By Ned A. Lenhart, MBA CPA
Over the past several years I’ve written frequently about the obligations retailers have for collecting and remitting sales tax on taxable personal property sales shipped to customers located outside of the retailer’s home state. Each article has clearly stated that states cannot require a non-resident retailer to collect and remit sales tax on sales unless the retailer is ‘doing business’ in the taxing state based on the tax rules of the taxing state. This concept is normally referred to as ‘nexus’. As such, the taxing state can only require the non-resident retailer to collect sales or use tax if the retailer has nexus in that state. These articles have addressed the common nexus creating activities such as having employees working in the taxing state, having sales agents working in the taxing state, or renting real or personal property in the taxing state.
In order for retailers to become more efficient in fulfilling sales orders, many retailers are now storing inventory in third-party warehouses located throughout the U.S. Many companies provide these storage and fulfillment services. Given this change in fulfillment methodology, the time has come to move from discussing the general nexus rules to discussing the specific nexus rules related to this type of storage and fulfillment activity. Specifically, does the ownership of inventory held at a distribution center in another state create nexus for the retailer in the state where the property is located? For purposes of this article, I am focusing only on the rules in the states of California, Florida, Illinois, Pennsylvania, and Texas.
The Nexus Bright Line Test of Quill
The current sales tax nexus standard by which all state nexus statutes and regulations must be evaluated is found in the U.S. Supreme Court opinion of Quill Corp v. North Dakota, 504 U.S. 298, 309 (1992). The U.S. Constitution in Article I, § 8, cl. 3, grants to Congress the power to “regulate Commerce … among the several States. The Supreme Court has consistently held this provision also contains a further, negative command, known as the dormant Commerce Clause, prohibiting certain state taxation even when Congress has failed to legislate on the subject. In other words, state tax authorities do not have the independent right to impose tax on interstate commerce just because Congress has failed to act.
Quill is a mail-order office supply company located in Illinois. It had no employees in North Dakota, it owned no significant property in North Dakota, and it had no independent sales representatives working in North Dakota. Quill’s only activity in North Dakota was the mailing of mail order catalogs to customers in the state and the presence of some ‘floppy disks” sent to customers. Quill asserted that these physical connections with North Dakota did not create nexus with the state and that Quill had no obligation to collect tax. Before the Supreme Court, the North Dakota Department of Revenue argued that because Congress had failed to pass legislation addressing the taxation of these transactions, the state of North Dakota had the Constitutional right under the Commerce Clause to develop its own rules as to what activities create nexus and to require Quill and other companies to collect and remit tax on their mail order sales.
The U.S. Supreme Court disagreed with North Dakota and held that it did not have the legal right to require Quill to register and collect use tax on sales shipped into North Dakota. North Dakota’s plan would place an illegal burden on interstate commerce. The Court concluded that undue burdens on interstate commerce sometimes may be avoided by the application of a bright line rule. The Quill court concluded that the dormant Commerce Clause and the Court’s earlier holding in National Bellas Hess, Inc. v. Department of Revenue of State of Ill. 386 U.S. 753, 758 (1967) create a bright line rule with regard to the collection of sales and use tax.
In its Quill decision, the Court held that the Commerce Clause of the U.S. Constitution requires that non-resident taxpayers have “substantial nexus” with the taxing state while the “Due Process Clause” of the Constitution only requires these retailers to have “minimum contacts” with the taxing state. Only those companies with substantial nexus or substantial presence in the taxing state can be compelled to register to collect and remit sales tax. In other words, retailers must have Commerce Clause nexus in a taxing state before the taxing state can require that retailer to collect tax; Due Process nexus is not sufficient to create nexus.
The Quill decision does not list specific substantial nexus activities nor does it list examples of what constitutes minimum contacts within a state. From the Quill opinion, we learn that companies without any physical connection in the taxing state only meet the ‘minimum contact’ rule and do not have sales tax nexus. Further, it appears that the presence of some low value computer diskettes in the state also do not create nexus in the taxing state. Other than these examples, Quill provides no guidance on the activities that can occur in a taxing state without the retailer creating nexus in that state.
Under the Quill holding, non-resident businesses either have ‘minimum contacts’ or ‘substantial contacts’ with the taxing state. There is no middle ground. Substantial contacts are those contacts that exceed the ‘minimum’ threshold. This is not a very helpful definition. From a legislation standpoint, as long as state law provides a reasonable definition of what the state considers ‘substantial contacts’ with the state, it is likely that the Courts will consider the statutes to be Constitutional.
