by Kenneth R. Appleby, Esq.

            The Internet Tax Freedom Act (the "Act") was signed into law on October 21, 1998 with much ballyhoo after extended debate, and continues to serve as a lightning rod for many factions protesting the supposed "right" of Amazon and others to sell goods over the Internet and not collect sales and use taxes. As it turns out, it is truly unfortunate that the name of the legislation is the Internet Tax Freedom Act (the "Act"). Why unfortunate? Because the name implies a freedom from taxation that the legislation does not (nor is intended to) provide. It is a common misconception that the Act relieves e-commerce businesses from any sales and use tax collection responsibilities. If only this were true. Quite frankly, the Act has little current impact on most e-commerce businesses notwithstanding its lofty title and the great deal of misplaced hype.

The Internet Tax Freedom Act

            The Act imposes a three year moratorium on both: (i) taxes on Internet access and (ii) multiple or discriminatory taxes on electronic commerce, unless in either case the tax was imposed and enforced prior to October 1, 1998. This moratorium prohibits state and local governments from imposing new taxes of such character between October 1, 1998 and October 20, 2001.

            All the Act attempts to accomplish is to put a halt to new legislation meant to either tax Internet access or impose "multiple or discriminatory" taxes on e-commerce. This does not really change the tax landscape for two reasons. First, existing statutory schemes were left in place and most are broad enough to cover e-commerce transactions. Second, most "multiple or discriminatory" taxes are unconstitutional to begin with, and would not be able to withstand a taxpayer's challenge to the imposition of such taxes. Strictly speaking, the Act did not even maintain the status quo as states can still pass sales and use tax legislation that impacts e-commerce businesses so long as the legislation is not discriminatory. Where does this leave us? In just about the same spot as the day before the Act became law. In other words, e-commerce businesses are subject to sales and use taxes after all. Understanding the nature of these taxes and the responsibility for collecting them is extremely important in order to avoid potentially substantial problems, including the complication of corporate transactions, the imposition of penalties and interest, and even personal liability for corporate officers, all arising from the failure to collect and remit the tax.

What are Sales and Use Taxes?

            Sales and use taxes are transactional taxes imposed on the sale or lease of certain types of property. There are over 5,000 taxing jurisdictions capable of imposing sales and use taxes in the United States. Not only do 46 states impose a form of these taxes, but many local jurisdictions also have the ability to impose these taxes, either independently or as a piggy-back on the state tax. This has resulted in a crazy patchwork quilt of statutes that differ in terms of applicable rates, types of transactions covered and how and when a given retailer is responsible for collecting the tax and remitting it to the appropriate taxing authority.

            While statutes differ, a sales tax is generally imposed on retail sales of tangible personal property (and certain limited services) made within a particular state. To make things interesting, while all of the statutes cover sales of tangible personal property, states vary widely on what types of services, if any, are covered. States also tend to vary widely on their extensive lists of exemptions. While a full review of the scope of sales and use tax statutes is beyond the scope of this article, there are some general guidelines that may be helpful.

          The sales tax is a customer-based tax which means that the tax is imposed on the customer rather than the seller. But, even though the tax is customer-based, the seller almost always has the responsibility for collecting the tax. This means that if the seller fails to collect any applicable sales tax and remit it to the appropriate jurisdiction, the seller will be liable for the unpaid tax along with the customer. The seller also faces the cost of interest and penalties if it fails to make the necessary withholding. Sales taxes are limited in a geographic sense. They apply to sales occurring in a given state. The difficulty is determining where a sale actually occurs in interstate commerce. In other words, if the sale is conducted over the Internet, does the sale occur in the state where the seller is located or where the buyer is located? The rules have evolved so that sales taxes are generally imposed only when the seller and the buyer are located in the same state. It is the use tax that comes into play where the buyer and the seller are located in different states.

