Up the Amazon Without a Paddle: Examining Sales Taxes, Entity Isolation, and the “affiliate Tax”

• Publication year: 2009

Michael R. Gordon ⁰

As a result of the Supreme Court's decision in Quill v. North Dakota, unless a retailer has a physical presence in a state, it is not obliged to collect sales taxes in that state. In order to avoid collecting sales taxes, many companies like Amazon.com have set up subsidiary companies in many states to ship, but not sell, goods to customers. This tactic is called entity isolation. In response, states are creating legislation, commonly, but inaccurately, called an "affiliate tax," which provides that if a company makes a certain amount of money through an affiliate's presence in the state, it is deemed to have legal physical presence and is required to collect sales taxes. This Recent Development discusses how Quill has reacted to the Internet age, the possibility of states cutting through entity isolation, and the constitutionality of the so-called "affiliate tax."

I. Introduction

In many states, sales tax accounts for a large portion of the state's total revenue;¹ nationally, in 2008, 30.8% of nationwide state tax revenue came from sales tax, and individual states that had sales taxes obtained anywhere from 22% to 63% of their revenue from it.² Thus, with the recent economic downturn cutting into tax revenue,³ it is no surprise that states have begun to fight for all the tax revenue to which they believe they are entitled.⁴ Online retailers with no physical presence in a state have been, until recently,⁵ exempt from collecting the sales tax, effectively giving them in some cases an 8% or more discount over their local "brick-and-mortar"⁶ competition.⁷ In many states, including New York,⁸ North Carolina,⁹ and California,¹⁰ purchasers of goods online are obliged to pay the appropriate amount in tax to the state, but this rarely occurs.¹¹ According to one recent study, over $7.7 billion was lost by states in sales and use taxes from e-commerce sales in 2008, including $145 million lost by North Carolina alone.¹² The situation described creates a virtual arms race between the states, who want online retailers to collect taxes, and the online retailers, who do not want to take on the burden and expense of calculating and collecting taxes.¹³ The factor that has most limited the states in their race to collect sales tax is the United States Supreme Court's decision in Quill Corp. v. North Dakota,¹⁴ which held that a state may only impose a duty to collect sales tax upon a corporation when that corporation has minimum contacts with the state for the purposes of the Due Process Clause¹⁵ and a substantial nexus with the state for the purposes of the Dormant Commerce Clause.¹⁶ The methods being used by online retailers to avoid collecting sales tax, such as entity isolation, while legal, can be bypassed by states and used to force the collection of tax. The "affiliate taxes" are also constitutional, and are likely to see increasing use.

Part II of this Recent Development discusses the consequences of the Quill decision in the Internet world. Part III explores a sales tax avoidance tactic used by online retailers with mixed success called "entity isolation." Part IV analyzes the constitutionality of the "affiliate tax" used by states, including New York and North Carolina, to require out-of-state companies with affiliate marketing programs, such as Amazon.com, to collect sales tax. Part V lays out policy arguments for and against imposing the duty to collect sales tax on out of state retailers, and Part vI concludes that online retailers collect sales taxes in states to which they have a substantial connection.

II. Quill and Post-Quill Sales Tax Law

A. Quill v. North Dakota

The Supreme Court's decision in Quill has had a major influence on state sales tax jurisprudence.¹⁷ The case set the standards governing the ability of states to collect sales tax from retailers based out-of-state.¹⁸ It clarified the requirements set in National Bellas Hess, Inc. v. Department of Revenue of Ill.¹⁹ Quill Corporation had no offices or employees in North Dakota, but it solicited sales from customers in the state.²⁰ While North Dakota posited that the solicitation of sales was sufficient to force Quill to collect sales tax, the United States Supreme Court disagreed.²¹ Although taking advantage of the North Dakota market was sufficient to create jurisdiction under the Due Process Clause,²² it did not create a sufficient nexus requiring Quill to collect sales tax under the Dormant Commerce Clause.²³ North Dakota contended that modern sales methods had rendered the physical presence test of National Bellas Hess, which states that a seller could only be forced to collect sales taxes for a state if it had physical presence in the state, obsolete.²⁴ The Court found that interstate commerce could be burdened by "state-imposed duties to collect sales and use taxes."²⁵