The remainder of this article summarizes the statutes, regulations, rulings, and court cases from California, Florida, Illinois, Pennsylvania, and Texas that specifically address the nexus implications of retailers owning inventory located in a distribution center or warehouse located in that state. Many commentators have expressed their belief that there is some question or uncertainly as to whether owning property in a state creates sales tax nexus. In the states listed below, there is no uncertainly about the answer to that question. Retailers holding title to property stored for fulfillment and sale in warehouses or distribution centers in any one of the states listed have sales tax nexus in that state which obligates the retailer to collect and remit sales tax on taxable sales shipped to customers in that state.
California Revenue and Tax Code Section 6203(c) defines the phrase “retailer engaged in business in this state” to mean any retailer that has substantial nexus with this state for purposes of the Commerce Clause of the United States Constitution and any retailer upon whom federal law permits this state to impose a use tax collection duty. “Retailer engaged in business in this state” specifically includes, but is not limited to, any of the following:
(1) Any retailer maintaining, occupying, or using, permanently or temporarily, directly or indirectly, or through a subsidiary, or agent, by whatever name called, an office, place of distribution, sales or sample room or place, warehouse or storage place, or other place of business.
Further, California Regulation 1684(c)(1) outlines a number of specific activities that the California State Board of Equalization (SBE) determines to constitute a ‘retailer engaged in business in this state”:
(1) A retailer is engaged in business in this state as defined in section 6203 of the Revenue and Taxation Code if:
(A) The retailer owns or leases real or tangible personal property, including, but not limited to, a computer server, in California; or
(B) The retailer derives rentals from a lease of tangible personal property situated in California (under such circumstances the retailer is required to collect the tax at the time rentals are paid by the lessee); or
(C) The retailer maintains, occupies, or uses, permanently or temporarily, directly or indirectly, or through a subsidiary, or agent, by whatever name called, an office, place of distribution, sales or sample room or place, warehouse or storage place, or other place of business in California; or
(D) The retailer has a representative, agent, salesperson, canvasser, independent contractor, solicitor, or any other person operating in California on the retailer’s behalf, including a person operating in California under the authority of the retailer or its subsidiary, for the purpose of selling, delivering, installing, assembling, or the taking of orders for any tangible personal property, or otherwise establishing or maintaining a market for the retailer’s products.Fu
In the Matter of Petition for Redetermination under the Sales and Use Tax Law of Robert L. Reynolds and Donald R. Reynolds, California State Board of Equalization, May 31, 2007. This ruling discusses the application of one or more of the provisions outlined above.
Taxpayer (Reynolds) was a business located in Oregon but had numerous California customers. Many items were shipped directly from Oregon to California via common carrier. Taxpayer would also use a separate legal entity with a California location to assemble and store the assembled merchandise until a California sale occurred. Once the sale occurred, this third-party would arrange shipment to the customer on behalf to the Oregon business. The Oregon business argued that it was not a “retailer engaged in business in this state” as outlined above.
The state of California ruled against the taxpayer. In its opinion it made the following statement as to the application of the provisions discussed above:
Based on petitioner’s description of its business, petitioner did not have a permanent business location in this state in its own name. However, the business location requirement is satisfied even where the retailer simply occupies or uses a place of distribution, warehouse, storage place, or other place of business in this state on a temporary basis, indirectly through an agent (regardless of characterization). The facts do not indicate that petitioner had an explicit agreement with the third-party that some portion of the California facilities would be reserved and dedicated to the use of petitioner… Nevertheless, even in the absence of such an explicit agreement, the facts indicate that there was sufficient of petitioner’s tangible personal property located at the California location and sufficient activity was performed on petitioner’s behalf that petitioner essentially had a place of business at the location in California.
The California statute, regulation, and ruling mentioned above make it clear that the State Board of Equalization believes the use of third-party warehouses to store finished property creates nexus for the non-California retailers. The SBE also believes that when the operator of the distribution center facilitates shipment of the product to the customer, the operator is acting as an agent for the seller. If the California distribution center pulls, packs, and ships the property to the retailer’s California customers and the operator is compensated for activity, the SBE will likely conclude that the retailer has nexus in California and that the non-resident retailer must collect tax on these sales. In this case, nexus is created at the first date that the retailer begins storing property in the California distribution center.
