Tax Issues for Arizona Retailers and Taxpayers

In the summer of 2018, the U.S. Supreme Court officially recognized our country’s significant shift from local to online sales of goods by overruling the longstanding precedent that previously prevented state and local governments from imposing sales taxes unless a seller had a physical connection or “nexus” with the state. While earlier decisions had determined that physical presence was not required to establish minimum contacts required by the Due Process Clause of the U.S. Constitution (see Quill Corporation v. North Dakota), in South Dakota v. Wayfair, Inc., the Court determined that a seller’s economic presence within that state rather than just its physical presence was a sufficient connection or nexus to allow taxation, as long as the taxing scheme otherwise satisfies the requirements of the Commerce Clause of the United States Constitution. The question for the Court was whether physical presence was the only way in which a state could satisfy the requirement that, “a state tax must be applied [only] to an activity with a substantial nexus with the taxing state.” (Complete Auto Transit v. Brady).

The Court considered South Dakota’s new statute that conditioned taxation on a remote seller reaching defined sale benchmarks of either: (i) One hundred thousand dollars or more in sales, or (ii) Two hundred transactions for the delivery of taxable goods or services. The state’s objective was to level the playing field between brick-and-mortar stores and online sellers. Under prior law, local merchants competed with difficulty with online sellers because of the cost of physical facilities, sales that were always taxable and compliance audits, while on-line sellers did not pay or report tax unless they had a physical location in the state.

The Court recognized that customers who purchase products provided by their online sellers enjoy the benefits provided by their state governments. Consequently, online sellers have a direct economic relationship to the services provided by their respective customers’ states of residence. In Wayfair, the Court decided that the “physical presence” standard, “must give way to the far-reaching systemic and structural changes in the economy and many other societal dimensions caused by the Cyber Age … The Internet’s prevalence and power have changed the dynamics of the national economy.”

The Court listed the several characteristics of the South Dakota statute that ensured its compliance with the Commerce Clause of the U.S. Constitution, including:

1. A safe harbor for small sellers,
2. Prospective application of the statute,
3. Single state-level tax administration,
4. Uniform definitions of products and services,
5. Simplified tax rate structures, and
6. Uniform rules.

Since Wayfair, all states must conform their sales tax statutes to the new standards. Arizona had two challenges in meeting this mandate. Firstly, Arizona has a complex transaction privilege tax system with 16 different tax classifications with separate definitions, rates and exemptions. Secondly, Arizona allows each municipality to adopt its own version of a model tax code, so no city code matches the state statutes.

Arizona law now taxes both remote (online) sellers and large online “marketplace facilitators” that provide a sales platform to multiple individual online sellers, all with standards intended to comply with Wayfair. Remote sellers with sales of more than $200,000 in 2019, $150,000 in 2020 and $100,000 for all years thereafter must report their sales and pay tax. Marketplace facilitators must report and pay tax if sales exceed $100,000 in any year. A remote seller reaching the threshold must commence reporting and paying tax on the first day of the month after that event. If sales volume decreases, the remote seller can discontinue reporting and tax payment after being below the threshold for one year.

The new Arizona law now governs all retail sales transactions in this state, subject to a few necessary exemptions for select items like food sales and college textbooks, which municipalities can still independently tax. Otherwise, Arizona law preempts separate city regulation of retail sales. Municipalities must tax marketplace sellers at the same rate as local retailers, but can vary the rate for both.

As with any major legislation with nationwide attention and controversial impact, legal challenges can be expected. We should learn in the next few years how Arizona’s transaction privilege tax reform will hold up.

Otto S. Shill III is an attorney with Jennings, Strouss & Salmon, P.L.C. For more than 30 years, he has helped businesses, business owners and individuals comply with tax and other government regulations, navigate government investigations, and build wealth through business transactions and longterm business and estate planning.