States Struggle to Collect Taxes from Online Retailers

E-newsletter Issue #68/March 31, 2011

By 2014, Internet sales are estimated to reach almost $250 billion a year, says Forrester Research. And for some of the Internet’s largest retailers, many of those sales take place without the customer paying state sales taxes. That’s a big chunk of revenue states are trying to figure out how to capture with, so far, little success.

As state budget crises have deepened, many policymakers have looked toward enacting so-called “Amazon laws,” named after the Internet’s retail giant. While states already have well-established rules regarding tax collection for bricks-and-mortar stores, online-only retailers have proved to be a trickier nut to crack.

The legal question comes down to how states can prove a retailer has a nexus, or a physical presence inside a state, which would allow the state to require the retailer to collect a use tax on the items sold. Recently, policymakers have focused on an online retailer’s use of affiliates—or people living within a state who link to the retailer’s website and earn a percentage of the sales—as proof of the company’s business presence.

“When you buy on the Internet, you still do owe a tax,” said Richard Pomp, the Alva P. Loiselle Professor of Law at the University of Connecticut. “The question is, can states enforce it? If you don’t get the vendor to collect, you can’t really depend upon people to voluntarily pay that. … A lot of money could be gathered if you can do it. The question is, how do you do it?”

The affiliate tactic appears to be failing for states. On March 10, Illinois Gov. Pat Quinn signed a bill into law requiring Internet companies to collect taxes if they have affiliates in the state. On March 11, Amazon and both announced they were ending their affiliate program in the state. Amazon also ended affiliate programs in Colorado, North Carolina and Rhode Island under similar circumstances.

In a slightly different case, Amazon shuttered a distribution center in Texas due to an unresolved dispute after the state comptroller sent the retailing giant a tax bill for $269 billion in what it claimed were uncollected sales taxes.

“Amazon is playing hardball with the states,” Pomp said. “If you push hard and get nothing back and Amazon severs its associate’s program, it’s not clear at all what you have gained.”

Pomp said states have two options. One, they can be aggressive in court fighting online-only retailers who refuse to pay state sales taxes. He said some states are doing that, but it’s unclear what the result will be. The second option is try to get Congress to pass federal regulations requiring online retailers to collect state sales tax, but he said it is highly unlikely that would happen.

“The problem with that is it’s not very attractive to Congress,” he said. “What it would mean is Congress would pass a law, everybody would get pissed at Congress and the money would go to the states. … Certainly in the short term, it would cause a lot of political flack.”

Pomp said he eventually sees this problem going away with all but the largest online-only retailers. Many retailers already have brick-and-mortar stores in states, he said. As they try to create a seamless Web impression for customers—such as buy an item from the Internet and pick it up in a store—they will eventually begin collecting sales taxes as it becomes more likely a court would find proof of the critical nexus, or presence, for the business.

“Here’s the way the world looks for one of these hybrids (online and brick-and-mortar stores),” Pomp said. “If we don’t collect and the state litigates and we lose, we’re going to have to pony up from our own pocket. If we go ahead and collect, we’re at least covered. Unless they see a dramatic falloff in sales, I think they’ll go ahead—although the law is gray—and collect.”

Hear more of Pomp’s thoughts about what states can do in these challenging fiscal times in The Council of State Government’s Growth & Prosperity Virtual Summit of the States 2.0. He will be speaking along with Sen. Daniel DaPonte, chair of the Committee on Finance in Rhode Island, at a 1 p.m. EDT webinar on Thursday, April 14, called “Challenges to State Revenue Structures & Responses to Revenue Reductions.”

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