            While sales taxes are more commonly understood, use taxes are often overlooked because businesses are not as familiar with the concept. Understanding the use tax is important, however, because it may create a greater problem for e-commerce businesses since virtually all of their sales occur in interstate commerce. The use tax is an attempt by states to impose a "sales tax" on transactions that would otherwise avoid the imposition of a traditional sales tax. This could occur, for example, where the seller is physically located outside the state in which the sale occurs (e.g., a Massachusetts resident purchases goods over the Internet from a seller located in California) or because the buyer travels to a state which does not impose a sales tax (e.g. New Hampshire) and purchases property to be brought back into the buyer's home state. The use tax works by imposing a tax on the use (as opposed to the sale) of tangible personal property within a particular state. A credit is given to the buyer against the use tax for any sales taxes paid by the buyer to the seller in the transaction. This avoids double taxation. Like the sales tax, the use tax is a customer-based tax but most states attempt to impose a use tax collection responsibility on sellers. Imposition of this collection responsibility is more problematic in the use tax context because often the seller will have no contact with the state seeking to impose that responsibility. Just how far states can go in forcing out-of-state e-commerce businesses to collect the tax is a controversial topic, and akin to the tax controversies which mail order businesses have fought over the years.

The Problem for E-Commerce Companies

            In a bricks and mortar economy, the traditional sales and use tax works fairly well because sales occur in person within one state's boundaries. Historically, the only businesses that typically had to address use tax issues were larger companies with customers in many states or mail order businesses. These larger operations were able to afford a tax compliance department or sophisticated outside professionals that could insure the proper tax collections in the many jurisdictions in which the business operated.

            The simplicity of the brick and mortar transaction is being supplanted in the New Economy. Even small e-commerce businesses are capable of (and are) selling in virtually every state. The problem is that these small businesses do not have the budgets to devote to tax compliance that the much larger mercantile businesses have, yet their compliance burden is just as complex, if not more complex. One example of the complexity e-commerce businesses face is the need to integrate their tax compliance practice with their on-line order processing package so that customers can observe the tax due on sale real-time as they order goods on-line. Without that integration, customers have to be assessed any taxes after the order is placed by manual means and an additional charge placed on their credit card. This presents the possibility of customer confusion and dissatisfaction. Given the huge number of taxing jurisdictions, the task of on-line integration is much more complex than it seems because it depends on not only geographic distinction (both state and local) but also availability of product exemptions and exclusions in some jurisdictions but not others. There are a number of third parties providing both sales tax calculation software as well as on-line tax processing services. As you might suspect, the real hurdle for smaller e-commerce businesses is the fairly substantial cost of those programs and services. This is the primary reason that sales tax simplification has moved to the top of a number of political agendas.

An Example

            Examining a hypothetical sales transaction may be helpful in understanding two key questions that need to be answered in order to determine whether a business has sales and use tax collection responsibility - what types of property are typically subject to the sales and use tax and when a particular state can impose a use tax collection responsibility on an out-of-state e-commerce company. is a small web retailer located in Massachusetts which sells hammers over the Internet. With one exception, all of its employees and its sole office and warehouse are located in Massachusetts. Its website is hosted on third party servers located in Virginia. In addition, it has a part-time CFO who telecommutes from Vermont.  

            Due to the pent-up demand for mail order hammers and the phenomenal reviews of its patented double-headed hammer, on-line orders have been pouring in from all 50 states. The obvious question is whether has a duty to collect and remit sales and use tax from transactions with residents of each of these jurisdictions.

            Let us start with the example of a California resident purchasing a hammer from by placing an order over the Internet. This order was filled by sending a hammer directly to the purchaser from the Massachusetts warehouse. Delivery was made by common carrier. There are three steps we need to proceed through in order to determine whether has a sales and use tax collection responsibility.

Step One Which State Law Governs?

          Step one in our analysis is determining which state's statute governs the transaction. While the law is not as well settled as one would like, the general rule of thumb is that an intrastate sale typically invokes the sales tax in the jurisdiction where the sale occurs and an interstate sale typically invokes the use tax in the jurisdiction where the buyer resides and from which the purchase is made.

            In our example, we can safely assume that the California use tax statute will apply. The sales tax statutes are not implicated because this is not an intrastate sale. As an interstate sale, the use tax statute of the buyer's jurisdiction will govern. But having determined that California's statute applies to the transaction doesn't end our inquiry. We need to determine whether California can impose a use tax collection responsibility on If so, the company will have to collect and remit the use tax directly. If not, our buyer is likely to have an obligation to "declare" his or her purchase and pay the use tax to the taxing authority directly.

