Out-of-State Sales Tax Collection Obligations
Is Physical Presence Still the Standard?

By Jennifer M. Boll

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The following is a review of the current status of nexus interpretations governing the obligations of out-of-state businesses to collect sales tax. These obligations have expanded in recent years through court cases and administrative interpretations. Accordingly, the most recent interpretations are not always readily available or straightforward to apply. Mistakes, however, can be extremely costly for businesses that fail to collect sales tax but are deemed to have been required to do so.

In most states, out-of-state vendors are required to collect a “use tax” rather than a sales tax. Collection obligations and rates of use tax are identical to those of sales tax. Generally, if sales tax applies, use tax does not, and vice versa. To avoid confusion, this article refers to both sales and use taxes as only “sales tax,” although in many cases “use tax” is the precise tax at issue.

Forty-five states and the District of Columbia impose a sales tax. If a business should have collected sales tax from its customers but did not, the business (and, in many cases, its owners) may be required to pay the tax on all taxable sales made in the state from the inception of the business activity in such state, plus interest and penalties. In most cases, no statute of limitations applies because no returns were filed. State tax rates range from 5% to 9.35%. Penalties and interest rates vary from state to state, but they mount quickly and generally compound.

Nexus

A business must collect sales tax from its customers when it has a direct or indirect physical presence in a state, known as “nexus.” The standard for nexus is not difficult to articulate, but can be nearly impossible to apply.

In most states, a business (whether a sole proprietor, or organized as a partnership, limited liability company, or corporation) has a physical presence in a state if any employees or agents have had a physical presence in the state or if the business owns or leases property there. This is a direct physical presence. Many businesses assume that if they do not have a direct physical presence in a state, they have no sales tax collection obligations there. This is a common misconception, and it can prove costly in the case of a sales tax audit.

Certain types of indirect presence in a state, alone, will not trigger a sales tax collection obligation. A business owner can be comfortable that the mere selling of products over a website or by a catalog and shipping them to a state (by the U.S. Postal Service or common carrier) will generally not trigger a sales tax collection obligation because such activity does not constitute a physical presence. The U.S. Supreme Court confirmed that such activities do not create nexus in 1992 in Quill Corp. v. North Dakota (504 U.S. 298). Any other contact with a state, however, should be carefully reviewed because it might obligate a business to collect sales taxes.

Many forms of indirect physical presence often create nexus. Since the Quill decision in 1992, the scope of indirect physical presence necessary to create nexus has steadily lessened. Any individual or entity working on behalf of a business that physically enters a state may trigger a collection obligation, even if the individual or entity is an independent contractor. A common example is an independent sales agent or representative in the state; the presence of these individuals often triggers the obligation to collect sales tax. Similarly, contractors performing repairs, installation, or similar work on behalf of the business, or accepting returns for the business, may trigger a collection obligation in a state. These “agents” could be individuals or they could be other entities. They do not need to be employees; they do not even necessarily need to be paid.

Indirect Presence: The Cases

Consider the business model of Scholastic Book Clubs, Inc. Scholastic sells books to children in elementary schools. Teachers distribute the order form, collect the money from students, and send the money and order form to Scholastic. Scholastic then sends the books to the teachers, who distribute them to students. A number of states have held that teachers are the “sales agents” of Scholastic [see Scholastic Book Clubs, Inc. v. State Board of Equalization, 207 Cal.App.3d 734 (1989); Appeal of Scholastic Book Clubs, Inc., 260 Kan. 528 (1996)].

Because the teachers are deemed agents of Scholastic and they are physically present in the state, Scholastic must collect sales tax in all applicable states. Some state tax authorities attribute the physical presence of the teachers in the state to Scholastic. The teachers are not employees; they are not even paid, and yet their actions on behalf of Scholastic trigger a sales tax collection obligation.

Further extending the concept of indirect presence by an agent, many states have applied the concept known as “attributional nexus” to require out-of-state businesses to collect sales tax. Typically, this concept is applied when any individual or entity with a physical presence in the state contributes in any manner to the out-of-state business making sales there.

For example, in the Borders Online case, California required Borders Online to collect sales tax because, among other things, its customers were permitted to make returns at the separately owned and operated Borders bookstores located throughout California [Borders Online, LLC v. State Board of Equalization, 129 Cal.App.4th 1179 (2005)]. Even though the Borders bookstores were not typical sales agents and were not directly involved in the selling process, the court held that the ability of customers to make returns at physical locations in California assisted in the sales process. Accordingly, the court held that Borders bookstores were Online’s representatives for the purpose of selling goods in California. Online was assessed more than $150,000 in tax for prior periods based on its relationship with Borders bookstores.

