United States: Nexus, The Threshold Requirement For State Taxation Of Multi-State Businesses

Both the due process clause and the commerce clause of the United States Constitution limit the state’s power to impose sales taxes or a use tax collection obligation on an out-of-state vendor, including an internet vendor. Both of these constitutional limitations come into play, in the main, when dealing with interstate sale transactions, and limit a state’s ability to impose a sales tax or use tax collection duty on an interstate sale transaction.

2. The Due Process Clause – Actual Physical Presence Not Needed.

Section 1 of the Fourteen Amendment to the United States Constitution provides that … "[n]o State shall … deprive any person of life, liberty or property, without due process of law." The due process clause "requires some definite link, some minimum connection between a state and the person, property or transaction it seeks to tax". Miller Brothers Co. v. Maryland , 74 S. Ct. 535, 539 (1954). This "definite link", or "minimum connection" is referred to generally as "nexus". The focus of most cases in this area has been to determine what set of factual circumstances satisfies the requirement of that "definite link" or "minimum connection."

The due process clause applies not just to tax cases, but to other situations, as well, and particularly the question of when a state has personal jurisdiction over an out-of- state defendant for purposes of maintaining a suit in that state. One of the leading due process clause cases arose in this context. In International Shoe Co. v. Washington, 66 S. Ct. 154 (1945), the United States Supreme Court dealt with the question of what contact an out-of-state defendant needed with the state for purposes of the states’ asserting personal jurisdiction over that out-of-state defendant. The inquiry as framed by the Supreme Court is whether the defendant had minimum contacts with the jurisdiction "such that the maintenance of the suit does not offend traditional notions of fair play and substantial justice". The test dealing with personal jurisdiction has evolved from requiring the defendant to have a "presence" in the foreign state to a more flexible test of whether a person’s contacts with the foreign state make it reasonable to require it to defend a suit there. See State and Local Taxation Second Edition, Vol. 1, Pomp and Oldman, page 299.

When it comes to taxation, "the controlling question is whether the state has given anything for which it can ask in return". Wisconsin v. J. C. Penney Co., 61 S. Ct. 246 (1940).

In Quill v. North Dakota, 112 S. Ct. 1904 (1992), the United States Supreme Court was faced with an out-of-state mail order retailer making mail order sales into North Dakota, and the obligation of the out-of-state retailer to collect the destination state’s use tax. North Dakota imposed that use tax collection obligation on Quill and Quill challenged the state on both due process and commerce clause grounds. On the due process side, the Supreme Court essentially applied its approach to personal jurisdiction cases to the use tax collection obligation. The Court stated "if a foreign corporation purposely avails itself of the benefits of an economic market in the foreign State, it may subject itself to the State’s personal jurisdiction even if it has no physical presence in the State." Id. at 307. The Court further stated that "it is an escapable fact of modern commercial life that a substantial amount of business is transacted solely by mail and wire communication across the state lines, thus obviating the need for physical presence within a State in which business is conducted." Id. at 308, quoting Burger King Corp. v. Rudzewicz, 471 U.S. 462, 476 (1985). The Court then went on to conclude that "[c]omparable reasoning justifies the imposition of the collection duty on a mail-order house that is engaged in continuous and widespread solicitation of business within a State." Id. at 308.

In so holding, the United States Supreme Court concluded that actual physical presence in a state was not necessary to satisfy due process clause concerns. Rather, the economic exploitation of the market state, by an out-of-state retailer, is sufficient. Thus, under the due process clause alone, an out-of-state mail-order retailer with no physical presence in the destination state, would be required to collect that destination state’s use tax, as long as it was "engaged in continuous and widespread solicitation of business within" that state.

As will be noted, the Quill court concluded, though, that physical presence, and something more than the "slightest physical presence", is still needed to satisfy the nexus concerns of the commerce clause. As a result, the nexus focus for tax cases is now on the commerce clause.

