Fotolia_99128693_S_nexusI commonly work with clients that have nexus questions.  These days those questions often involve some of the more technical aspects of nexus, such as affiliate or click-through nexus.  But, even where I’m addressing some of the more technical aspects of sales and use tax nexus, I always try to make sure our clients understand where it all started, which is the subject of this article.  Having a clear understanding of the genesis of sales and use tax nexus, will better enable you to address fact-specific nexus questions that relate to your business operations.

State sales and use taxes have been around since 1930.  For many years they were a comparatively small component of state revenues, but over time both the tax bases and the rates have expanded to the point where they are now major sources of funds for the great majority of states.

Forty-five states and the District of Columbia have enacted comprehensive sales and use tax laws.  Of the five states that have not (Alaska, Delaware, Montana, New Hampshire, and Oregon), Montana has a limited version that taxes accommodations, campgrounds, and rental vehicles; Delaware levies a use tax on motor vehicle rentals; and Alaska allows its local jurisdictions to enact their own sales and use taxes.  Only New Hampshire and Oregon lack any form of sales or use tax provisions.

For most purposes the term “sales tax” is applied to a broad range of similar excise taxes.  These taxes are measured by sales of tangible personal property in every state that has a sales tax law.  In many states, the tax is further extended to sales of specifically enumerated services.  In a couple of states (Hawaii and New Mexico), the tax applies to gross receipts from virtually all business activities.

A few states refuse to designate these taxes as sales taxes.  For example, Hawaii calls its tax a general excise tax; New Mexico calls its tax a gross receipts tax; and Arizona calls its tax a transaction privilege tax.  Since everyone else lumps these taxes into the sales tax category, I do the same here.

Every state that has imposed a sales tax has also enacted a complementary use tax.  The purpose of the use tax is to capture any transaction that would normally be subject to sales tax but escaped the tax (generally because the purchase was made outside the state in which the property was to be used, or the property was bought under a deduction or exemption that was subsequently found to be inapplicable).  The purchaser/consumer is always the primary taxpayer for use tax purposes, but under some circumstances a state may pursue either the buyer or the seller for the tax.  I will be addressing some of the relevant distinctions between sales and use tax in a future article.

When sellers are required to collect a state’s tax for products shipped from an out-of-state point, it’s generally use tax that’s involved. In most cases, when a seller in one state ships merchandise by common carrier directly to a customer in a different state, neither state’s sales tax will apply.  Although states are constitutionally prohibited from imposing sales tax on transactions that occur outside their boundaries, when someone buys tangible personal property from an out-of-state seller for use within the destination state, the destination state’s use tax will be due.  The following question then arises: which party will the state pursue for the tax – the buyer or the seller?

If the seller has nexus in the buyer’s state, the state may hold either the seller or the buyer responsible for remitting any applicable use tax.  Since states prefer assessing one seller to chasing down each of the seller’s customers, they virtually always pursue the seller for the use tax in these circumstances.  If the seller does not have nexus, however, the buyer is the only party that the state can assess.  States continue to get more creative with the methods in which they claim a seller can be held responsible for use tax collection, which will be the subject of subsequent articles.

Nexus can be defined as the threshold of connection that would require a business to register with a state and collect that state’s sales and use taxes.  (Having nexus is sometimes referred to as “doing business in the state.”)

Because it is governed by provisions of the United States Constitution, the nexus threshold has been addressed by the U. S. Supreme Court in several leading cases that are addressed below.


Constitutional Issues

The general federal criteria for sales and use tax nexus proceed from two clauses of the U.S. Constitution: the Due Process Clause and the Commerce Clause.  As the case law has evolved, the Commerce Clause has become the primary basis for determining sales and use tax nexus and the Due Process Clause has faded into relative insignificance for this purpose.