The Florida Legislature has clarified when it requires an out-of-state seller to collect Florida’s sales tax on the seller’s sales of products to customers within Florida. Florida statute Section 212.0596(2)(e) requires an out-of-state seller to collect Florida sales tax on “mail order sales” when: …
- (j) The dealer owns real property or tangible personal property that is physically in this state, except that a dealer whose only property (including property owned by an affiliate) in this state is located at the premises of a printer with which the vendor has contracted for printing, and is either a final printed product, or property which becomes a part of the final printed product, or property from which the printed product is produced, is not deemed to own such property for purposes of this paragraph;
Provision (j) above makes it perfectly clear that the ownership of property in Florida creates nexus for the owner of the property. Absent a case or ruling to the contrary (which I could find none) this statute is perfectly legal and constitutional. Retailers that own inventory located in a Florida warehouse or distribution center have nexus in Florida and are obligated to collect tax on taxable sales made to Florida customers.
Illinois Tax Code Section 105/2 (1) defines the phrase “Retailer maintaining a place of business in this State”, or any like term, means and includes any of the following retailers:
A retailer having or maintaining within this State, directly or by a subsidiary, an office, distribution house, sales house, warehouse or other place of business, or any agent or other representative operating within this State under the authority of the retailer or its subsidiary, irrespective of whether such place of business or agent or other representative is located here permanently or temporarily, or whether such retailer or subsidiary is licensed to do business in this State. …
The Illinois Supreme Court in Brown’s Furniture, 171 Ill. 2d at 424 held that the physical presence of an out-of-state vendor need not be substantial, but must be demonstrably more than a ‘slightest presence.’ The question, then, is whether a retailer owning inventory located in an Illinois distribution center exceeds the “slightest presence” test.
This question appears to have been answered in Chemed Corp., Inc. v. Dept. Rev., Ill. App. Ct. (1989) 186 IllApp3d 402 , 542 NE2d 492. In this case, an out-of-state retailer was engaged in the business of retail selling in Chicago for RTA (and municipal) retailers’ occupation tax purposes because it maintained an inventory in a public warehouse in Chicago and filled orders for Illinois customers from the warehouse. The Court held that the regulation providing that a retailer is engaged in business in the municipality where the property is located at the time of sale is a reasonable interpretation of the statute, and within the authority of the department to promulgate. The Court held that the RTA (and municipal) regulations were not unconstitutionally vague.
While this case applies to a locally administered and home rule sales tax, there is no reason to believe the Illinois courts would not apply this same standard to the general Illinois sales tax as they interpret Illinois Tax Code Section 105/2(1). As such, there is significant justification for non-Illinois retailers owning property located in Illinois distribution centers to be an Illinois retailer and subject to sales tax collection and remittance obligations.
Pennsylvania Tax Code Section 7201(b) defines the phrase “maintaining a place of business” in Pennsylvania to include the following:
- having, maintaining or using either directly or through a subsidiary, representative or agent, an office, distribution house, sales house, warehouse, service enterprise or other place of business regardless of whether the place of business, is permanently or temporarily in the state or is authorized to do business in the state;
- having or maintaining an agent of general or restricted authority or a representative in Pennsylvania, regardless of whether the person, agent or representative is located permanently or temporarily in the state; or whether the representative or agent is authorized to do business in the state;
- maintaining a stock of goods in the state;
Further, Pennsylvania Sales Tax Bulletin Number 2011-01, 12/1/2011 elaborates on this statute by outlining the following activities that the Pennsylvania Department of Revenue deems to create nexus with the state of Pennsylvania:
Examples of maintaining a place of business in the Commonwealth include, but are not limited to:
- (1) A remote seller storing its property or the property of a representative at a distribution or fulfillment center located within the Commonwealth, regardless if the center also stores property of third parties that is distributed from the same location.
- (2) A remote seller who has a contractual relationship with an entity or individual physically located in Pennsylvania whose website has a link that encourages purchasers to place orders with the remote sellers. The in-state entity or individual receives consideration for the contractual relationship with the remote seller.
- (3) A remote seller utilizing affiliates, agents and/or independent contractors located in Pennsylvania who will provide repair, delivery or other service relating to tangible personal property sold by the remote seller to Pennsylvania customers.
- (4) A remote seller’s affiliates, agents and/or independent contractors provide service(s) within the Commonwealth (including, but not limited to storage, delivery, marketing or soliciting sales) that benefit, support and/or complement the remote seller’s business activity.
- (5) A remote seller’s employee(s) regularly travel(s) to Pennsylvania for any purpose related to the remote seller’s business activity.
- (6) A remote seller who accepts orders that are directly shipped to Pennsylvania customers from a Pennsylvania facility which is operated by a remote seller’s affiliate, agent or independent contractor.
- (7) A remote seller who regularly solicits orders from Pennsylvania customers via the website of an entity or individual physically located in Pennsylvania, such as via click-through technology.
