When internet businesses first entered the mainstream in the 1990s, few people were able to predict the transformational impact e-commerce would have on the U.S. economy. In 1999, total online retail sales in the United States amounted to about $15 billion, or approximately one-half of one percent of all retail sales nationwide.[1] By 2016, this figure had skyrocketed to over $389 billion, with e-commerce amounting to eight percent of total retail sales.[2] This type of growth is nearly unparalleled in U.S. economic history, and lawmakers have worked to develop rules for the e-commerce industry that ensure both continued development and effective regulation of this increasingly important market. This is particularly true in the development of e-commerce tax laws, which have recently shifted focus from facilitating growth in e-commerce markets to ensuring that online businesses contribute their fair share of revenues to the public coffers.
This module explains how e-commerce activities are taxed. The discussion begins with how e-commerce taxes arose in an environment designed to protect this burgeoning industry from undue financial and regulatory burden. Next, the analysis highlights recent developments in e-commerce taxation that have shifted national policy. These developments will impact online businesses. The module closes with a discussion of tax issues associated with business activity common across e-commerce, including online auctions, credit card and third-party payment network transactions, and virtual or “crypto” currency activities.
Protective e-Commerce Tax Policies
As e-commerce was first establishing itself in the U.S. economy, federal lawmakers wanted to make sure that this promising new market had the opportunity to grow without unnecessarily burdensome regulation and taxation. To this end, Congress passed the Internet Tax Freedom Act in 1998.[3] This law imposed a three-year moratorium on duplicate or discriminatory taxes levied on e-commerce activities. This law also precluded state and local governments from taxing internet access, a policy which was made permanent with the enactment of the Trade Facilitation and Trade Enforcement Act of 2015.[4] However, internet access is still taxed in seven of the 50 states, as these jurisdictions had pre-existing internet laws that were preserved by the Internet Tax Freedom Act’s “grandfather” clause.[5]
In addition to banning taxation on internet access, the Internet Tax Freedom Act prohibits multiple jurisdictions from levying taxes on the same e-commerce transaction. This limits sales or use taxes levied against e-commerce companies to the state or county in which the transaction takes place.[6] So, for example, an e-commerce company based in New York that ships an order to customers in New Jersey could be taxed on the transaction by either New York or New Jersey, but not both.
Protective tax policies for e-commerce transactions originate from the Commerce Clause in the Constitution.[7] The Supreme Court has interpreted the Commerce Clause to prevent the states from passing laws that have the effect of discriminating against certain activities in interstate commerce. This prohibition has been applied by federal legislation to online businesses by the Internet Tax Freedom Act’s ban on discriminatory e-commerce taxes, which prevents state and local governments from imposing taxes on electronic transactions that are higher than they would be for identical activities performed at brick-and-mortar businesses.[8]
Tax policies embodied in the Internet Tax Freedom Act reflect national support for electronic business. However, as e-commerce companies have increased their market power, concerns regarding the dampening effects of taxation have subsided. In fact, the Supreme Court recently established that some types of state and local taxes can be levied against online businesses without running afoul of the Commerce Clause.
Recent Developments in e-Commerce Taxation
The Internet Tax Freedom Act was passed during a time of lax e-commerce taxation. This conservative approach was largely due to the Supreme Court’s interpretation of how the Commerce Clause applies to taxation in e-commerce in the case of Quill Corporation v. North Dakota. The Quill precedent required that e-commerce companies have a physical presence or a business nexus to a state before that state would be allowed to tax their activities. Thus, under Quill, states could not collect sales tax from purchases that state residents made from out-of-state companies.[9] However, the Quill precedent has been discarded in favor of a more liberal e-commerce tax policy, as we’ll discuss shortly.
Another reason the federal government was slow to warm up to the idea of allowing state and local governments to tax e-commerce transactions was the practical concern of how difficult it would be for online companies to comply with the tax policies of every state to which they shipped . Forty-five states and Washington D.C. collect sales taxes and most of them also allow municipalities and local governments to levy taxes.[10] Thus, e-commerce companies face the potentially daunting task of complying with dozens, if not hundreds, of tax policies from every jurisdiction in which they have customers . These jurisdictions vary with respect to what e-commerce activities are taxable, the applicable sales tax rate and when and how often sellers must file tax returns. Effective compliance would be extremely burdensome, and when Quill was heard back in the early 1990s the Supreme Court viewed this compliance burden as an unconstitutional burden on e-commerce companies’ abilities to engage in interstate commerce.
The basis for this ruling dated back to 1967, well before the internet was invented. Then, the Supreme Court struck down the State of Illinois’ policy of charging state sales tax on catalog companies selling in Illinois but located out of state. The case, commonly known as the Bellas Hess case, held that the complexity of requiring out-of-state sellers to comply with the sales tax requirements of every customer’s jurisdiction would be an unconstitutional burden on interstate commerce.[11] The Court applied the Bellas Hess precedent decades later in the Quill case.