Cl. 3, section 8, article 1 of the United States Constitution provides that "the Congress shall have the power … to regulate Commerce with foreign Nations, and among the several States, and with the Indian Tribes." The commerce clause focus or concern is on the effects of state regulation on the national economy. The power to regulate commerce between and among the states, was left with the Congress, and not with the individual states. While the commerce clause does not, by its own wording, expressly protect interstate commerce, the United States Supreme Court has held that the commerce clause "by its own force prohibits certain state actions that interfere with interstate commerce." Quill at 1911, citing South Carolina State Highway Dept. v. Barnwell Brothers, Inc., 58 S. Ct. 510 (1938). This facet of the commerce clause is called the "negative" or the "dormant" commerce clause.

The dormant commerce clause has evolved over the years. There have been three significant tests or evolutions:

(a) No tax on interstate commerce. The initial interpretation of the dormant commerce clause was that no state has the right to lay a tax on interstate commerce in any form. Leloup v. Port of Mobile, 8 S. Ct. 1380 (1988); Brown v. Maryland, 12 Wheat. 419, 6 L. Ed. 678 (1827).

(b) No direct tax on interstate commerce. The flat prohibition against a tax in any form on interstate commerce was liberalized and evolved into the interpretation that no state has the right to lay a direct tax on interstate commerce. Spector Motor Service v. O’Connor, 340 U.S. 602 (1951); Freeman v. Hewit, 67 S. Ct. 274 (1947). This distinction between a direct tax on interstate commerce and a prohibition on a tax in any form allowed an indirect tax such as a franchise tax on interstate state.

(c) States have the right to tax interstate commerce if four prong test is met. The most recent evolution of the commerce clause is found in Complete Auto Transit, Inc. v. Brady, 97 S. Ct. 1076 (1977). In that case, the Supreme Court specifically overruled Spector Motor Service, and held that all states have the right to lay a tax on interstate commerce so long as the tax:

1. is applied to an activity with a substantial nexus with the taxing state,
2. is fairly apportioned,
3. does not discriminate against interstate commerce, and
4. is fairly related to the services provided by the state.

This four prong test is generally referred to as the Complete Auto test.

In Goldberg v. Sweet , 488 U.S. 252, 109 S. Ct. 582 (1989), the United States Supreme Court applied the four prong Complete Auto test to Illinois’ imposition of a sales tax on interstate phone calls. The court went through each prong, analyzed it in view of the interstate telecommunications tax in question, and concluded that the Illinois tax, under the four prong test of Complete Auto, did not violate the commerce clause. Goldberg is one of the more recent and substantial cases dealing with the application of the four part Complete Auto test.

The first prong of the Complete Auto test requires "substantial nexus" between the taxing state and the activity being taxed. That substantial nexus test must be satisfied before a tax will be found not to violate the dormant commerce clause. Following is the case law development of that "substantial nexus" test in the mail-order retailer and use tax collection context.

(a) National Bellas Hess – Physical Presence Required.

In National Bellas Hess, Inc. v. Department of Revenue, 386 U.S. 753, 87 S. Ct. 1389 (1967), the United States Supreme Court was faced with the issue of what constituted sufficient nexus for a destination state to require an out-of-state mail-order vendor to collect it use tax on mail-order sales made into the state. National Belles Hess was a mail-order company with no offices, warehouses or distribution centers in Illinois. It had no employees, salesmen or agents in the state, either. Neither did National Bellas Hess have any tangible personal property or real property located in the state. It had no telephone listing in Illinois and did not advertise its products on Illinois television, radio, billboards, or in Illinois newspapers. The only contact National Bellas Hess had with Illinois were its mailings of catalogs in advertising flyers into the state through the U.S. mail common carrier.

Illinois imposed the use tax collection duty on National Bellas Hess for its Illinois mail-order sales. National Bellas Hess challenged that tax under both the due process and commerce clauses, focusing on the nexus requirement. The Supreme Court relied on the commerce clause and held:

386 U.S. at 759.

With that as background, the court established a bright line, physical presence test:

386 U.S. at 758.

The National Bellas Hess rule is quite simply that the commerce clause prohibits states from imposing the use tax collection duty on an out-of state mail-order retailer that does not have any physical presence in the state.