New York’s Proposal: Website Links Create Nexus

New York State has extended the indirect physical presence standard for nexus even further. In November 2007, the New York State Department of Taxation and Finance issued a Sales Tax Memorandum [TSB-M-07(6)S] purporting to interpret New York’s nexus requirements applied to out-of-state businesses. The memorandum was withdrawn shortly after it was issued, but the 2008 budget included legislation amending New York’s definition of a vendor required to collect sales tax to include a nexus standard similar to the standard described in the memorandum.

According to the memorandum, if an out-of-state business solicits sales by paying any sort of fee to an in-state person or entity associated with a “click-through” from the in-state person or entity’s website, or otherwise, the in-state person is considered a “sales agent” of the out-of-state business. The Tax Department provided an example in the original memorandum:

XYZ Company (XYZ) is an Internet-based retailer of sporting goods specializing in downhill skiing equipment. XYZ is located in Vermont, where it has its administrative offices and its warehouse, which holds its inventory for sale. XYZ makes sales of its merchandise throughout the United States and has customers in New York State. The merchandise sold by XYZ is delivered by the U.S. Postal Service or by common carrier, such as United Parcel Service or Federal Express. As part of its marketing plan, XYZ has entered into an agreement with Downhill Ski Club (Ski Club), which is based in Saratoga Springs, New York, whereby Ski Club will maintain links to various skiing equipment listed for sale on XYZ’s retail website on the Club’s own website. XYZ will pay a commission to Ski Club based on the amount of sales that XYZ makes that originate from the links on Ski Club’s website. Ski Club uses the commissions as a fundraising activity to partially offset the expenses for the ski trips it sponsors. To maximize its commissions, Ski Club actively solicits its members and the local community to purchase new skiing equipment through the Ski Club’s website by clicking on the link to XYZ’s retail website and making their purchases from XYZ.

XYZ may have similar arrangements with other representatives in New York, but otherwise has no other additional connection with New York state that would cause XYZ to register as a New York state sales tax vendor. Based on its agreement with Ski Club … XYZ must register as a New York state sales tax vendor, collect New York state and local sales taxes, and file the required sales tax returns.

New York’s interpretation and the newly proposed legislation are natural extensions of Scholastic and Borders Online. Any assistance in the selling process by a person or entity physically located in the state will create nexus with that state for an out-of-state business selling goods there.

A common example of this business model might involve pet supply retailers or small pet stores with online capabilities. Arrangements with humane societies and other animal-related charities are common and often involve click-throughs from the charity’s website to the online pet supply retailer’s website. The retailer will often pay a percentage of the sales price to the charity if a customer makes a purchase. Based on the proposed legislation, this type of business model may require the online pet supply retailer to collect sales tax on all taxable sales to New York residents if any of the charities are physically located in New York State.

Complying with this broad nexus interpretation requires a careful review of all of a business’ compensated and uncompensated arrangements that may assist in out-of-state sales. Given a broad scope of indirect physical presence, merely confirming the location of employees and property is not sufficient. To confirm whether nexus is likely to exist, a much more detailed compliance review is required.

Compliance Review

To determine whether a business has sales tax nexus in any particular state, a careful review of all of its business connections to that state is necessary. A business should review the following nexus issues in all states in which it or any related entity:

• Owns or leases offices, warehouses, stores, or equipment;
• Solicits sales through independent sales representatives, authorized agents, or distributors;
• Makes deliveries by company-owned trucks;
• Participates in trade shows;
• Picks up goods;
• Uses contractors or employees to make warranty repairs;
• Uses contractors or employees to provide installation services;
• Makes payments to any person or entity located there in connection with any sales made there;
• Uses contractors to accept returns; and
• Has officers maintaining a residence.

The above list is not complete, but it does provide a starting point for reviewing a typical business’s connections with other states. If a review of the business connections reveals that any of the connections described above exist in any states other than the business’ home state, sales tax nexus might exist there. The next step is to review, with legal counsel, the scope of the connection in conjunction with the particular state’s laws, regulations, administrative interpretations, and court cases to confirm whether a collection obligation has been triggered.

If an obligation has been triggered, there may be an amnesty program available. Amnesty programs may reduce the tax, interest, and penalties payable for prior periods. In many cases, amnesty is available only for businesses that voluntarily register. Once an audit has commenced, it is generally too late to qualify. Accordingly, a proactive approach in reviewing sales tax collection issues before receiving audit notices is important.

©2009 The New York State Society of CPAs. Legal Notices