However, in 2018, Quill was overturned by a landmark decision in South Dakota v. Wayfair, Inc. Wayfair involved a South Dakota law that imposed sales taxes on out-of-state vendors providing goods to state residents. The law included several exemptions and safe harbor terms designed to protect small e-commerce companies from undue burdens associated with out-of-state taxation.
South Dakota began enforcing its new tax policy against major e-commerce retailers active in the state, including Overstock.com, Newegg, and Wayfair. Both the trial and appellate courts hearing South Dakota’s enforcement cases struck down the law under the Supreme Court’s precedent in the Quill case. In reviewing the case, the United States Supreme Court determined that the changes that have occurred in the e-commerce markets over the past two decades necessitated a departure from the outdated precedent set forth in Quill.[12] The technical challenges associated with state and local sales tax compliance have declined substantially due to e-filing and the plethora of bookkeeping and tax preparation software on the market today. As a result, compliance is no longer a burden on interstate commerce.
State and Local E-Commerce Taxes After Wayfair
While some concerns remain regarding the long-term impacts the Wayfair decision will have on e-commerce activity, the Supreme Court clarified that permissible state and local sales tax laws must be designed to prevent unnecessary burdens on interstate commerce. For example, the South Dakota law under review included a safe harbor provision for small e-commerce retailers, a prohibition on retroactive taxation and a set of clear, uniform, and simple methods that companies can follow to ensure compliance with the law.[13] Thus, the Wayfair case did not simply unleash the floodgates of taxation on e-commerce retailers. Rather, the ruling allows state and local governments to tax e-commerce sales only when the applicable tax rules are designed for simple compliance and do not improperly burden commerce. Additionally, state and local governments are still barred from imposing sales tax on internet access by the Internet Tax Freedom Act and subsequent amendments.
The Supreme Court’s decision in Wayfair caught many tax policy experts by surprise, but some e-commerce companies saw this change in law coming well in advance. In fact, Amazon.com, the world’s largest retail e-commerce company, began collecting state sales tax on all direct sales in 2017. However, the retail giant has been less generous when it comes to local taxes. In at least six states –Alaska, Idaho, Iowa, Mississippi, New Mexico, and Pennsylvania – Amazon was not fully complying with local tax laws.[14] This has placed some local governments at a disadvantage, as the Government Accountability Office recently estimated that taxing all e-commerce sales would net state and local governments between $8 billion and $13 billion in additional tax revenues.[15] Now that the Wayfair decision clarified these jurisdictions’ authority to require e-commerce sales to pay local taxes, it’s expected that more e-commerce retailers will charge both state and local sales tax where required.
Practical Taxation Issues Unique to E-Commerce
The internet revolution has given rise to several new ways to buy and sell things online, as well as new technologies designed specifically for the processing of electronic payments. These include online auctions, secure credit card transactions and the new wave of virtual or “crypto” currency and related financial services. Each of these activities is subject to taxation under the federal tax code in addition to any state or local sales or use taxes that may apply.
Online auctions have become increasingly common since e-commerce giant eBay first launched in 1995. This site and the thousands that have followed offer marketplaces for direct person-to-person trading, propelling online auctions well into the world of mainstream retail.[16] Often, the entities selling goods in online auctions are laypeople who don’t think they have to report this income on their tax returns. However, proceeds from nearly any auction – whether online or physical – are taxable unless the circumstances merit specific exemption. Depending on the way the online auction is carried out, this may include individual income tax, business income tax, self-employment tax and/or excise taxes like sales and use taxes. The IRS does not levy taxes against all online auctions, and the agency generally does not require people to report auction proceeds “akin to an occasional garage or yard sale.”[17] However, any entity that sells goods through online auctions as a regular business activity or hobby must report its profits to the IRS on its tax return.
Credit card companies and third party financial networks like PayPal or Venmo must abide by the reporting requirements found in Section 6050W of the Internal Revenue Code. Credit card and third-party payment companies are legally required to document and report the gross amounts paid to individuals and companies who have performed more than 200 transactions totaling $20,000 or more across their payment networks. Section 6050W requires these financial service companies to file informational returns with both the IRS and the company that accepted the credit card or third-party payment.[18]
Although the IRS does not collect taxes directly based on these informational returns, this sort of third-party reporting has been shown to increase compliance with applicable tax laws. When the IRS receives a report of revenues generated by credit card or payment networks, which are submitted to the agency and the payments recipient on a Form 1099-K, it can use this information to check the accuracy of income reported on the business’ returns and identify non-filers.[19] Thus, the rule is a key tool that the IRS uses to help ensure online payments are reported and taxed appropriately.
Cryptocurrencies
With the rise of cryptocurrencies, a new type of financial product powered by blockchain technology, the IRS has had to develop a new approach to collecting tax revenues on online transactions.
