Tax Law Blog

When Will a Company's Website Create Nexus with a State for Sales Tax Purposes Post-Wayfair?

This is the fifth in a series of articles written for MICPA members examining the far-reaching impact of the Supreme Court’s decision in South Dakota v. Wayfair, Inc.

The Supreme Court’s decision in Wayfair has shifted our understanding of when a state can tax out-of-state companies. Recall that courts use two constitutional standards when considering whether a state can tax an out-of-state company: the Due Process Clause and the Commerce Clause. 

Prior to Wayfair, the Commerce Clause requirement could only be satisfied if a retailer had a physical presence in a state. If a retailer met the physical presence requirement, it almost certainly met the lower standard of minimum contacts set by the Due Process Clause. As a result, courts tended to focus heavily on the Commerce Clause and relatively little on due process.

Now, with the physical presence requirement eliminated, the Due Process Clause will be increasingly important. Companies that maintain a website and sell to out-of-state residents must now consider whether those states impose a sales tax obligation on an ongoing basis. 

Due process focuses on whether a company has a minimum connection to the state. A company that purposefully avails itself of a state's markets by directing its actions toward the state’s residents creates a sufficient connection with the state to be burdened by the state's laws, including those imposing taxes.

Prior to the rise of the internet, it was a relatively straightforward analysis for a court to find that an out-of-state retailer sending mail order catalogues or making telephone sales calls was actively targeting state residents.[i] The company selected specific residents of a state by their physical address or home telephone number, and solicited sales from them.

This analysis is complicated by websites. Does a company purposefully direct its actions towards the customer’s state by allowing the customer to place an order? Courts have recently begun to wrestle with this question, and with Wayfairrenewing the importance of due process, we expect to see more disputes in this area.

The Zippo Scale and the Interactivity of Websites

Courts commonly use the “Zippo Scale” developed in a 1997 case to determine if a website has targeted a specific jurisdiction.[ii] The Zippo Scale measures the interactivity of a website and places it on a spectrum between active and passive.

An active website conducts business over the internet and purposefully directs commercial activity towards the state. A passive website simply posts information that is accessible to users anywhere and does not give rise to jurisdiction. In the middle of the scale are an infinite variety of interactive websites that are semi-active and semi-passive, where users and the company may exchange information.

The renewed importance of due process may mean that courts will have to decide how much interactivity is allowed before a company is purposefully availing itself of a state's markets.

Courts' application of the Zippo Scale is not always easy to predict or understand. For instance, a decision in Michigan's Western District found that a distillery's website was at the "extreme" active end of the Zippo sliding-scale because it was interactive in requiring visitors to confirm that they were over 21 (as not required by law but strongly recommended by FTC to prevent advertising to underage kids) and it contained a link that sent users directly to a checkout cart on a third-party distributor’s website. [iii] The checkout process included a dropdown box with “MI” as an option for shipment. The court reasoned that the ability to select Michigan on the third party's linked website signified that the retailer was purposefully directing business to Michigan residents.

Similarly, the Sixth Circuit Court of Appeals addressed the interactivity issue in Neogen, a case that involved a company that developed diagnostic test kits.[iv] The company, NGS, allowed customers to send in blood samples that NGS would test and then send the customer the results. NGS allowed customers to print off blood-collection forms, mail them to NGS and pay via check. After the test, NGS would send a password to the customer, allowing them to access the results on the website.

The Court determined that the website “primarily consist[ed] of passively posted information;” however, the website enabled customers from Michigan to use NGS’s services. Importantly, the website stated that any parent from any state could submit samples for testing, and the site also contained a chart showing data collected from Michigan residents. This was interactive enough for the Court to find that NGS was “hold[ing] itself out as welcoming [to] Michigan business.”[v]

As a result, the state could properly exercise jurisdiction over the Pittsburgh-based NGS. The court's focus on "welcoming" business from a state is somewhat surprising given the conceptual difference between "welcoming" business and "purposefully directing" efforts there.

In contrast, the Seventh Circuit has criticized the Zippo interactivity test, stating that "the interactivity of a website is [ ] a poor proxy for adequate in-state contacts.”[vi]

In one case, the court refused to find that a company had sufficient connection to the state when the company maintained an email list that included some residents of the state and had shipped a small number of goods to them. Because anyone can access an interactive website, any plaintiff could sue anywhere. Holding that an interactive website grants jurisdiction to every state would “offend the traditional notions of fair play and substantial justice”[vii] – touchstones of due process.

It is tempting to think that a very small or large volume of sales to a state might prove purposeful availment, and it may be true that volume is important. There is no doubt that Wayfair and the other plaintiffs in the Wayfair case conducted significant business in South Dakota.

However, courts have not treated sales volume consistently. Circuits do generally agree that a company must make at least one sale in the state for the state to validly tax the company under the Due Process Clause.[viii] But, in at least one case, two sales were sufficient to create Due Process nexus with a state jurisdiction.[ix]

This disagreement among the many circuit courts offers a trap for the unwary. The same website for a Michigan business, accessible by residents of Ohio and Indiana alike, may give rise to obligations to Ohio but not to Indiana. Given the fact that most websites are interactive to some degree, companies with websites and sales into multiple states must consider whether the site causes due process nexus.

Although many companies are concerned about website interactivity, several other factors may cause Due Process nexus. The next article will take a look at these additional due process factors.

Categories: Sales Tax, Tax