Commerce Clause:

The Commerce Clause of the Constitution is provided in Article I, section 8, clause 3.  It states that Congress has the power “To regulate Commerce with foreign Nations, and among the several States, and with the Indian Tribes.”  In addition to granting Congress the sole authority to regulate interstate commerce, the clause has been universally interpreted as prohibiting states from interfering with or unduly burdening such commerce, even though the prohibition is not specifically stated.  This prohibition interpretation is known as the “dormant” or “negative” commerce clause.

Since Congress has been given the sole power to regulate interstate commerce, it is the only branch of government that can pass legislation providing conditions under which states may require out-of-state sellers to collect use tax on merchandise delivered to customers within their borders when the sellers lack nexus.  Such legislation has been introduced, but none of it has been enacted to date, despite explicit pressure from the courts.  The latest version is the Marketplace Fairness Act, which was passed by the Senate and forwarded to the House of Representatives, where it died a relatively quiet death.

Unless or until Congress acts, the current nexus requirements will remain in effect and will continue to be defined and clarified by the ongoing case law.

Due Process Clause:

The Due Process Clause appears in the second sentence of section 1 of the fourteenth amendment to the U.S. Constitution.  It says that “No State shall make or enforce any law which shall abridge the privileges or immunities of citizens of the United States; nor shall any State deprive any person of life, liberty, or property, without due process of law; nor deny to any person within its jurisdiction the equal protection of the laws.”

The relevance of the clause to tax issues arose from cases determining whether companies could be forced to defend themselves in the courts of a state other than their own.  The U.S. Supreme Court established the following minimum criteria for a state’s ability to compel a company to appear and defend itself in the state’s courts: the firm must (1) have minimum contacts with the state; and (2) purposefully direct its sales activity into the state’s market place.  Essentially, an economic presence (and not necessarily a physical presence) would create nexus in the state for due process purposes.

Leading U.S. Supreme Court Cases:

In recent years, sales and use tax nexus issues have generated increasing attention and activity at state levels for three primary reasons: (1) sales and use taxes have become an increasingly important component of state revenues; (2) the explosion of e-commerce over the Internet has resulted in a huge volume of sales by out-of-state sellers that are inaccessible to state taxing agencies due to their lack of nexus in the destination states; and (3) the states’ only alternative, which is to collect use tax from the in-state customers, has proven nearly impossible to enforce on a broad scale.  Although these issues generated less attention in the past, nexus related litigation is not new.

It is important to note that states may, at their own discretion, enact laws that allow businesses to have a greater level of in-state presence than that required by the U.S. Supreme Court before asserting nexus.  The states may not, however, create laws that will assert nexus based on a lesser level of in-state presence than the level established by Court rulings.  It’s worth pointing out that States don’t always seem to agree with that concept.

To provide a framework for present day law, we’ll proceed chronologically from some of the earlier U.S. Supreme Court cases through the Court’s most recent ruling in Quill, infra, the current leading sales and use tax nexus case.

In Felt & Tarrant Mfg. Co. v. Gallagher, 306 U.S. 62 (1939), the Court addressed one of the first challenges to a state’s efforts to impose use tax collection requirements on an out-of-state retailer.  Felt & Tarrant, an Illinois corporation, was engaged in manufacturing and selling comptometers that were delivered to purchasers nationwide by common carrier.  The company had several sales representatives acting in various states, including two full time sales agents operating in California.  The agents were compensated strictly on a commission basis.  All of the orders and related payments were processed directly through the company’s offices in Illinois, and all of the machines were shipped from points outside California by common carrier.  Sometimes machines would be shipped directly to the purchasers, and other times they were shipped to the in-state agents for subsequent delivery to the purchasers by the agents.

The retailer argued that its transactions with California were “interstate in character,” that it was not subject to California’s jurisdiction, and that California therefore lacked constitutional authority to require it to collect use tax.  The retailer also claimed that subjecting it to California’s Use Tax Act was a direct unconstitutional burden on interstate commerce, and that if California’s laws were imposed, the retailer would be deprived of its property without due process of law.

