Will Tax-Free Online Sales Die With Newest Challenge?

South Dakota is a sparsely populated state that is highly dependent on its sales tax for revenue because it has no state tax.

But as Internet sales have taken off at a galloping pace, South Dakota is finding its state-revenue cupboard is growing increasingly bare because many Internet purchases are not taxed if a company does not have a physical presence in a state.

With few nearby stores and shopping centers in the state, more South Dakota residents have let their fingers do the shopping by using mobile phones and computers to purchase major items such as computers, cameras and clothes.

Inside the South Dakota Department of Revenue, accountants have estimated that the government this year could lose as much as $50 million in sales-tax revenues, a huge sum when you factor in there are only about 860,000 people who live in the state, which is home to Mount Rushmore.

“Particularly in sparsely populated areas, online shopping becomes more important, and that decreases the revenue for the state,” said Deborah White, president of the Retail Litigation Center in Arlington, Va., which is an advocate for making online sites charge sales tax on their transactions.

Even in densely populated states, lost sales-tax revenue is significant. It is estimated that California is losing as much as $900 million a year in sales tax while Texas is short $600 million.

In South Dakota, the consequences of this lost sales-tax revenue from online purchases was evident recently when it came time for South Dakota to give its teachers a pay raise. To finance the salary hikes, the state had to increase its sales tax by 0.5 percent, said Andrew Fergel, the state’s chief legal counsel who works in the Department of Revenue.

But raising local sales tax has its consequences. It often entices more consumers to shop online to avoid higher sales taxes.

Now South Dakota wants the U.S. Supreme Court to do something about this decades-old federal rule, which exempts online sites from collecting sales tax if they have no stores, warehouses or other physical presence in a state. Several organizations have joined South Dakota’s efforts to change the law.

Yet many online sites oppose the idea, and a recent poll showed that 66 percent of consumers are also against it.

After seeing a growing revenue shortfall, South Dakota last year passed a law that required retailers with more than $100,000 in state sales or 200 in-state transactions to collect sales tax on all purchases.

The state then notified a number of out-of-state retailers about the new law they believed would meet the threshold, requesting that they step up to the plate on taxes. When some did not, it then filed a lawsuit among some of the bigger purveyors of goods in South Dakota—Wayfair Inc., Inc. and Newegg Inc. A fourth online site, Systemax Inc., decided to comply and registered for a state tax license.

The three online sites fought the lawsuit and won in a state court. When South Dakota appealed to the state Supreme Court, the justices knocked it down again, referring to the federal law that governed the issue.

South Dakota now is asking the U.S. Supreme Court to decide the matter after years of debate and attempts by states to get back a revenue stream they badly need.

Many retail organizations and trade associations that support South Dakota’s efforts have filed friend-of-the-court briefs urging the U.S. Supreme Court to listen to states and bricks-and-mortar retailers that feel they are losing a pitched battle with online sites. E-commerce is being blamed for contributing to the demise of more than 6,700 stores going out of business this year.

“Collecting sales tax is what mom-and-pop stores do across the country every day,” said Deborah White of the Retail Litigation Center. “Online-only retailers have had this loophole that has allowed them to not do this.”

The loophole dates back decades. One of the most recent cases governing online sales is a 1992 case called Quill Corp. v. North Dakota, which ultimately was heard by the U.S. Supreme Court.

Quill Corp. was an office supplier with no physical stores or outlets in North Dakota. But it sold its supplies through a computer software program, catalogs and telephone calls and delivered its product by mail from out-of-state locations.

When North Dakota tried to collect taxes on the sales, arguing that Quill’s floppy discs were located in North Dakota, Quill sued and eventually won with the U.S. Supreme Court saying a business must have a physical presence in a state for that state to require it to collect sales tax.

Two of the justices who heard that case are still on the Supreme Court—Clarence Thomas and Anthony Kennedy. They have indicated that business has drastically changed since 1992 when e-commerce sites and online shopping didn’t even exist.

Kennedy and Thomas have said they would like to see an online-sales-tax case presented that would give the court a chance to review the issue. That may happen with the South Dakota case.

For years, the National Retail Federation—the trade association representing department stores, specialty stores, grocers and chain restaurants—has been pushing for online sales to be taxed. It also filed a friend-of-the court brief urging the Supreme Court justices to take the case.

The NRF said that part of the rationale for the 1992 decision on the Quill case was that there were more than 7,000 state and local jurisdictions across the country with sales taxes and that the regulations were too complex for a seller to know what to charge unless they did business locally.

Today, technology has made that issue obsolete with a variety of software programs available to calculate the tax owed in various cities, which varies, for example, from 8.5 percent in San Francisco to 9.5 percent in Los Angeles.

At the earliest, the case would be heard by the U.S. Supreme Court in 2018. “The current playing field is uneven and dependent on antiquated ideas about in-state and out-of-state commerce,” said Stephanie Martz, the NRF’s senior vice president and general counsel. “We are hopeful that the court will agree to review this critical issue and replace its catalog-age ruling with one that reflects the realities of the Internet age.”