In House of Lloyd v Commonwealth of Pennsylvania (Commonwealth Court of Pennsylvania, 5/22/1997) the Court addressed several nexus creating activities that occurred in Pennsylvania which created a sales tax collection obligation for House of Lloyd. One of the means by which House of Lloyd created nexus in Pennsylvania was by maintaining ownership of “sample kits” that sales people used to showcase the types of property that could be purchased from House of Lloyd. The Court held that because the kits were under the control of the Taxpayer and ownership remained with the Taxpayer while the kits were in Pennsylvania, House of Lloyd was deemed to have ownership of property in the state and had nexus.
Pennsylvania Tax Code Section 7201 and Bulletin 2011-01 put retailers on notice as to the nexus creating activities adopted by the Pennsylvania legislature and the Pennsylvania Department of Revenue. Absent a published court ruling to the contrary (which there is none) these provisions are legal and will be enforced by the Pennsylvania Department of Revenue against any retailer who meets these standards. In short, non-resident retailers with property located in Pennsylvania distribution centers are deemed to be “maintaining a place of business” in Pennsylvania and have nexus with the state of Pennsylvania for sales tax purposes. .
In the case of House of Lloyd, the retailer created nexus in Pennsylvania in many different ways including the ownership of property in the state. While this case does not address property ownership in Pennsylvania as the only nexus creating activity, the Court’s holding clearly indicates that ownership and control of property in Pennsylvania can be a significant factor in concluding that a retailer has nexus in the state.
Texas Tax Code Section 151.107(a)(2) specifies that out-of-state sellers engaged in business in Texas and selling, leasing, or renting taxable items for storage, use, or other consumption in Texas must collect use tax from the purchaser. “Retailer engaged in business in this state” means any retailer:
- maintaining, occupying, or using, permanently or temporarily, directly or indirectly, or through a subsidiary, or agent, by whatever name called, a kiosk, an office, distribution center, sales or sample room or place, warehouse, storage place, or any other physical location where business is conducted
- having any representative, agent, salesperson, canvasser or solicitor operating in the state under the authority of the person or its subsidiary to sell, deliver or take orders for any taxable items…
Texas Tax Publication 94-108, 11/01/2006 discusses what the term “Engaged in Business” means with respect to the Texas sales and use tax. This publication makes the following statement:
A seller of taxable goods or services that engages in any of the following activities or with any of the following items in Texas is engaged in business and must collect sales or use tax on taxable goods or services sold, delivered, or provided in Texas.
- Physical location – This includes both permanent and temporary locations, whether operated by the retailer directly or by an agent. It may be an office, warehouse, distribution center, storage place, sales or sample room, or any other business location.
- Agent – A representative operating under the authority of the retailer for the purpose of selling, delivering, or taking orders for taxable goods or services.
- Texas franchisee or licensee who sells taxable goods or services.
- Trade show participant – An out-of-state seller that participates in a trade show for the purpose of soliciting or taking orders for taxable goods or services sold, shipped, or delivered in Texas.
- Delivery of taxable items to Texas customers via company vehicles (whether owned, leased, or rented).
- Deriving income from the rental or lease of equipment or other tangible personal property in Texas.
- Providing taxable services through company employees, authorized repair or service agents, or independent contractors.
- Using independent salespersons to make sales or take orders for taxable goods or services on behalf of an out-of-state seller.
The Texas provisions noted above clearly put retailers on notice as to the nexus creating activities espoused by the Texas legislature and the Texas Comptroller. The statute states that the act of storing property in Texas creates nexus. Absent a published court ruling to the contrary (which there is none) these provisions are legal and are being enforced by the Texas Comptroller against retailers meeting these tests. In short, non-resident retailers with property located in Texas distribution centers are deemed to be “engaged in business” in Texas and have nexus with the state of Texas for sales tax purposes.
Many multistate retailers are waiting for a ruling from the U.S. Supreme Court stating, in no uncertain terms, that owning property in a state creates sales tax nexus. Absent such as holding, these retailers simply cannot believe they have any obligation to collect and remit sales tax in states where they own property. Let me be the first to say that such a ruling has been issued and it’s called Quill. You may not like the answer or believe that the rule applies to your particular business. You are free to hold this belief and to move forward on this belief. However, if your business gets audited by one of the listed states or by any state with a similar nexus rule, your business could be bankrupted by the tax, interest, and penalties assessed by the state. In states that have owner/officer liability rules, these liabilities can also attach to your personal assets.
The material provided above is the law; it is not just a suggestion of what the states want retailers to do or a recommendation by the state legislatures or departments of revenue. If these statues and rules were unconstitutional, they would have been removed from the books years ago. These are the rules, they are constitutional, and the states expect you to follow them. You can be sure that the states will be using these very same rules against you on audit.