(b) The Quill Case – Upholds National Bellas Hess On The Common Clause Analysis.

Quill Corp. v. North Dakota, 504 U.S. 98, 112 S. Ct. 1904 (1992) was a re-run of National Bellas Hess. The facts were essentially the same and both involved mail-order retailers with no physical presence in the destination state, making mail-order sales into that state.

In Quill, North Dakota imposed its use tax collection duty on Quill, an out-of-state mail-order of office products. The North Dakota Supreme Court upheld the use tax collection obligation and the U.S. Supreme Court granted certiorari (took review). Both the due process and commerce clauses were at issue in Quill as they were in National Bellas Hess. The Quill court distinguished the two clauses, recognizing the distinctions between the two.

For due process clause purposes, the court referred to Miller Brothers and reaffirmed that the due process clause requires a definite link or minimum connection between the state and the person it seeks to tax. However, the court observed that its due process analysis in the area of personal jurisdiction had evolved over the recent years and that formalistic tests focusing on a defendant’s physical presence in the state had been relaxed in favor of a broader analysis of all of the defendants contacts with the state to determine whether jurisdiction was reasonable under the circumstances. The court held that under the evolution of the due process clause, physical presence was not necessary in order to satisfy the due process nexus requirement:

112 S. Ct. at 1911.

On the commerce clause side, the court reaffirmed the four part test of Complete Auto, and that that test continues to govern the validity of a state’s ability to tax interstate commerce under the commerce clause.

As previously noted, the first prong of the Complete Auto test is that there be substantial nexus between the activity being taxed and the state. The United States Supreme Court recognized that an out-of-state seller, such as Quill, could satisfy the much lower standard of the due process clause of "minimum contacts", without also satisfying the more rigorous test of the commerce clause of "substantial nexus." The court then reaffirmed the physical presence test for the commerce clause:

112 S. Ct. at 1916.

It should be noted that the Supreme Court commented that there is no constitutional bar to congressional legislation in this area, since the commerce clause relegates to Congress the power to regulate interstate commerce. Thus, Congress could pass legislation establishing a lower threshold for use tax collection than physical presence. Such congressional legislation has been introduced over the past several years, but there has been no real agreement between the mail-order industry and states over the particulars of such a congressional test. At this juncture, such legislation has not been passed.

The focus or inquiry of the cases since Quill, is how much physical presence in a state is required for "substantial nexus", and use tax collection. There are two schools of thought on this question.

"Any Physical Presence". The first view is that "any" physical presence in the state, that does not constitute a de minimis connection is sufficient for "substantial nexus". Quill’s reference to the bright- line test as creating "a safe harbor for vendors’ whose only connection with customers in the State is by common carrier or the United States mail" (112 S. Ct. at 1914) is the basis of this view; the converse of such a statement is that any physical presence in the state would be sufficient.

"More Than Slightest Physical Presence". The other, and the author believes the better view, is that "substantial nexus" requires some type of ongoing physical presence in the state, which is more than the "slightest physical presence." Quill rejected the "slightest physical presence" standard in National Geographic Society v. California Board of Equalization, 430 U.S. 551 97 S. Ct. 138 (1977). If the "slightest presence" standard was rejected by Quill, doesn’t physical presence require something more than "slightest physical presence". This view is also supported by the language in Quill that "whether or not a state may compel a vendor to collect a sales or use tax may turn on the presence in the taxing state of a small sales force, plant or office". 112 S. Ct. at 1914. Wouldn’t this language mean that physical presence requires a plant, office, or a small sales force (perhaps one individual) present in the state. It should. And, as previously mentioned, the post Quill litigation, for the most part, involves the interpretation and application of the physical presence test, essentially, how much physical presence in the state is required before the "substantial nexus" requirement of the commerce clause is satisfied.

