Editor’s Note: Richard J. Crow is a member of the Business Practice Group at Ward and Smith, P.A.

It is estimated that states lose billions of dollars each year in tax revenue due to noncompliance with sales and use tax laws. The state of New York recently enacted legislation amending its sales and use tax statute to provide a presumption that certain sellers constitute "vendors" under the statute which requires those vendors to collect state and local sales and use taxes on Internet transactions. This revision appears aimed at Internet retailers such as Amazon.com and Overstock.com, both of whom previously avoided any requirement to collect sales and use taxes on sales to customers located in New York because the retailers had no physical presence in the state.


A "sales tax" is levied by the state in which a sale occurs. A "use tax" is levied by the "home" state of a buyer who purchases property outside of the buyer’s home state for use inside the buyer’s home state. Technically, both a "sales tax" and a "use tax" are taxes levied against the buyer of property. However, rather than chase millions of buyers, the states require retailers to act as "collection agents" and hold the retailers liable for any taxes not collected or turned over. An out-of-state retailer generally has no obligation to collect a use tax unless the retailer has a sufficient connection (or "tax nexus") with the taxing state so as to justify the state’s authority to compel the retailer to act as its collection agent under penalty of law. The problem of noncompliance has become severe in the context of Internet sales because the location where the Internet sale "occurs" is ephemeral, and online retailers usually have no obvious physical presence in the state where the buyers of its products reside. In these cases, the common outcome is that neither the retailer nor the buyer pays any sales or use tax to the state.

"Physical Presence"

The United States Supreme Court has ruled that out-of-state retailers cannot be required to collect a state’s use tax if they do not have a physical presence in that state. Typically, companies are considered to have a physical presence in a state if they maintain a store, office, or distribution center in the state, or if any employees are based therein. However, the Supreme Court also has held that physical presence in a state can be in the form of solicitation by sales representatives located in the state that is significantly associated with the retailer’s ability to establish and maintain a market in the state. The question of how far the meaning of "physical presence" in a state can be taken has been the origin of several interesting developments in the context of Internet retailers and their obligation to collect use tax on sales made in states in which the retailer has no office, warehouse, or employees.

The Borders Online Case

In 2005, a California court ruled that Borders Online, a sister corporation of Borders Books and Music, had to collect California use tax on all sales made to California customers, despite the fact that Borders Online had no actual physical presence in California, i.e., it had no stores, employees, warehouses, or otherwise. The decision rested on a finding that, because of its relationship to Borders Books and Music, which had numerous locations in California, Borders Online had a physical presence in California. Customers of Borders Online were permitted to return products and receive cash refunds at any Borders Books and Music locations in California. Further, Borders Online was promoted actively by Borders Books and Music. Based on these and other facts, the court found that Borders Books and Music acted as the agent of Borders Online and provided the physical presence in California necessary to require Borders Online to collect California use tax. The holding in the Borders Online case was an extension of the meaning of having a "physical presence" in a state.

New York’s Attempt at Collecting Use Tax

New York, like California in the Borders Online case, is attempting to extend the definition of "physical presence" to include receiving direct or indirect referrals of business from any resident of New York in exchange for a commission or other consideration. New York law imposes on every vendor of tangible personal property or services the obligation to collect sales and use taxes. The term "vendor" is defined as any person who solicits business by employees, independent contractors, agents, or other representatives. The recent revision to the New York law ("New York Law") provides that a retailer that makes taxable sales of tangible personal property or services to a resident of New York is required to collect use tax on all taxable sales to New York residents, if the following two conditions are met: (1) the retailer enters into an agreement with a New York resident ("Retailer Agent") under which, for a commission or other consideration, the Retailer Agent directly or indirectly refers potential customers to the retailer, whether by link on an Internet web site or otherwise; and (2) the retailer’s gross receipts from sales to New York residents as a result of referrals to the retailer by all of its Retailer Agents total more than $10,000 during the preceding four quarterly sales tax periods. The New York State Department of Taxation and Finance has stated that a retailer may avoid the obligation to act as the state’s collection agent if it can establish that the only activity of its Retailer Agents in New York is a link on the Retailer Agents’ web sites to the retailer’s web site and that none of the Retailer Agents engages in any solicitation activity in New York targeted at potential New York customers. However, this burden is particularly onerous for a company that uses many Retailer Agents in New York. Proving that not one of them is soliciting business in New York is virtually impossible.

Two large Internet retailers, Amazon.com and Overstock.com, wasted no time filing suit against the state challenging the constitutionality of the New York Law. Amazon has no physical property or employees in New York, but uses thousands of third parties in that state to advertise Amazon on their web sites pursuant to an "Associates Program." Each associate is paid a commission based on purchases made from Amazon by customers who click on the link shown on the associate’s web site.

Amazon’s argument is that New York has eliminated the requirement of the existence of a physical presence before a seller can be obligated to collect use tax for a state. Unfortunately, it is likely to be some time before the results of Amazon’s constitutional challenges to the New York Law are decided.


State efforts to increase compliance with their sales and use tax laws are only going to continue, and the trend appears headed to imposing on out-of-state retailers, and particularly Internet retailers, the obligation to collect and pay over to the appropriate taxing authority the required use taxes. If the New York Law withstands challenge, it may form a model for other states to follow. Therefore, companies selling products in states in which they have no physical presence, particularly Internet retailers, would be well-advised to stay abreast of the sales and use tax law of the states where their customers reside, and review and appropriately modify their advertising and solicitation of business methods in order to avoid being compelled to serve as a use tax collection agent in other, perhaps multiple, states.

© 2008, Ward and Smith, P.A.

Ward and Smith, P.A. provides a multi-specialty approach to the representation of technology companies and their officers, directors, employees, and investors. Richard J. Crow practices in the Business Practice Group, where he is involved in business startups, business transactions, acquisitions and mergers, and tax matters. Comments or questions may be sent to rjc@wardandsmith.com.

This article is not intended to give, and should not be relied upon for, legal advice in any particular circumstance or fact situation. No action should be taken in reliance upon the information contained in this article without obtaining the advice of an attorney.