In this way, Quill both clarifies and expands the National Bellas Hess bright-line test of physical presence in a state. To pass the Quill test, a statute that imposes a duty to collect sales tax must be consistent with both the Due Process Clause and the Dormant Commerce Clause.²⁶ Simply because a corporation has minimum contacts with the state does not mean the state can constitutionally force the corporation to collect sales taxes.²⁷ The ability of a state to impose such a duty "may turn on the presence in the taxing State of a small sales force, plant, or office."²⁸ Justice Stevens, speaking for the majority, admitted that this creates a bright-line rule that "appears artificial at its edges."²⁹ It is easy to imagine situations where the Quill test seems inappropriate.³⁰ Despite the artificiality of the Quill bright-line test, the Court found that the benefits of simplicity in administering the tax laws outweighed any benefit of having a rule that better reflects present-day economic realities.³¹ The Court, however, stated that Congress would be permitted to regulate how state sales taxes may be collected,³² but Congress has yet to act.³³

B. Quill in the Internet Age

With the bright-line test in mind and no congressional action to regulate state sales taxes for remote sellers, corporations began to devise ways to avoid collecting sales and use taxes in order to make their prices appear lower.³⁴ A prime example came in a 2005 California Court of Appeal case, Borders Online, LLC v. State Bd. of Equalization,³⁵ in which the requirement to collect California sales tax was stretched to its limit. Borders Group, Inc. owned both Borders Online, LLC and Borders, Inc.³⁶ The latter owned Borders Books and Music stores across the United States, including in California.³⁷ Borders stores accepted returns from online orders, Borders Online advertised that the products could be returned to the physical stores, and store employees were encouraged to refer customers to the website.³⁸ The court determined that because the Borders Books and Music stores were accepting returns, they were acting as Borders Online's agents.³⁹ Therefore, Borders Online had an effective presence in California and could be taxed.⁴⁰

The practical consequence of the Borders decision is that companies with online divisions that do not wish to collect sales taxes for online orders must create a corporate structure where the online division is completely distinct from the "brick-and-mortar" division.⁴¹ However, Borders cannot point us to a direct conclusion about tactics used by online-only retailers like Amazon.⁴² The case also lays the groundwork for a state to impose sales tax liability based on a "brick-and-mortar" company promoting an online company's products and services and vice versa.⁴³

Two years later, in St. Tammany Parish Tax Collector v. Barnesandnoble.com, LLC,⁴⁴ however, a separate court faced with similar facts found that bookseller Barnesandnoble.com, LLC was not responsible for collecting state and local taxes. The main differences between this case and Borders were that: 1) Barnes & Noble stores only gave Barnesandnoble.com customers store credit, not cash, for merchandise purchased online and returned to the stores; and 2) stores would give similar credit to purchasers from competitive stores.⁴⁵ The St. Tammany court reached the opposite conclusion of the Borders court: Barnesandnoble.com did not have a sufficient nexus to pass the Quill test.⁴⁶

In spite of an attempt to create a bright-line rule in Quill,⁴⁷ numerous gray areas continue to exist in areas like the determination of physical presence, as illustrated by Borders and St. Tammany. However, it appears from the post-Quill jurisprudence that a business may be structured such that it serves the entire United States while never having to collect sales taxes.⁴⁸ This leaves the door open to online retailers trying to find a way to both provide timely delivery service to their customers while maintaining the price advantage over local "brick-and-mortar" retailers. Retailers attempt to provide timely service by having warehouses in more states than those that do not impose sales taxes.

III. Taking Advantage of Quill: Entity Isolation

To avoid being forced to collect sales taxes, some online retailers such as Amazon.com take advantage of the Quill physical presence requirement by using a tactic called "entity isolation."⁴⁹ To use this tactic, a corporation sets up other companies to perform specific functions, such as order fulfillment or research and development on new products.⁵⁰ Because the subsidiaries are legally distinct from the company selling the product, the seller is not deemed to have a physical presence in the state. Thus, under Quill, the seller cannot be required to collect sales tax.⁵¹

As stated earlier, Amazon has been one online retailer to take advantage of this loophole in Quill.⁵² In Pennsylvania, Amazon operates five distribution centers, but it does not collect sales taxes.⁵³ The distribution centers are legally operated by two subsidiary companies, Amazon.com DEDC LLC (DEDC) and Amazon.com kydc...