In fact, the court in Quill noted that "although title to a few floppy diskettes present in a state might constitute some minimal nexus, in National Geographic Society v. California Board of Equalization [citation omitted] we expressly rejected the slightest presence standard of constitutional nexus." Quill at footnote 8. So, the in-state presence of computer disks, and perhaps even other types of de minimis property and equipment, would not satisfy the substantial nexus test under Quill. This interpretation was applied by the Arizona State Board of Tax Appeals in Care Computer Systems, Inc. v. Arizona Department of Revenue, Ariz. Board of Tax Appeals 1995 Ariz. Tax LEXIS 24 (1995), affirmed by the Arizona Tax Court. After citing Quill’s commentary that the mere licensing of software and the presence of diskettes in the state did not establish substantial nexus, the Arizona Board of Tax Appeals also noted that Arizona case law held that the presence of a full time salesman in Arizona was insufficient to create taxable presence, at least for city privilege license tax purposes, citing Phoenix v. West Publishing Co., 148 Ariz. 31 (1985), cert. denied 477 U.S. 909 (1986). While Care did have software and some computers in the state, and a travelling salesman (not based in Arizona), the Board considered presence of the computer equipment and software was not substantial nexus under Quill.

The first prong of the Complete Auto test requires that the tax be applied to an activity with a substantial nexus with the taxing state. This language suggests that the activity sought to be taxed must have the substantial nexus with the taxing state.

Use Tax – Indirect Relationship is "O.K." However, just a month after the Complete Auto decision, the United States Supreme Court issued its decision in National Geographic, supra. Complete Auto involved a sales tax, while National Geographic involved a use tax collection duty. The United States Supreme Court distinguished a use tax from a direct sales tax and concluded that although disassociation between the activity within the state and the activity sought to be taxed is fatal to a direct, sales tax it is not an impediment to the imposition of the use tax collection duty. National Geographic involved California’s imposition of the use tax collection duty on National Geographic’s subscription sales to California residents. California based this duty on the existence in California of two National Geographic sales offices for advertising solicitation. Those advertising sales offices were disassociated from the subscription activities of National Geographic. The Supreme Court concluded, though, that the presence in the state of a physical activity disassociated from the sales sought to be taxed, is sufficient substantial nexus for the imposition of the use tax collection duty.

Sales Tax – Direct Relationship is Needed. The Supreme Court in Norton Co. v. Department of Revenue, 340 U.S. 534 (1951) held that for sales tax purposes, the particular transaction to be taxed must be associated with the taxpayer’s in-state activity, and if it is not, that is fatal to a direct tax on the particular transaction. It should be noted, though, that Norton was decided in the same year that Spector Motor Service laid out the interpretation of the dormant commerce clause that no state has the right to lay a direct tax on interstate commerce. It should also be noted that Quill made no distinction between a sales and a use tax in this area and we might well expect states to test the distinction between the sales and use tax as laid out in National Geographic and Norton, with the states arguing that there should be no distinction between the two, and for sales tax purposes, the transaction sought to be taxed can be disassociated from the taxpayer’s in-state physical presence.

This portion of the paper will provide an overview of the various United States Supreme Court and state court cases dealing with the use tax collection duty, and particularly the type of in-state physical presence needed to satisfy the substantial nexus requirement.