The Court concluded that both contentions were foreclosed based on its previous rulings, including Henneford v. Silas Mason, 300 U.S. 577 (1937) (wherein the court upheld the validity of a use tax imposed on property purchased without tax at an out-of-state location and subsequently consumed in the State of Washington in the performance of construction contracts).  In its Felt ruling, the Court established that having permanent sales representatives within a state constitutes a sufficient presence to permit the state to require use tax collection.

In 1941 the U.S. Supreme Court granted certiorari to review two Iowa state Supreme Court rulings that had enjoined the state’s efforts to require Sears and Montgomery Ward to collect use tax on mail order sales.  (Nelson v. Sears, Roebuck & Co., 312 U.S. 359 (1941); Nelson v. Montgomery Ward & Co., 312 U.S. 373 (1941).)  The Court heard oral arguments on the same day for each case and issued its decisions for both cases on the same day.

The relevant facts in the cases were virtually identical.  Both retailers maintained multiple retail locations within Iowa.  Both companies utilized separate mail order houses that operated outside the state but within the same entities.  Sales for the mail order houses were generated by catalogs that were distributed to Iowa residents through the mail.  The companies charged and collected sales tax on sales from the in-state stores, but refused to collect use tax on mail orders.  The orders were sent by Iowa purchasers to the out-of-state mail houses which filled the orders by direct shipments through the mail or by common carrier.

Sears and Montgomery Ward claimed protection from use tax collection requirements under the Commerce Clause because the mail order houses had no relevant in-state activity.  Ruling in favor of the two companies, the Iowa Supreme Court had somewhat surprisingly held that the mail order transactions were separate and distinct from the retail store activity, and therefore Iowa did not have the power to require use tax collection on the mail order sales.

The U.S. Supreme Court recognized that there was no local activity that generated the mail orders, but it found the orders were still a part of the taxpayers’ business activities in Iowa.  The Court concluded that the companies could not avoid the burden of use tax collection just because the mail order houses were departmentalized into separate divisions within the same entities.  Because both retailers maintained retail locations within the state, they could legally be required to collect use tax on the mail order transactions.

In National Geographic Society v. California Board of Equalization, 430 U.S. 511 (1977), the Court found that the presence of two in-state offices whose sole function was to solicit advertising for the Society’s magazine was sufficient to establish that the Society was engaged in business in California, despite the fact that the offices were not engaged in any activities related to sales of tangible personal property.  The case made it clear that the in-state physical presence necessary to establish nexus for a retailer does not need to be related to its sales activities.

In another Iowa case, the Court in General Trading Co. v. State Tax Commission, 322 U.S. 335 (1944), considered whether salespersons traveling into the state, but not permanently residing in the state, was sufficient to establish nexus.  General Trading Company maintained no retail location, office, branch or warehouse inside the state, but the sales of items delivered into Iowa by common carrier from points outside the state were solicited by traveling salesmen sent into Iowa from Minnesota.  General Trading argued that Iowa was precluded from imposing use tax collection requirements under the Commerce Clause because the company maintained no permanent physical presence within the state and all of its products were delivered by common carrier from points outside the state.

The Court stated that while no state can tax the privilege of doing interstate business, the mere fact that property has come into an owner’s possession as a result of interstate commerce does not exempt it from state taxation.  Relying on Felt & Tarrant, supra; Sears, Roebuck & Co., supra; and Montgomery Ward & Co., supra, the Court upheld the Iowa Supreme Court’s ruling that General Trading Co. was subject to use tax collection requirements on its Iowa sales.  General Trading Co. confirmed that a consistent physical presence within a state establishes nexus, and that such a presence can be created by non-resident salespersons entering the state periodically.

Although some states’ laws and rulings currently permit a retailer to have a permanent physical presence inside the state without establishing nexus (e.g., a single telecommuting accounting employee who has no direct association with sales), such states are in the minority and have elected to apply a higher nexus threshold than the Supreme Court rulings require.  Under the aforementioned rulings, and National Geographic in particular, states arguably may use any permanent physical presence of the retailer within the state to establish nexus.  Particular state applications are covered in more detail in later chapters.