Step Two What Types of Property Are Covered?

          As we noted before, retail sales of tangible personal property are almost always subject to the sales and use tax. In our example, we can safely assume that a retail sale of a hammer will almost always be subject to the sales or use tax. It is a classic example of tangible property. But suppose sold other items. Distinguishing between what is tangible and what is not is not always that simple. For example, retail sales of software are more complex. Many states tax the retail sale of "canned" or "off-the-shelf" software. Most states do not tax custom software (as it represents more of a service than a product) although there are a number of exceptions. As you might surmise, there is great uncertainty surrounding the sale of hybrid software (i.e., canned software that is modified for a particular customer but where most of the value is reflected in the underlying canned program).

          Up to this point, the issues facing e-commerce businesses are not that different from the issues facing traditional mail order concerns. E-commerce businesses do have some unique distinctions that raise some novel issues (bearing in mind that novel issues are not a good thing when trying to determine the applications of various laws with some degree of certainty). The Internet allows e-commerce businesses to deliver digital products. Everything from software to music can be delivered digitally and without any tangible medium. As you might suspect, the existing statutes and regulations have not been updated to deal with these new issues and there is great uncertainty as to how various states will deal with digital products. For example, in some states software delivered electronically avoids taxation even if the software would otherwise be taxable if delivered on a tangible medium such as a disk. Other states have taken a contrary view. Still other states have remained silent on the issue and the answer depends on who you get on the phone on any given day. To add further complexity, some states allow for digital downloads free of tax but if backup copies or instruction manuals are sent in tangible form, all or part of the transaction may then be subject to tax.

Step Three Can They Make Me Do It?

          Step three in our process is to determine whether must collect and remit use taxes to California on the sale of those hammers. There is no question that our California buyer has a use tax obligation since he or she is using tangible personal property in California on which a sales tax has not been paid. It is's obligations which are at issue. California's statute, like most comparable statutes, requires collection by vendors who are making sales covered by the statute. On its face, the statute would seem to require to collect and remit use taxes on the sale. This is not unusual, as most state statutes will assert the right to collect the tax. Naturally, analyzing the California statute by itself does not supply the complete answer. The real issue is whether California has the legal right to force an out-of-state retailer to collect and remit sales and use taxes where that retailer has no contact with the state. This issue is not simply a matter of state statutory law; but rather, a matter of constitutional law.

            The Constitution does not address the propriety of sales and use taxes but, rather, addresses a state's ability to tax interstate sales and impose collection responsibility on the out-of-state seller. Historically, out-of-state sellers with little or no contacts with a buyer's state have resisted the imposition of the buyer's state's sales or use tax on the grounds that such state was constitutionally prohibited from taxing the sale under either the Due Process Clause of the Fourteenth Amendment or the Commerce Clause of Article I of the Constitution. So far, the out-of-state sellers (particularly mail order businesses) have been winning the battle. A series of Supreme Court decisions have allowed states to force out-of-state sellers to collect and remit use taxes only where that seller has some "nexus" with that state. Just what constitutes "nexus" is the real issue.

            For now, the law of the land is that if an out-of-state e-commerce company simply markets through the Internet to residents of a state and all orders are filled out-of-state and shipment is via common carrier, the state into which the goods are being sent may not impose a use tax collection responsibility on the out-of-state seller. The Supreme Court has required some physical presence in the state in order to achieve the necessary nexus. In our example, has no contacts with the State of California other than the fact that it sold a hammer to a California resident who ordered the hammer on-line over the Internet. does not have any employees or property located in California, nor does it have any other contacts with the State. Therefore, California would not be constitutionally able to impose use tax collection responsibility on, even if the underlying state statute would seem to impose that obligation. This is not to say that the buyer would not have a use tax liability to California because he or she is a resident; this only says that California cannot impose the collection responsibility on It is interesting to note that many, if not most, states have statutes that on their face are unconstitutionally overbroad in that they impose use tax collection responsibility on virtually any out-of-state person selling to residents of that state.

What Constitutes Nexus?