(a) Travelling salesmen not sufficient for the imposition of the sales tax. McCloud v. J.E. Dilworth Co., 322 U.S. 327, 64 S. Ct. 1023 (1944). Dilworth involved Tennessee businesses that sold goods into Arkansas. Arkansas attempted to impose its sales tax on these sales. The sellers had no place of business, employees or property in Arkansas. The sellers’ only contact with Arkansas was the solicitation of orders by travelling salesmen who resided in Arkansas, with some orders being taken over the telephone or by mail. The orders were accepted in Tennessee, not in Arkansas; the goods were shipped from Tennessee and title passed to the purchaser in Tennessee upon delivery to the carrier. Arkansas attempted to impose its sales tax on those sales. It should be noted that from a sales law standpoint, most of the indicia of the sale took place in Tennessee, with the order being accepted in Tennessee and delivery and title passing in Tennessee. Nevertheless, Arkansas imposed the sales tax and Dilworth objected on commerce clause grounds. The United States Supreme Court, in a narrow 5 to 4 decision, struck down the Arkansas sales tax on the transactions:

322 U.S. at 330.

Arkansas argued that it could have levied a use tax on the Arkansas buyers and if it could impose such a use tax, it should be able to impose a sales tax directly on the seller. The Supreme Court made a crucial distinction that it was the Arkansas sales tax at issue and not the use tax:

322 U.S. at 331.

(b) Travelling salesmen are sufficient for use tax collection. General Trading Co. v. State Tax Commission, 322 U.S. 335, 64 S. Ct. 1028 (1944). General Trading Co. was a companion case to Dilworth. In General Trading, Iowa imposed its use tax collection duty on a Minnesota based vendor. General Trading had no place of business, employees or property in Iowa. All of its products were sold by travelling salesmen. The salesmen did not have the power to accept the orders; rather those orders were transmitted to the home office where they were accepted and processed. The key distinction between Dilworth and General Trading was that while Arkansas attempted to impose its sales tax in Dilworth, Iowa attempted to impose its use tax on General Trading.

The Supreme Court concluded that the presence of the travelling salesmen was sufficient physical presence in the state for the use tax collection duty to be imposed:

322 U.S. at 338 (emphasis added).

The decision was a 7 to 2 decision, with the dissent observing that Iowa could not have imposed its sales tax on the sales in question but that "we are holding that a state has power to make a tax collector of whom it has no power to tax." 322 U.S. at 399.

The Dilworth – General Trading distinction still survives – travelling salesmen in a state will not be sufficient for the state to impose its sales tax but is sufficient for the use tax collection duty.

(c) Employees In-State. Full or part time employees living and working in the state is sufficient nexus, for use tax collection. See General Trading, supra. (travelling salesmen were employees). See also Scripto, Inc. v. Carson¸ 362 U.S. 207, (1960) and Tyler Pipe Industries, Inc. v. Washington Department of Revenue, 483 U.S. 232 (1987).

(d) Delivery into the state by the out -of-state retailer. In Miller Brothers Co. v. Maryland, 347 U.S. 340, 794 S. Ct. 535 (1954), a department store based in Delaware, sold goods to Maryland residents that came into the Miller Brothers store in Delaware. When Maryland residents made their purchases, some took the goods with them, other items were delivered to the Maryland purchasers by common carrier and others by the store’s own delivery trucks. Maryland sought to impose the use tax collection duty on Miller Brothers on the basis that Miller Brothers made delivery of goods into Maryland by its own vehicles, that Miller Brothers advertising reached Maryland residents (it was not aimed at Maryland residents but Delaware radio stations were also heard in Maryland), and sales that circulars were mailed to Maryland customers.

The Supreme Court set out the now familiar test that "due process requires some definite link, some minimum connection, between a state and the person, property or transaction it seeks to tax." 347 U.S. at 344-345. The court concluded that such link or connection did not exist between Maryland and Miller Brothers, contrasting the Miller Brothers facts with those in General Trading:

"There is a wide gulf between this type of active and aggressive operation within a taxing state [the in-state travelling salesmen in General Trading] and the occasional delivery of goods by an out-of-state store with no solicitation other than the incidental effects of ge neral advertising."

347 U. S. at 347.

It should be noted that Miller Brothers was decided under the due process clause, with the commerce clause not considered.

