Annette Nellen
Annette Nellen

How states can improve sales and use tax collection

While states await help from Congress, they face challenges in collecting from remote vendors and residents.

October 25, 2012
By Annette Nellen, Esq., CPA

States have faced a long-standing challenge and frustration in collecting sales and use tax on sales made by remote vendors. The U.S. Supreme Court held in 1967 and 1992 that a physical presence is necessary for states to be within constitutional parameters to make vendors collect sales tax. (See National Bellas Hess, Inc. v. Department of Rev., 386 U.S. 753 (1967), and Quill Corp. v. North Dakota, 504 U.S. 298 (1992).) The growth of e-commerce enables a growing number of vendors to have customers in a state without a need for a physical presence. While states theoretically can collect the use tax from consumers, the reality is that few states are successful in collecting use tax from their residents.

The 112th Congress introduced and considered three bills that would allow states to collect from some remote vendors. Various issues remain with these bills, such as how to define the size of small vendors who would be exempt from collection.

While some states have enacted legislation to try to broaden their sales tax nexus reach, constitutional issues exist, and the efforts do not reach all vendors. What else should states consider to reduce their sales and use tax gap? This article suggests some legislative and administrative actions.

For more information on the congressional bills and state legislation, see the author’s affiliate nexus website.

State actions and constraints

In recent years, a number of states have adopted one or more of four basic methods to try to improve sales and use tax collection. A few of these efforts are discussed later. It is important to note that despite these various efforts, no state is collecting all of the sales and use tax to which it is entitled. The four basic methods are:

1. Enacting the Streamlined Sales and Use Tax Agreement (24 states as of October 2012).
2. Enacting a nexus law involving a related entity and similar product, trademark, or goodwill; specifics vary by state.
3. Enacting an affiliate nexus law involving a third party that promotes a weblink per a contractual arrangement (i.e., “click-through” nexus) or affirming such a policy through administrative ruling.
4. Enacting a law requiring remote vendors to note use tax obligation on invoices.

State legislative actions

The states that have adopted the Streamlined Sales and Use Tax Agreement (SSUTA)  continue to wait for Congress, in effect, to reverse the Quill decision to allow them to collect from remote vendors.

Several states have pursued legislation to try to broaden nexus if a remote vendor has a particular relationship with an in-state related entity. This approach might not pass constitutional muster, though, if the remote vendor does not have a physical presence that meets the “substantial nexus” standard of Quill and Complete Auto Transit, Inc. v. Brady, 430 U.S. 274 (1977). Also, if a remote vendor’s relationship with an in-state entity does rise to the level of substantial nexus, state legislation is probably not necessary, unless the state’s existing law has some type of allowance or language that makes that connection exempt from sales tax collection.

The so-called Amazon affiliate or click-through nexus laws enacted by nine states so far are not ideal solutions for states either. These laws apply only to vendors that have affiliate relationships with in-state entities that typically provide some type of compensation for weblinks and/or purchases made by first clicking on that link. Not all vendors have these relationships. Also, as has happened in some states, the remote vendors just cancel the contracts with their affiliates to avoid becoming subject to the law. When that happens, the state loses income tax revenue and still has its sales tax collection problems.

If an in-state website owner is indeed soliciting sales or helping to maintain a market for the vendor and is compensated for doing so, the state likely does not need a special law to find that vendor has a physical presence in the state. Consider the recent Scholastic Book cases in Connecticut and Tennessee where teachers assisting with the sales process were found to create sales tax nexus for Scholastic Books. (See Nellen, “Back to School: Sales Tax Nexus Lessons,” Corporate Taxation Insider (Aug. 23, 2012).) Also consider the administrative ruling issued by Pennsylvania (Bulletin 2011-01 (12/1/11)) on remote seller nexus.

Because some of the vendors that states would like to require to collect sales tax may already have a physical presence in the states, instead of trying to broaden nexus beyond what may be constitutionally permissible, legislatures should instead consider providing additional funding to their tax agencies to help find noncompliant vendors.

Additional actions legislatures might consider to reduce their use tax gap include:

  • Provide funds to the state tax agency for a public awareness campaign on the use tax and the benefits of paying it. Michigan has such an ad on its website that explains what a use tax is and notes that schools benefit from it.
  • Review the system in place for self-assessment of use tax to be sure it is simple and not riddled with loopholes. States should consider having a line on the state income tax form for use tax. States can address the common consumer issue of insufficient records for computing the amount owed by allowing use of a “lookup” table, such as the one used in California and a few other states. Individuals should be required to either put a number on the use tax line or check a box on the return noting that they filed a separate use tax return (unless they state they have zero use tax liability).
  • Allow state agencies to share information. This may help in finding nonfiling vendors with a physical presence in the state.
  • Find ways to encourage remote vendors to voluntarily register to collect sales tax. Possible enticements include:
    • Sufficient vendor compensation.
    • Amnesty for past liabilities if the vendor starts collecting by a specified date.
    • Allow the state tax agency to develop simpler compliance methods, such as annual rather than quarterly filing for small vendors.
    • Provide that registered tax collectors are automatically approved as possible state vendors.
    • Allow state agencies to purchase only from vendors that are registered to collect sales tax.

Administrative actions

Administrative actions may be the easiest way to reduce a state’s use tax gap  without state or federal legislation. Actions here include ramping up efforts to find vendors who have a physical presence in the state and finding ways to get in-state buyers to pay their use tax.

Possible actions tax agencies might take to improve sales and use tax compliance include:

  • Developing plans to find noncompliant vendors who have a physical presence. Such plans may also include requesting increased funding for the programs.
  • Be sure that clear information is readily available to vendors, such as on the agency’s website, to help vendors know if they may be liable to collect sales or use tax.
  • Require applicants for jobs in the state tax agency to verify that they are use tax compliant.
  • If use tax can be paid on the state personal income tax form, states need to be sure the line and instructions are explicit. For example, line 95 on the California Form 540, California Resident Income Tax Return, is not as clear as line 22 on the Michigan Form MI-1040, Michigan Individual Income Tax Return (see below).

Looking forward

With the 112th Congress winding down and significant federal tax issues on its plate, the proposals to reverse the Quill decision for certain vendors are likely to be pushed to the next Congress or beyond. But state legislatures and tax agencies can take actions to improve sales and use tax compliance while respecting constitutional limitations.

Actions are needed even when Congress steps in to help, because federal legislation will not apply to non-U.S. vendors or small vendors. The growing sales/use tax gap all states face and continuing state fiscal challenges should provide impetus for renewed attention to what states can do on their own to address the sales and use tax collection problem.

 Rate this article 5 (excellent) to 1 (poor). Send your responses here.

Annette Nellen, Esq., CPA, is a tax professor and director of the MST Program at San José State University. She is an active member of the tax sections of the AICPA, ABA, and California State Bar. She chairs the AICPA Individual Income Taxation Technical Resource Panel. She has several reports on tax policy and reform and a blog. She will be a speaker at the AICPA National Tax Conference, which will be held on Nov. 7 and 8 in Washington.