its obligation, or lack thereof, to collect and remit sales tax. Throughout its decision-making, the Court has emphasized two principles that “mark the boundaries of a State’s authority to regulate interstate commerce.” First, states may not regulate in a way that discriminates against interstate commerce. Secondly, states may not create an undue burden on interstate commerce. With these boundaries in mind, three pivotal cases culminated in the interpretation, now overruled, that only a seller with a “physical presence” in the taxing state was required to collect and remit the taxes.
In National Bellas Hess, Inc. v. Department of Revenue of Ill., the Court considered the extent to which an activity must be connected to a state, before the state has the power to tax it. The Court determined that in the case of a mail-order company, some type of physical presence (such as a solicitor or property) was required to establish a requisite “minimum contact” with the state, as required under both the Due Process Clause and the Commerce Clause. Without such minimum contact, states could not obligate an out-of-state seller to collect and remit tax.
A decade later, in Complete Auto Transit, Inc. v. Brady, the Court created the four-pronged test used for deciding the sustainability of a state tax confronted with a Commerce Clause challenge. Per this test, a tax is sustained if “the tax is applied to an activity with a substantial nexus with the taxing State, is fairly apportioned, does not discriminate against interstate commerce, and is fairly related to the services provided by the State.”
Subsequently, the Court definitively distinguished Bellas’ “minimum contact” from Complete Auto’s “substantial nexus.” In Quill Corp. v. North Dakota, the Court, clarified that the Commerce Clause’s “substantial nexus” prong requires something more than the “minimum contacts” requirement under the Due Process Clause. In short, Quillsolidified the interpretation that “substantial nexus” requires a “physical presence” as indicated in Bellas.
Obviously, during the twenty-six-year period since Quill, the Internet dramatically changed the interstate marketplace. The combination of the expansion of e-commerce, the states’ inability to tax sellers lacking a physical presence, and the impracticability of the use tax as a backstop, has caused substantial depletion to the states’ revenue coffers.
Correcting the Error of Quill
Recently, South Dakota, declaring a financial “emergency” (directly tied to the loss of revenue due to the inability to compel out-of-state retailers to collect and remit taxes), enacted legislation imposing tax obligations on certain sellers lacking a physical presence in the state. South Dakota sought state court validation of the legislation and an injunction requiring respondents-Wayfair and other prominent online retailers without a physical presence in the state-to comply with the act. Respondents maintained the act was unconstitutional, and eventually, the State Supreme Court agreed. The Supreme Court granted certiorari to hear the matter.
The Court carefully considered its own interpretive obligation, stating that “if it becomes apparent that the Court’s Commerce Clause decisions prohibit the States from exercising their lawful sovereign powers, the Court should be vigilant in correcting the error.”After a thorough review of the development of the physical presence rule, the Court found Quill “flawed” for three reasons:
First, the physical presence rule is not a necessary interpretation of the requirement that a state tax must be “applied to an activity with a substantial nexus with the taxing State.” Complete Auto, 430 U. S., at 279. Second, Quill creates rather than resolves market distortions. And third, Quill imposes the sort of arbitrary, formalistic distinction that the Court’s modern Commerce Clause precedents disavow.
As pertaining to the first reason, the Court rather summarily stated that:
The reasons given in Quill for rejecting the physical presence rule for due process purposes apply as well to the question whether physical presence is a requisite for an out-of-state seller’s liability to remit sales taxes. Physical presence is not necessary to create a substantial nexus.
The Court introduced its second criticism of Quill, by Citing Philadelphia v. New Jersey, which reiterated the fundamental principle that the Commerce Clause was designed to prevent states from creating situations of economic discrimination. The Court further stated that “it is certainly not the purpose of the Commerce Clause to permit the Judiciary to create market distortions.” Noting the burdens on brick and mortar companies which remote sellers escape, the Court stated that:
In effect, Quill has come to serve as a judicially created tax shelter for businesses that decide to limit their physical presence and still sell their goods and services to a State’s consumers-something that has become easier and more prevalent as technology has advanced.
The Court was also clearly concerned that Quill creates an incentive to remain remote, and it stated that “rejecting the physical presence rule is necessary to ensure that artificial competitive advantages are not created by this Court’s precedents.” 
Finally, the Court found flaw in Quill’s “arbitrary” and disparate treatment of economically identical actors. The Court considered an example contrasting two furniture businesses. The Court described one business as having limited inventory in a warehouse in South Dakota. The other business used a warehouse outside of the state, but it had a website with virtual showrooms accessible in every state (including South Dakota). The Court noted that:
By reason of its physical presence, the first business must collect and remit a tax on all of its sales to customers from South Dakota, even those sales that have nothing to do with the warehouse. [Citation omitted]. But, under Quill, the second, hypothetical seller cannot be subject to the same tax for the sales of the same items made through a pervasive Internet presence. This distinction simply makes no sense.
Next, the Court readily pronounced the physical presence test as “artificial” and incompatible with the realities of modern e-commerce. According to the Court, a virtual showroom can actually provide “greater opportunities for consumer and seller interaction than might be possible for local stores.”
The Court continued its abrogation of the physical presence rule noting that the rule is an example of “an extraordinary imposition by the Judiciary on States’ authority to collect taxes and perform critical public functions.” The Court also clarified that the advantage remote sellers have over competitors with a physical presence in fact limits the “States’ ability to seek long-term prosperity and has prevented market participants from competing on an even playing field.”
In the end, the court found the respondents’ virtual and economic contacts with South Dakota sufficient to establish nexus. The door is now open for the entry of other states pursuing South Dakota’s legislative goal. It remains to be seen which state will be next to enact revised sales tax legislation, but we can be certain that change is coming.
If you have any questions about sales tax issues, please feel free to contact Eli Noff at Frost & Associates, LLC today.
 No. 17-494.
 Id. at 22.
 U.S. Const., Art. I, §8, cl. 3.
 South Dakota, No. 17-494 at 5.
 Id. at 7.
 386 U. S. 753 (1967).
 430 U.S. 274 (1977).
 Id. at 279.
 504 U.S. 298 (1992).
 S. 106, 2016 Leg. Assembly, 91st Sess. (S. D. 2016) (S. B. 106). It should be noted that South Dakota’s statute was carefully tailored. Significantly, South Dakota’s tax is only applicable to a threshold amount, which the Court believed would not have been reached “unless the seller availed itself of the substantial privilege of carrying on business in South Dakota.” The Court was careful to specify that this threshold offers reasonable protection from undue tax burdens to smaller and/or newer merchants. Also, the South Dakota legislation is not retroactive-removing any concern for risk of a double tax burden. Other states wanting to achieve South Dakota’s result would be wise to consider the specifics of the legislation.
 South Dakota, No. 17-494 at 17.
 Id. at 10.
 Id. at 11.
 437 U. S. 617, 623 (1978).
 South Dakota, No. 17-494 at 12.
 Id. at 13.
 Id. at 13.
 Id. at 14.
 Id. at 15