In Miller Bros. Co. v. Maryland, 347 U.S. 340 (1954), the Court deviated from its 20 year trend, ruling in a five to four decision that the activities under review did not establish nexus.  Miller Brothers Company, a Delaware corporation, operated its only residential furniture store in Wilmington, Delaware, approximately 15 miles from the Maryland border.  The company didn’t have employees, agents or representatives in Maryland, and it didn’t accept telephone or mail orders.  It never intentionally directed advertisements toward Maryland residents, although it was stipulated that some television and radio ads placed on Delaware stations probably reached Maryland residents.  The company did mail sales circulars to all of its former customers, including customers in Maryland.  The company also delivered some furniture purchased at its Delaware store to Maryland purchasers using its own trucks.  Maryland agents seized one such truck under the assertion that Miller Brothers had an unpaid use tax obligation for sales made to residents of the state.

The Court addressed whether the foregoing factors, separately or in the aggregate, established the state’s power to impose a duty on an out-of-state merchant to collect and remit use tax.  The Court stated that its historical decisions on taxation were not necessarily consistent or reconcilable in all respects, but that “one time-honored concept” persisted: “that due process requires some definite link, some minimum connection, between a state and the person, property or transaction it seeks to tax.”

In distinguishing the instant case from its decision in General Trading Co., supra, Justice Jackson (who dissented in General Trading Co.) stated that “there is a wide gulf between [General Trading’s] type of active and aggressive operation within a taxing state and the occasional delivery of goods sold at an out-of-state store with no solicitation other than the incidental effects of general advertising.”  The court ruled that Maryland could not establish jurisdiction over Miller Brothers under the Due Process Clause and therefore found it unnecessary to consider whether the Maryland statute imposed an undue burden on interstate commerce.

In Scripto, Inc. v. Carson, 362 U.S. 207 (1960), the Court considered whether the engagement of ten independent contractors to solicit sales on Scripto’s behalf within Florida was sufficient to establish nexus.  The Court held that this activity created nexus and that there was no constitutional significance as to whether the taxpayer was using independent contractors or employees to make the sales. The Court stated that to permit such formal contractual relationships to make a constitutional difference “would open the gates to a stampede of tax avoidance.”  The State’s use tax collection requirements were upheld.

The Court’s decision in National Bellas Hess, Inc. v. Department of Revenue, 386 U.S. 753 (1967), served as the primary precedent for Quill.  National was a mail order house, headquartered in Missouri, without any physical presence in Illinois.  As noted by the Court, “All of the contacts which National does have with the State are via the United States mail or common carrier.  Twice a year catalogues are mailed to the company’s active or recent customers throughout the Nation, including Illinois.  This mailing is supplemented by advertising “flyers” which are occasionally mailed to past and potential customers. Orders for merchandise are mailed by the customers to National and are accepted at its Missouri plant.  The ordered goods are then sent to the customers either by mail or by common carrier.”

According to the Illinois statute at issue, a “retailer maintaining a place of business in this State” included any retailer “[e]ngaging in soliciting orders within this State from users by means of catalogues or other advertising, whether such orders are received or accepted within or without this State.”  Pursuant to the statute, the Illinois Supreme Court had upheld the lower court’s ruling that National was sufficiently engaged in business in Illinois to require use tax collection.

In its opinion the U.S. Supreme Court reiterated that the Constitution requires “some definite link, some minimum connection, between a state and the person, property or transaction it seeks to tax.”  The court went on to reference the various circumstances it had previously addressed in use tax cases, citing most of the cases discussed above and pointing out that it had upheld the power of states to impose use tax collection requirements in a variety of circumstances.  The Court indicated, however, that it “has never held that a State may impose the duty of use tax collection and payment upon a seller whose only connection with customers in the State is by common carrier or the United States mail.”  The Court stated that it refused to obliterate the “sharp distinction” it had “drawn between mail order sellers with retail outlets, solicitors, or property within a State, and those who do no more than communicate with customers in the State by mail or common carrier as part of a general interstate business.”