            We now know that at a minimum, having no physical presence in a state avoids the imposition of collection responsibilities. The next question which arises is what minimum contacts with a state will subject an out-of-state retailer to use tax collection responsibility. States have become very aggressive in attempting to find sufficient "physical presence" so as to be able to impose collection responsibility. There is little question that the presence of employees or sales personnel in a state will subject the out-of-state retailer to the use tax. As you may recall from the hypothetical, does have a telecommuting employee that lives in Vermont (and if you did recall that, you are well on your way to becoming a lawyer). If sells to a Vermont resident, the analysis changes because does have a telecommuting employee who works from home in Vermont. While most states have not addressed the issue of telecommuting in this context, it is highly likely that the existence of a telecommuting employee working in a state will constitute sufficient nexus for taxation.

            Even if the telecommuter in our example is an independent contractor, it is well settled that nexus exists - even where all of a seller's in-state solicitation or other activities are performed by independent contractors. In other words, the distinction between an employee and an independent contractor who acts as an agent is not relevant for determining whether nexus exists for sale and use tax purposes.

            One of the many unanswered questions is whether occasional visits by sales or customer service representatives in a taxing jurisdiction will establish sufficient nexus for the tax to be imposed by such jurisdiction and, if so, where the "nexus line" is drawn. The states have been split on this issue with courts increasingly finding that even occasional visits into a jurisdiction will subject the retailer to tax in such jurisdiction. The New York Court of Appeals has recently taken a very expansive reading with respect to minimum contacts. In one case, nexus was found with as little contact as twelve one-day visits by sales personnel during a three-year period and no more. In another New York case involving licensing of computer hardware and software, nexus was found where there were visits of employees to New York customers to resolve problems and give additional instruction in connection with the use of the software programs. In the course of a thirty-month audit period, the company sent employees to New York on 41 occasions to handle follow-up and training.

            To date, New York appears to be the only state that has set such a minimal threshold for nexus. Arizona, on the other hand, has set a somewhat higher threshold and requires the physical presence to be "substantial." On the other hand, the highest courts in most states have not yet addressed these issues. As you can see, the threshold is set quite low. It should be unsettling that some states have either legislatively or administratively provided that nexus would not exist if a company sends personnel to trade shows in their state for no more than 5 days. Does this suggest a different result if the personnel attend a trade show for 6 days? This highlights how even seemingly insubstantial contacts with a state can trigger sales and use tax collection responsibility.

            Another complication that e-commerce businesses must consider is the multiple locations of servers hosting a website. If the business owns its own servers, the ownership of property in a given state may constitute nexus. But what if the website is hosted on third-party servers as is the case in our example? What little authority exists on this issue is split. Some, but not all, jurisdictions take the position that web hosting does in fact constitute nexus. In our example, has its website hosted on servers in Virginia. Virginia is one of a handful of states that has taken the administrative position that website hosting alone will not constitute nexus. Therefore, sales by to Virginia residents will not require use tax collection by simply because its website is hosted on third-party servers located in Virginia.

Attributional Nexus

            The Supreme Court has held that maintenance of local retail stores in a state will subject the retailer to that state's use tax responsibility, even if the sales are made from out-of-state. In addition, the Supreme Court has held that the existence of two offices within a state created sufficient nexus for taxation even though there was no relationship between those offices and the mail order activity or transactions which were being taxed. This creates a complication for traditional "brick and mortar" businesses that are seeking an e-commerce strategy. The existence of physical retail outlets and offices will create nexus with each state in which those stores and offices are located. This puts those businesses at a competitive disadvantage as they may be required to collect use tax on sales to customers in most states while on-line retailers selling the same product are not subject to those collection responsibilities outside of their "home" state.

            This problem has given rise to some creative corporate maneuvering. Barnes & Noble, Home Depot and other brick and mortar businesses are making substantial use of affiliated corporations within their corporate structure in order to isolate their e-commerce ventures from the brick and mortar activities that might otherwise be deemed to constitute nexus, and facilitate the taxation of their e-commerce businesses. Whether the nexus-creating activities of the brick and mortar business can be imputed to the affiliated e-commerce corporation, and thereby create a use tax collection responsibility for the e-commerce corporation, is an interesting legal and monetarily significant issue . Obviously, if the entity which owns the brick and mortar stores is also the entity which, directly or indirectly, owns the on-line operations, nexus will exist in many states simply due to the presence of the stores and personnel.

