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California’s Retroactive Sales Taxes Shock Out-of-State Sellers

Nov. 7, 2019, 9:46 AM

We knew that Wayfair would change the way that online sales were taxed, but even the savviest of tax pros weren’t precisely sure how states and retailers would react.

Over the past year, states have been moving ahead with rules intended to expand the kinds of sales and customers that might be subject to sales and use tax. Now, an aggressive move by California has changed the sales tax landscape again.

On June 21, 2018, the U.S. Supreme Court ruled in South Dakota v. Wayfair Inc. that the physical presence requirement was no longer the standard for the imposition of sales tax. The idea that you could only impose a tax on sales where a retailer maintained a physical presence in a state had previously been established in National Bellas Hess, Inc. v. Department of Revenue of Ill. and was affirmed in Quill Corp. v. North Dakota.

But it’s a different world now. When Hess was decided, the internet had not even been born yet (it was still nearly a generation away). And when Quill popped up, fewer than 2% of Americans had access to the internet.

By the time Wayfair appeared on the docket, online sales made up 14.3% of total retail sales, with consumers spending $517.36 billion online with U.S. merchants.

The explosion of online sales meant that states had to re-examine how they looked at sales tax on internet purchases. Retailers, of course, pushed back, and the questions of what sales are subject to tax, and where, became more important. In Wayfair, the Supreme Court offered an answer, essentially killing Quill and ruling that states have broad authority to require online retailers to collect sales taxes.

In a post-Wayfair world, states ushered in changes to sales tax laws expanding the tax base, and in some cases testing the waters to see how far they can go. More than 40 states have tweaked their sales tax laws since the ruling, and new requirements for remote sellers and marketplace facilitators in more than a dozen states kicked in last month.

Under the new laws, in most states remote sellers, or out of state sellers, are now required to charge sales tax to customers using certain criteria. The requirements typically kick in at dollar minimums or numbers of transactions, with some quirky exceptions. For example, Kansas has no small-seller exception (all sales are subject to tax), while Maryland’s new law expands economic nexus to specific tobacco taxes.

The new laws also target marketplace facilitators, consolidated sites like Amazon Marketplace. Marketplace facilitators make it possible for smaller retailers—third-party retailers—to reach a bigger audience without the need for a sales platform of their own. As with remote sellers, the sales tax requirements typically kick in at certain thresholds.

One state that fully embraced taxes focused on marketplace facilitators was California.

At first glance, the Golden State’s new law, which went into effect Oct. 1, seemed just like any other. The Special Notice for merchants opened simply, “A marketplace facilitator that is registered or required to be registered as a retailer with the California Department of Tax and Fee Administration (CDTFA) will generally be responsible for paying the sales tax or collecting and paying the use tax on all retail sales for delivery to California customers facilitated through its marketplace.”

But the push to collect didn’t stop there: California also started aggressively pursuing third-party merchants for sales taxes back to 2012.

To understand how California justified the tactic, you need to understand the history. In 2011, the state advanced a bill intended to collect sales tax from online retailers. The original bill, AB-153, eventually died in committee largely due to pushback from online retailers like Amazon.com Inc. But in 2012 Amazon reached a deal with then-Gov. Jerry Brown to start charging sales tax.

The change in the law was widely publicized, but one question remained: Did the law apply to third-party sellers on the platform?

Informally, most assumed that the law couldn’t apply to third-party sellers who were out of state. They were—before Wayfair—considered untouchable. There was no physical presence, and thus, no nexus. Case closed.

But Wayfair changed the way states looked at nexus. Physical presence was no longer a requirement for the imposition of sales tax: An economic connection was generally sufficient. With that, the cash-strapped state had found something of a pot of gold at the end of its online sales rainbow, and in 2019 the CDTFA began sending out notices to third-party merchants demanding sales tax remittances dating back to 2012.

Depending on sales, the amounts that might be due from those merchants can be staggering.

In March, MBW Northwest, a husband and wife with an online sales store in Washington state, reported that they had received a bill demanding “tens of thousands of dollars” in back taxes. More recently, a Pennsylvania man, Brian Freifelder, who sells clothing, shoes, and groceries on Amazon, went public about his $1.6 million sales tax bill from California.

As merchants grew increasingly unhappy, other state agencies stepped in. In March of this year, California State Treasurer Fiona Ma sent a letter to Gov. Gavin Newsom seeking leniency for online retailers. In response, the budget Newsom signed this summer included a provision that would appear to limit the CDTFA from demanding more than three years of back taxes from out-of-state third-party merchants. Some retailers, however, believe that any such retroactive taxes are unfair and have vowed to fight back.

As the controversy rages, it’s not clear whether other states may follow suit and try to extend the reach of sales tax laws to previous years. You can bet, however, that states are closely watching what happens in California.

Third-party sellers take up a lot of retail space in today’s online markets. In its annual filing with the Securities and Exchanges Commission, Amazon reported that 58% of its 2018 sales were by third-party retailers—up from 3% in the first year of business. Over the same period, sales from those retailers rocketed from $0.1 billion to $160 billion on Amazon alone.

For years, those dollars went largely untaxed, but in a post-Wayfair world, states are grabbing as many of those dollars as possible.