The Court expressed a significant concern about the troubles that would be created if states were granted the authority claimed under the Illinois statute, pointing out that National could be subject to up to 2,300 state and local tax permutations.  According to the Court, the “very purpose of the Commerce Clause was to ensure a national economy free from such unjustifiable local entanglements.”  In closing, the Court reaffirmed that Congress alone has the power of regulation and control in this domain.

Bellas Hess is widely recognized as establishing a bright line rule that a retailer must have some physical presence within a state before it can be required to collect use tax.  As discussed below, the Court in Quill upheld the ruling in Bellas Hess but in doing so made a greater distinction between the Due Process and Commerce Clauses.

The U.S. Supreme Court established a four-point test for determining whether a state tax violates the dormant Commerce Clause in its seminal ruling in Complete Auto, Inc. v. Brady, 430 U.S. 274 (1977).  The tax at issue was a sales tax imposed on Complete Auto’s receipts generated from the transportation of automobiles.  The vehicles were manufactured by a separate company and shipped by rail to Mississippi, where Complete Auto picked them up and transported them to Mississippi dealers.  Although Complete Auto’s participation was strictly intrastate, it argued that the activity was part of interstate commerce, and therefore the tax was precluded under the Commerce Clause.

Complete Auto’s claim was based on prior U.S. Supreme Court holdings, which it claimed precluded a tax on the “privilege” of engaging in an activity that is part of interstate commerce.  In particular, Complete Auto relied on Spector Motor Service, Inc. v. O’Connor, 340 U.S. 602 (1951), which in fact had established a prohibition against taxation of the “privilege” of engaging in interstate commerce.  The Complete Auto Court analyzed Spector and the related cases, ultimately overruling the theory that a state tax on activities involving interstate commerce was unconstitutional per se and instead holding that the permissibility of such a tax should be based upon the four-point test described below.

Under the test, a state tax does not violate the Commerce Clause if all four of the following criteria apply:

  1. The tax is applied to an activity that has a substantial nexus with the taxing state;
  2. The tax is fairly apportioned;
  3. The tax does not discriminate against interstate commerce; and
  4. The tax is fairly related to the services provided by the state.

For purposes of sales and use tax nexus, the most relevant element is the first criterion of the four part test (substantial nexus), which is the primary determinant of whether an out-of-state seller can be required to collect the destination state’s use tax.  (Since sales tax applies wherever a retail sale takes place, a retailer making such a sale within a given state would be automatically required to register and collect and remit the state’s sales tax.)

The decisions discussed up to this point establish that a substantial nexus exists if:

  1. The retailer maintains a place of business within the taxing state, even if the location is unrelated to sales activity; or
  2. The retailer has sales representatives soliciting orders in the taxing state, irrespective of whether the representatives are considered to be employees, agents or independent contractors, and regardless of whether the representatives are permanent or travel to the state to solicit orders.

Despite the apparent bright line rule established by Bellas Hess and the first prong of the Complete Auto test, in 1987 North Dakota amended its legal definition of a retailer engaged in business in the state to include “every person who engages in regular or systematic solicitation of consumer market in the state.”  “Regular or systematic solicitation” was interpreted by North Dakota’s taxing agency as meaning three or more solicitations within a 12 month period.  This low threshold purported to create nexus for any company that engaged in such solicitation even if it maintained no physical presence in the state.

North Dakota determined that the Quill Corporation met the state’s “regular or systematic solicitation” criterion.  Quill was (and is) a Delaware corporation selling office equipment and supplies.  At the time of the case it solicited business through catalogs, flyers, periodicals and telephone calls.  With the exception of a minor amount of software that it licensed within the state, the corporation maintained no physical presence in North Dakota and delivered all of its products by common carrier.  During the period at issue the company’s annual total sales exceeded $200 million, with approximately $1 million of that amount attributable to North Dakota residents.

