Collateral Damage from Wayfair

By: Mark L. Nachbar, Principal and Mary Bernard, Director, Ryan

Although Wayfair¹was a sales tax case, a concerning side effect of the overturning of the physical presence rule of Quill² has surfaced in the income tax arena in California recently. Out-of-state sellers using third-party platforms like Fulfilled by Amazon (FBA) have been receiving Demand for Tax Return notices from the Franchise Tax Board (FTB), claiming that the sellers may be deriving California-sourced income through their selling activities.

Previously, the Online Merchants Guild, a trade association representing many small FBA businesses, filed a federal lawsuit in the United States District Court for the Eastern District of California challenging California’s unlawful pursuit of nearly 10 years of back sales tax from thousands of small, out-of-state businesses that supply goods sold by Amazon through the FBA program. In Online Merchants Guild v. Nicolas Maduros,³ the complaint raised the question of whether FBA sellers should be held liable for back sales taxes based on inventory stored in the state, even without their knowledge, in Amazon warehouses.

Rather than pursue Amazon for the back taxes, California aggressively pursued small, out-of-state businesses for taxes stretching back nearly a decade, which could potentially bankrupt these small businesses. According to the complaint filed, California’s demand for these businesses to pay the uncollected taxes on sales by Amazon violates the Due Process Clause, other constitutional guarantees, and the federal Internet Tax Freedom Act.

Now, to add insult to injury, the California Department of Tax and Fee Administration (CDTFA) is attempting to assert income tax nexus, allegedly based on the same inventory located in Amazon warehouses in the state. Although the FTB maintains that these standard notices have been implemented for years based on the information provided by the CDTFA, this trend towards a more rigorous economic nexus policy in income tax principles raises concern. Before Quill and Wayfair, Congress enacted Public Law (PL) 86-272.⁴ The purpose of this law is to limit a state’s ability to impose an income tax on business entities that merely solicit sales in a state. The fact that the FBA businesses have no control over the physical location of their inventory based on the terms of their arrangement with Amazon should be taken into consideration in the imposition of economic nexus rules. The expansion of economic nexus for income tax purposes in California conflicts with the long-established principles of PL 86-272. 

California is now the second state to waive a flag of defiance in the face of PL 86-272. On July 2, 2020, the governor of Hawaii signed into law a provision applying economic nexus standards for income tax, ignoring PL 86-272. In addition, the Multistate Tax Commission (MTC) has held hearings that would limit the application of PL 86-272 to companies that have established economic nexus in a state. Ryan will continue to monitor these developments by rogue legislators and governors and the MTC to ignore the federal protections afforded by PL 86-272 and would encourage taxpayers affected by these policies to challenge any assessments. 

¹ South Dakota v. Wayfair, Inc. 138 S. Ct 2080 (2018).

² Quill Corporation v. North Dakota 504 U.S. 298 (1992).

³ No. 2:20-at-00954 (E.D. Cal.).

⁴ 15 U.S. Code § 381.