The impact of the U.S. Supreme Court’s decision in South Dakota v. Wayfair, now over a year since it was handed down, continues to reverberate throughout the business world. As the year wears on, it’s clear the decision carries implications for industries beyond retail and, indeed, for the very basic functions of any business with multi-state operations. Not understanding these implications can have significant financial consequences—failure to collect sales taxes on remote sales can result in significant tax assessments for the seller.
Management, with their tax advisor’s guidance, should be assessing potential sales and use tax exposures in light of Wayfair. Management should also consider how the Wayfair decision affects some less-obvious areas of their organizations. Managing the fallout from Wayfair requires a holistic view of how your business’ areas of operation intersect with sales taxes, as well as other state taxes, such as income or franchise taxes. In other words, it requires understanding your total tax liability.
The business world continues to pull at the thread of the Wayfair decision, unraveling its implications from income tax obligations and M&A repercussions, to financial reporting changes and new marketplace facilitator tax laws. As with most matters concerning taxes, these issues seem straight-forward but can be very complex.
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Wayfair Sheds Light on Historical Noncompliance
In its June 21, 2018, decision, the U.S. Supreme Court replaced the physical presence nexus standard in favor of an economic one, thereby removing constitutional barriers to states’ lawful ability to collect sales and use taxes from out-of-state sellers. The Wayfair decision had a domino effect: States began adding or revising statutory language for remote sales/use tax collection, and several states introduced laws that automatically went into effect following the decision. As of the publication of this article, all but three states (Florida, Kansas and Missouri) have enacted an economic nexus rule, which makes collecting and remitting sales taxes a likely necessity: If you aren’t collecting sales tax, or aren’t collecting the proper amounts, you may be taking on significant financial risks.
In light of the Wayfair decision, it is appropriate for every management team to reassess its organization’s nexus, or connection, with each state where it ships or delivers sales. For many, this assessment may reveal a business already had state tax nexus, even before the Wayfair decision was issued, because they had an in-state physical presence. For example, software providers often offer onsite installation and training to accompany their product sales. If this is the case, the software seller most likely already had an in-state physical nexus because of the onsite installation service performed in the state. It is prudent for such sellers to quantify their historical exposures and consider mitigating historical liabilities through voluntary disclosure agreements (VDAs) before registering for sales taxes.
Wayfair Case Studies
If you are in the business of making retail sales of tangible property or taxable services, it is more likely than not that you will need to charge, collect and remit sales taxes. For businesses that have not been collecting sales/use taxes on their out-of-state transactions, their financial statements should reflect this liability and, if audited, there may be a significant cash outlay.
Case Study #1 – Physical Nexus with Inventory Held by Amazon
A small business was selling a popular holiday toy online. It would buy the toys in anticipation of its popularity, and contract with Amazon to fulfill online purchases. As such, Amazon was holding onto the business’s inventory in various states where Amazon operates. When one of the state’s Department of Revenue made an investigation of Amazon, Amazon disclosed to the state the names of the businesses storing items in its warehouses, which led to the discovery of this business. The company (unknowingly) had an in-state physical presence because Amazon held the company’s inventory in the state and, as such, was required to collect sales/use tax. Failure to charge, collect and remit sales taxes resulted in a tax liability with interest and penalty payments in the six-figure range. Without the resources to pay, the small business declared bankruptcy.
Case Study #2 – Economic Nexus of a Software as a Service (SaaS) Company
In another case, a SaaS company was collecting sales and use taxes only for sales made to in-state customers, even though it had customers located nationwide. When the organization’s owners decided to sell the entire business, the buyers discovered the company’s failure to collect taxes on remote sales during their due diligence process and determined that there would be a significant successor liability related to these uncollected taxes. Once the sales tax liability was discovered, the buyers sought a considerable purchase price reduction for the acquisition of the company. Ultimately, the parties agreed on a plan to remediate the exposure in non-filing states through participation in state Voluntary Disclosure Programs, including an escrow that would allow the buyer to resolve the unpaid sales tax issue occurring under the seller’s watch. The buyer then spent the next year working with its outside sales tax professionals to negotiate and finalize the terms of VDAs.
State Income Tax Obligations Triggered
The tax implications of Wayfair extend beyond sales and use taxes. The Supreme Court held that an activity is subject to a state’s power to tax when “the taxpayer [or collector] ‘avails itself of the substantial privilege of carrying on business’ in that jurisdiction.” As such, Wayfair lifts the constitutional barriers to states imposing state income/franchise tax filing obligations on remote sellers, too.
Many businesses have been anticipating states will pass laws that codify not only their entitlement to sales taxes, but state income taxes, too. However, from the state income tax perspective, this generally has not happened. Most states already have a general nexus provision in their statutes that allows them to levy income taxes to the fullest extent allowed under the U.S. Constitution.
As a next step, states will likely clarify and/or enforce their preexisting laws. Massachusetts, for example, issued a proposed regulation indicating that if a remote seller’s sales volume exceeds the state’s sales tax safe harbor threshold, barring Public Law 86-272 immunity, the company will have an income tax filing obligation, too.
Rather than proactively preparing to address any income tax exposure, many companies are delaying action until they receive a notification from state taxing authorities that says they need to file income tax returns. For obvious reasons, this isn’t the best way to manage potential tax exposure. To determine whether you may be required to pay state income taxes, first look at the composition of your sales. Are you selling tangible property or a service?
If you are selling tangible property, then you may still be protected under a 1959 federal statute, Public Law 86-272, which prevents states from levying income tax on out-of-state companies if their activities within the state are limited to soliciting orders for the sale of tangible personal property and if the orders are approved and filled from outside the state.