North Dakota asserted its right to require Quill to pay taxes, interest and penalties on sales made after the effective date of its new law (July 1, 1987).  Quill challenged the state on the basis that the new law violated the Commerce and Due Process Clauses of the Constitution.  It further argued that the issue was foreclosed by the U.S. Supreme Court’s ruling in Bellas Hess.  The North Dakota trial court agreed with Quill, finding its case to be indistinguishable from Bellas Hess.

The Tax Commissioner appealed to the North Dakota Supreme Court, which reversed the trial court’s ruling.  The state supreme court concluded that “wholesale changes” in the economy and law made it inappropriate to follow Bellas Hess.  Specifically, the court cited the significant growth of the mail-order business from 1967, when Bellas Hess was decided, to 1989 when annual mail-order sales reached $183 billion.  The court claimed that Complete Auto and subsequent rulings indicated that the Commerce Clause “no longer mandated the sort of physical-presence nexus suggested in Bellas Hess.” The court also expressed the opinion that advances in computer technology would greatly ease the burden of compliance with state and local taxing authorities.

While the U.S. Supreme Court recognized that technological advancements would reduce the burden of multistate compliance, it disagreed with the state’s deviation from the Bellas Hess ruling and reaffirmed that the “bright-line, physical presence requirement” was the appropriate criterion for establishing “substantial nexus” sufficient to overcome the dormant Commerce Clause.  The Court found that the taxpayer had in fact established an economic presence by sending ads and catalogs into North Dakota and making sales to in-state customers, and that such presence created due process nexus.   However, because Quill did not have a physical presence beyond a de minimus level, it did not have Commerce Clause nexus and thus could not be compelled to collect the state’s use tax.  The Court found that the incidental ownership of property or the slightest presence in the state (a de minimus physical presence) will not constitute substantial nexus; something more than a “slightest presence” is required.  (Quill Corporation v. North Dakota, 504 U.S. 298 (1992).)

To date, Quill provides the most recent U.S. Supreme Court guidance for determining general sales and use tax nexus.  Unfortunately, the case (as well as the previous cases) left many specifics open to question.  In particular, the Quill Court failed to establish clear cut-off points between a de minimus physical presence and a presence sufficient to create substantial nexus.  As usual, the devil is in the details, which have triggered a broad range of post-Quill debates between taxpayers and taxing agencies across the nation.


Nexus Implications

As we now know, sellers located in one state can’t be required to collect sales or use taxes on behalf of a different state unless they are “doing business” in (have nexus with) the other state.  Nexus can be created by maintaining business property in a state, having employees or independent contractors in the state, or having agents in the state who operate on the taxpayer’s behalf.

Once a firm is “doing business” within a state, it must register, obtain a sales tax permit, and collect and report the state’s sales and use taxes.  These taxes will be due on all sales into the state (including mail order and Internet sales, even when the property is shipped from outside the state) unless a separate exemption applies.  If the state learns that the business had nexus before its registration date, it will assess taxes, interest, and penalties as far back as its statute of limitations allows (limited, of course, by the date the nexus was first established).

Since Quill, the states have become more and more creative in developing criteria for asserting nexus.  The basics of physical presence – maintaining property, a location, employees, or third-party representatives in the taxing state – have been modified and expanded to include a host of more or less tenuously related activities.  States have asserted (or attempted to assert) nexus based on relationships with in-state affiliates; advertising “aimed at” state residents; merchandise deliveries into the state by company-owned vehicles; conducting in-state seminars or trade shows; sales of gift cards in affiliated in-state stores; provision of after-sale services (such as repairs and maintenance) by employees or third parties; and selling property over the Internet through a website maintained by an in-state host.  These and related topics will be explored further in articles that follow.




(This article was adapted from a continuing education course that was coauthored by Jesse W. McClellan, Esq. and Dan Davis, CPA, that is offered by Western CPE® © McClellan Davis, LLC.)

Jesse McClellan, Esq.

Jesse McClellan, Esq.

Jesse is a licensed attorney and former sales and use tax auditor. He is a principal at McClellan Davis, LLC, a firm that specializes in representing businesses for sales and use tax matters. Email Jesse

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