            This idea of using affiliated corporations as a corporate shield from taxation has been fairly effective. The idea is to take the on-line business out of the direct chain of ownership by the traditional brick and mortar business and establish it as an affiliated or "brother-sister" corporation owned by a common holding company. The courts have been unwilling to find "attributional nexus" simply as a result of common ownership or an affiliate relationship. On the other hand, where a court can find an agency relationship between the two operating entities, nexus can more easily be found based not so much on an attributional theory, but rather on a simple agency analysis. In an extreme example of how far courts will sometimes go, the Kansas Board of Tax Appeals determined nexus was created by a scholastic book club's use of teachers within the state to collect money and orders for the books even thought the teachers did not work directly for the book club. One current "hot topic" involves whether the acceptance of returns and exchanges at a retail location will "taint" an affiliate engaged in Internet sales. Obviously the more intertwined the operations of the separate entities are, the more likely a successful challenge by taxing authorities.

Where Do We Go From Here?

            The significance of the factual circumstances in any sales and use tax analysis should suggest that there are a myriad number of issues involved in sales and use tax compliance. While the Act did little to deal with the current quagmire, it did create a Commission comprised of industry leaders and government representatives charged with preparing a report for Congress on these issues. Among the goals of the Commission is to reduce the compliance burden through simplification and to treat all retailers on a level playing field. The Commission submitted a report to Congress on March 31, 2000, although its recommendations were only approved by a simple majority of the Commissioners as opposed to the 2/3 majority that was required by the Act. The failure to obtain the necessary votes is a reflection of how complex this issue is and the lack of anything even approaching a consensus on how to move forward.

            The Commission's Report has a number of recommendations: the first is to extend the current moratorium for an additional five years; the second is to develop a uniform sales and use tax statute which could be adopted by all or at least a majority of states imposing a sales and use tax; third is for the elimination of sales tax on Internet access; fourth is for the elimination of excess tax burdens on telecommunications service providers; and last, but certainly not least, is a set of uniform nexus rules that could be adopted by Congress and would be binding on all of the States. This Report recommends that no "attributional nexus" be recognized, enabling the use of affiliated corporate structures. The Report also recommends that the following circumstances not constitute nexus in a particular state without additional activities in such state:

1.  use of an ISP in a state;

2.  use of server in a state;

3.  use of a telecommunications provider in a state;

4.  ownership of intangible property in a state (the license issue);

5.  performance of repair or warranty services; and

6.  advertisement of a web site.

          At present, the debate continues to rage in Congress as to what, if anything, can or should be done. As the New Economy becomes a larger part of the whole economy, many states have much to lose in this debate and not a whole lot to gain. The issues pit the states against not only the Federal government, but also against each other. For example, some states that are more e-commerce friendly have a vested interest in encouraging New Economy companies and see a benefit in taking a "softer" approach to e-commerce taxation. Other states simply see a revenue drain without much of an offset and would benefit from aggressive taxation of e-commerce.

          Some states are taking steps unilaterally to simplify and streamline their sales and use tax statutes in an attempt to increase voluntary compliance by out-of-state retailers. Other states are aggressively stepping-up enforcement in the e-commerce sector. Many states are still on the sidelines waiting to see where the winds ultimately end up blowing. Without any real consensus on this issue, particularly among the states, substantial reform of how states tax e-commerce transactions is unlikely in the short-term. Not surprisingly, the specter of a national sales tax continues to loom as an alternative tax paradigm.

          In the meantime, e-commerce businesses must carefully monitor their sales and use tax compliance programs. It should also be noted that in the confusion there is also opportunity. Variances in state statutes and inconsistent court decisions create certain planning opportunities. This is particularly true for software and other companies in the business of selling digital products. Any click and mortar business should carefully consider whether its corporate structure maximizes sales and use tax planning opportunities. The tax team at Lucash, Gesmer & Updegrove has substantial experience in the area of multi-state taxation and would be happy to discuss with you whether your sales and use tax program is minimizing risks and maximizing opportunities.

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