But see Brown’s Furniture Inc. v. Wagner, 171 Il. 2d 410, 665 N.E. 2d 795 (1996). Brown’s Furniture is a retail furniture store located in Palmyra, Missouri and made sales of furniture to Illinois customers, delivering the furniture into Illinois. Palmyra, Missouri is located approximately 15 miles southwest of Quincy, Illinois. Illinois residents frequently patronized Brown’s Furniture and their purchases comprised approximately 30% of the store’s total sales. On a regular basis, Brown’s Furniture delivered items purchased by Illinois residents into Illinois in its own trucks. During the ten month audit period at issue in the case, Brown’s Furniture made 942 deliveries of its merchandise, valued at more than $675,000, into Illinois. Brown’s Furniture collected neither Illinois nor Missouri sales tax on these sales. The Illinois Supreme Court, on these facts, concluded that the number of trips in the ten month period satisfied the more than "slightest physical presence" test of Quill, and upheld Illinois’ use tax collection obligation on Brown’s Furniture. The Illinois Supreme Court factually distinguished Miller Brothers based on the magnitude and frequency of deliveries made by Brown’s Furniture on the one hand and the occasional delivery of goods by Miller Brothers, on the other hand.

(e) Presence of independent contractors in the state are sufficient. Scripto, Inc. v. Carson, 362 U.S. 207, 80 S. Ct. 619 (1960). Scripto is a Georgia corporation and Florida sought to require Scripto to collect the use tax on pens which Scripto sold and shipped from Atlanta to Florida residents. The facts were essentially the same as those in Dilworth and General Trading, except that Scripto’s travelling salesmen were not employees, but were independent contractors. The Supreme Court held that did not make a difference, and the presence of independent contractors in the state is sufficient nexus for the imposition of the use tax collection duty:

362 U.S. at 211.

It does not matter if the independent contractors also represent other principals.

(f) In-state volunteers generally do not create nexus. Pledger v. Troll Book Clubs, Inc., 871 S.W. 2d 389 (1994); Troll Book Clubs, Inc. v. Tracy, Ohio BTA, Case No. 92-J-590, 1994 Ohio Tax LEXIS 1374 (August 1994); Freedom Industries, Inc. v. Tracy, Ohio BTA Case No. 92-N-597, 1994 Ohio Tax LEXIS 2025 (December 12, 1994). Scholastic Book Clubs, Inc. v. State Board of Equalization, 207 Cal. App. 3 rd 734 (1989) (in-state volunteers do create sufficient nexus). These are all teacher/book club cases. Book clubs normally will have teachers sell books to school children, with the teachers being volunteers and not being paid employees or independent contractors. All of the cases, except the California case, have held that as long as the teachers are not agents of the out-of-state book club, then there is not sufficient nexus. If on the other hand, the teacher is characterized as an agent of that out-of-state book club or retailer, then there will be sufficient nexus. So, in the context of these cases, the holding turns on whether the in-state volunteer is an agent or not.

(g) In-state visits by employees of out -of-state retailer.

In the matter of Orvis Co., Inc. v. Tax Appeals Tribunal of N.Y., 654 N.E. 2d 954 (1995). Orvis was based out-of-state and employees visited up to 19 New York wholesale customers on the average of four times a year. The Court of Appeals found that to be sufficient nexus.

Vermont Information Processing, Inc. v. Tax Appeals Tribunal of N.Y., 654 N.E. 2d 954 (1995). VIP employees visited New York customers some 41 times in three years to resolve computer hardware and software problems. The Court of Appeals held this to be sufficient nexus.

Care Computer Systems, Inc. v. Arizona Department of Revenue, supra. Twenty-one visits per year by out-of-state training personnel and an out-of-state travelling salesman. The Arizona Board of Tax Appeals held this not to be sufficient nexus.

(h) Attendance at conventions and trade shows not sufficient nexus. Florida Department of Revenue v. Share International, Inc., 1995 FL App. LEXIS 8839 (August 21, 1995). The presence at an in-state convention or trade show does not provide sufficient nexus for use tax collection on mail-order sales into the state. However, any sales made at the trade show were subject to Florida’s sales tax.

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