Effect of the Internet Sales Tax

by Michael on May 3, 2013 · 2 comments

Photo of an Antique Cash Register

I mentioned the internet sales tax debate in passing about six weeks ago. At the time, the Senate was talking about giving states more power to collect sales taxes.

Ultimately, they wound up voting on a non-binding measure in support of doing just that. And it passed easily, with bi-partisan support.

Since that time, the issue has been gaining steam — to the point that the Senate is expected to vote on the real thing in the coming week. And, given the results of that initial vote, the smart money says that it will pass.

Of course, it will still need to make it through the House, and it’s hard to predict what will happen there. The legislation — called the Marketplace Fairness Act — has been framed as a means of protecting local businesses against internet behemoths.

Given the above, pro-business sentiment may very well carry the day. Or maybe anti-tax sentiment will win out. Only time will tell.

Interestingly, while internet behemoths such as Amazon have long fought against being compelled to collect sales tax, they’ve recently warmed up to the idea. That is, as long as everyone else is required to do the same.

Why? I’ll get to that in a minute. But first, I want to provide a bit of background.

Online sales tax

As you may or may not be aware, if you live in one of the 45 states with a sales tax, then you’re already obligated to pay taxes on your online purchases. This is true even if such taxes aren’t collected by the vendor. Technically called a “use” tax, this is functionally the same as a sales tax. You just pay it after the fact.

Here’s how it works: You make taxable purchases throughout the year. Some are taxed at the time of sales, but others are not. At the end of the year, you’re supposed to tally up all those untaxed (but taxable) purchases and pay what’s due.

States, of course, don’t like this because most people don’t actually report these purchases and pay their use taxes. And local businesses are likewise unhappy because the effectively “tax free” status of online purchases puts them at a disadvantage.

So how is it that online retailers can get away without collecting sales tax? It all dates back to a 1992 lawsuit known as Quill Corp. vs. North Dakota. As it turns out, the North Dakota tax commissioner tried to force Quill to collect sales tax on items shipped into the state. Quill filed suit and (eventually) won.

Quill argued that, since they were based in Delaware and didn’t have any physical operations in North Dakota, they should be exempt from collecting sales tax on items shipped into the state.

The Supreme Court ultimately ruled in Quill’s favor, saying that businesses must have a physical presence in a state (referred to as a “nexus”) for the state to require it to collect sales tax. However…

The Court also ruled that Congress could override their decision via legislation. And so here we are. States can’t force companies to collect sales tax unless the company has physical operations within their borders. Great news for e-tailers, right?

The change of heart

So what’s with Amazon’s change of heart? Well, for one thing, they’ve been expanding their physical presence by adding warehouses and shipping facilities in more and more states. This increases efficiency and speeds delivery. But it also forces them to collect sales tax in more locales.

In addition, states have been arguing that Amazon’s highly successful affiliate program — wherein they pay a small commission to website operators (like me!) when customers click through and complete a sale — amounts to a physical presence in any state where an affiliate resides.

Amazon has responded by shutting down their affiliate program in certain states, which hurts their advertising efforts and also harms small businesses that depend in part on affiliate earnings. Not a good situation.

And, on top of everything else, Amazon is actually well-positioned to deal with the burden of tax collection — much moreso than your average online retailer. Hence, the change of heart. As long as their competition is forced to comply with the sales tax requirement, Amazon is willing to deal with it themselves.

Yes, they’ll be giving up an advantage over brick and mortar stores, but they’ll be saddling other online operators with a huge burden, freeing them up to expand their shipping operations and embrace their affiliate program.

Impact on businesses

Let’s set aside the fact that, if/when the Marketplace Fairness Act (or something similar) is enacted, you’ll be forced to start paying sales tax on your online purchases. You may not like this but, technically, you’re already required to do so.

Instead, let’s look at the impact on businesses.

For one thing, passage of the Marketplace Fairness Act will mean that both online and real-world purchases will be subject to sales tax collection, so this will (arguably) help to level the playing field between online and real-world retailers.

But it will also subject online retailers to a huge burden. Not only will they be forced to calculate sales taxes for thousands of locales (45 states + countless local tax authorities), they’ll also have to file tax returns wherever they collect taxes — typically on a monthly or quarterly basis.

Yes, the Marketplace Fairness Act exempts businesses that generate less than $1M in annual revenue, but… Let’s be honest. $1M in revenue really isn’t that much when it comes to retail businesses. There are an awful lot of small fries out there that will get caught up in this mess.

Compare this to how a real-world store operates. If I’m on vacation in another state and one of the headlights on my car burns out, I’ll stop to buy a replacement. And when I do, I’ll be taxed based on where that store is located, not where I live.

So… Why should we tax one type of sale based on where the seller is located and another type of sale based on where the buyer is located?

Rather than producing “Marketplace Fairness,” it seems more likely that this legislation will tip the balance in the other direction, placing a much greater burden on online businesses vs. their real-world brethren.

A possible solution?

All of this suggests a possible solution… If you want to give states the right to enforce collection of sales taxes for online purchases, why not treat online and real-world businesses the same?

That is, why not tax based on the source of the sale vs. the destination?

Yes, there would be instances in which businesses might re-locate to one of the few states without a sales tax, thereby avoiding the burden entirely. But other states could respond by reducing tax rates or offering other enticements. They could compete for the businesses — and the associated revenue.

There would, of course, be complications with this.

Take Amazon, for example. They’re based in Washington state, but they have warehouses all over the place. So, in that case, what’s the source of sale? Does it come out of Washington? Or wherever your purchase is actually shipped from?

To make this equitable, you’d probably have to assume the latter. After all, Best Buy is based in Minnesota, but if you make a purchase at a store in another state, you pay that state’s sales tax. The systems should be as parallel as possible.

Or… You could just punt and stick with the current rules. If you have a physical presence in a state, you have to collect sales tax. And if you don’t, you don’t. People are still required to pay, but it’s up to the state to collect.

What do you think? Should states be given the right to enforce sales tax collection on transactions generated by out-of-state businesses? If so, how should this be implemented? Or should we leave well enough alone?on

1 Adam May 3, 2013 at 11:26 am

I seem to recall reading something recently, related to this topic, that the legislation would require states to set up a single point of collection for internet retailers, specifically to prevent the retailers from having to submit payments directly to thousands of different municipalities.

2 Michael May 3, 2013 at 1:17 pm

Yes, there are requirements for simplification included in the MFA. In essence, states would have to sign on to the Streamlined Sales and Use Tax Agreement (which itself spans 160 pages!) or meet some other mandates.

This would simplify things to a point but (as I understand it) retailers would still be have to deal with each state individually — both for the ongoing filing and payment requirements and and for any followups, inquiries, audits, etc.

So if, for example, you develop a new product and bring it to market on the internet, once you hit $1M in revenue (that’s revenue, not profit) you’ll have to deal with up to 45 state tax authorities on an ongoing basis.

In my view, that’s a huge burden.

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