However, if you are selling a service or tangible property that is installed by a company employee or contractor, these sales, by definition, contain a service element, which precludes Public 86-272’s applicability, unless the unprotected activities are de minimus. Companies should also be aware of the possibility that while states may not seek to apply an economic nexus standard for sales and use taxes for periods prior to the June 2018 Wayfair decision, they may do so for other tax liabilities.
Financial Statement Obligations
Wayfair will also have an impact on financial accounting under GAAP, namely, Accounting Standards Codification (ASC) 450 for sales taxes and 740 for state income taxes.
ASC 450 outlines the accounting and disclosure requirements for loss contingencies. This GAAP rule provides that an estimated loss from a loss contingency must be accrued as a charge to income if both the amount of the loss can be reasonably estimated and if information indicates that it is probable that an asset had been impaired or a liability had been incurred at the date of the financial statements.
Under ASC 740, existing income tax positions must be reassessed at each balance sheet date to determine whether an income tax benefit should be recognized, or continue to be recognized and, if so, how much of the benefit should be recognized based on new information. Depending on a corporation’s specific situation, an analysis should be performed to determine if state income tax exposure exists in non-filing states due to economic nexus or factor presence rules. Given that a company may have taken a historic position in reliance on constitutional arguments that a physical presence was required before a state may impose an income tax, this position will now need to be re-evaluated in light of Wayfair.
For example, in a July 13, 2018, announcement, Wells Fargo disclosed a $481 million income tax expense mostly related to state income taxes and the Wayfair decision. Overall, companies should be prepared to justify their financial reporting decisions (both sales tax and income tax) to their external auditors, taking into account the Wayfair decision.
Full Impacts on M&A To Be Seen in 2020
Because Wayfair was decided in June 2018, its impact on deal making won’t be fully understood until after 2019 and beyond as potential buyers evaluate the consequences of Wayfair on financial metrics and potential contingencies.
For instance, deals involving foreign buyers may be delayed as these entities seek to understand how remote sales tax collection might affect their business. For foreign companies, Wayfair proves a bit of a paradox: On the one hand, they may see the benefit in striking a deal with a U.S.-based company that has a better grasp on the sales and use tax system, but on the other, the complexities around Wayfair and the amount of education required to understand the U.S. sales tax system may prove too intimidating for a prospect to tackle, even with a U.S. deal partner.
Of course, the nature of being a U.S. domestic company doesn’t mean being automatically endowed with all the knowledge required to be in compliance with Wayfair. Given the potential complexity, even companies with knowledge of their sales and use tax requirements may not be able to easily comply with their obligations.
Take, for example, a U.S. company being acquired by a private equity firm. Though the company had implemented a robust sales tax determination engine for the 35 states into which it made sales, it hadn’t employed subject matter experts to verify whether its products were correctly mapped to the proper code for the purpose of determining whether sales were subject to tax in a given state. Incorrect mapping resulted in a material historical sales tax liability prior to the acquisition, necessitating pre-close clean-up and precious time spent before the deal was closed.
If you are considering a sale and believe you may have uncollected sales and use tax exposure in a state, there are paths to remediation. To avoid a liability and payment of interest and significant penalties for failure to file, companies should engage a professional service firm to anonymously reach out to states with material exposure amounts by participation in a VDA, whereby the company acquiesces to payment of the historical liability while having the benefit of a limited lookback period (often three years) and a penalty waiver.
Some companies have chosen to file on a prospective basis, thereby ignoring the historical nexus and related exposure. This has resulted in sales tax assessments for prior years, by preventing their ability to negotiate a limited lookback period, since most voluntary disclosure programs are not available for a current registered taxpayer. For companies that have been making sales for seven, eight, or more years, this means their liability (and interest and penalty payments) may double or triple what they would otherwise have been required to pay had they qualified to enter into a VDA with the ability to take advantage of a limited lookback period.
Compounding Complexity: Marketplace Facilitator Tax Laws
While Wayfair has obvious effects on the e-commerce sector, its impact also extends to the middlemen of retail sales transactions. As the year continues to unfold, unforeseen exposure for both retailers and these middlemen has the potential to have great impact as companies begin to understand their collection and reporting responsibilities.
New sales tax laws are now requiring marketplace facilitators — third-party entities that facilitate sales such as Amazon — to collect and remit sales and use taxes on behalf of retailers. These laws help to substantially reduce the number of remote sellers that state tax authorities may seek to audit. We expect nearly all states will enact marketplace facilitator tax laws in the near future.
By nature, marketplace facilitators don’t have intimate knowledge of the goods or services being sold as the retailers themselves. This lack of familiarity could result in a fair amount of under-collected sales tax if these sales are not properly accounted for or mapped to the correct taxability classification. Also, this under-collecting is compounded by the fact that there is lack of clarity around who should ultimately be responsible for the correct amount of sales taxes collected and reported to the taxing agencies, whether it’s the retailer or the company facilitating the sale.
It is imperative that companies keep a record of how each sale is taxed and who has collected and/or reported the sales tax. This enables transparency into potential liabilities, which, by extension, allows companies to prepare for the payment of such liabilities.
The complexities and far-reaching effects of the Wayfair decision cannot be understated. Sales and use tax exposure is just the tip of the iceberg. From tangible goods to services, and state income/franchise tax to financial reporting, Wayfair has unleashed a formidable amount of change to the most basic tax operations of your business. If your company is in the business of making sales, you should be assessing how Wayfair compliance has altered your total tax liability.
Have questions about your company's sales tax liability following Wayfair? Contact our Tax Team for more information at info@concannonmiller.com