Cryptocurrencies, also known as virtual currencies or coins, are software programs used as digital representations of real-world economic value. Just like cash or credit card transactions, they are used as a means of exchange, unit of account or store of economic value.[20] However, the fact that cryptocurrencies are used to purchase goods and services as well as for investment and trading purposes has led to some confusion regarding the proper tax treatment of this new financial technology.
In 2014, the Internal Revenue Service issued a policy statement that shed some light on the federal taxation of virtual currencies. In this statement, the IRS explained that cryptocurrencies may be used for the purchase and sale of goods. Some cryptocurrencies are also convertible into U.S. dollars, just like stocks or bonds. Because they are convertible, the IRS concluded that these types of virtual currency profits should be taxed as property rather than income. Thus, profits made from either investing in or accepting payments in these forms of cryptocurrencies are taxed according to the capital gains tax rates. This means that every convertible cryptocurrency transaction – whether made as a payment for goods or services or as a revenue-generating investment – is a taxable transaction that must be reported to the IRS. [21]
Conclusion
The digital revolution has changed our economic reality. Now, many of the activities that used to bring consumers to brick-and-mortar establishments are performed entirely online. This has transformed the U.S. economy, and it has forced lawmakers to grapple with the growing presence of e-commerce in consumer and business finance. As a result, the federal and state laws regulating e-commerce transactions have developed substantially over time, and tax policy has been no exception.
Before South Dakota v. Wayfair, states were restricted from requiring e-commerce sites to collect sales tax unless the online seller had a physical presence or identifiable nexus in the jurisdiction. However, this prior policy was established in 1992, when e-commerce was still in its infancy.[22] Over time, this approach has put online sellers at an unfair advantage over local businesses required to pay state and local taxes. As e-commerce grew into an increasingly common method of making retail purchases, this unfair advantage grew into a significant policy concern. As a result, the Supreme Court expanded state and local authority to levy taxes against online retailers.
From a practical standpoint, the Wayfair decision will increase the cost of retail e-commerce transactions. However, this is unlikely to dampen the substantial growth we’ve seen in e-commerce in recent years. Even as more and more e-commerce companies like Amazon started building state and local sales tax into their prices, retail e-commerce has continued to expand significantly.[23] Much of this is due to the increasing role of e-commerce in our daily lives, but there are also new technological developments that make buying and selling online an increasingly common activity. Online auctions and person-to-person sales platforms are becoming the garage sales of the future, and online financial transactions are becoming more sophisticated as cryptocurrencies are increasingly integrated into regular business operations. Without a doubt, e-commerce will continue to have an important role in the U.S. economy, and state and federal revenue agencies will be keeping a close eye on online companies’ compliance with applicable tax laws.
In our final module, we will continue this discussion with a look at regulation of digital financial transactions and privacy concerns, including the Gramm-Leach-Bliley Act and comparable state and federal rules.
[1] U.S. Census Bureau, U.S. Dep’t of Commerce, E-Stats: E-commerce 1999, 1, 2 (March 7, 2001), https://www.census.gov/content/dam/Census/library/publications/2001/econ/1999estatstext.pdf.
[2] U.S. Census Bureau, U.S. Dep’t of Commerce, E-Stats 2016: Measuring the Electronic Economy, 1, 2 (May 24, 2018), https://www.census.gov/content/dam/Census/library/publications/2018/econ/e16-estats.pdf.
[3] Internet Tax Freedom Act, Pub. L. 105-277(1998).
[4] Trade Facilitation and Trade EnforcementAct, Pub. L. 114-125 (2016).
[5] Jeffrey M. Stupak, The Internet Tax Freedom Act: In Brief, 1, 3, U.S. Congressional Research Service, (April 13, 2016), https://fas.org/sgp/crs/misc/R43772.pdf.
[6] Id. at 3.
[7] U.S.Const. art. I § 8.
[8] Stupak, supra note 5, at 3.
[9] Quill Corp. v. North Dakota, 504 U.S. 298, 311 (1992).
[10] The Seller’s Guide to eCommerce Sales Tax, Tax Jar, (Mar. 30, 2018), https://www.taxjar.com/guides/intro-to-sales-tax/#what-is-sales-tax.
[11] National Bellas Hess v. Department of Revenue, 386 U.S. 753, 759-60 (1967)
[12] South Dakota v. Wayfair, Inc., 201 L. Ed. 2d 403, 410, 421-22 (2018).
[13] Id. at 425.
[14] Institute on Taxation and Economic Policy, Many Localities Are Unprepared to Collect Taxes on Online Purchases (March 2018) https://itep.org/wp-content/uploads/amazonlocaltax_0318.pdf.
[15] U.S. Government Accountability Office, Sales Taxes: States Could Gain Revenue from Expanded Authority, but Businesses Are Likely to Experience Compliance Costs, GAO-18-114 (Dec. 18, 2017), https://www.gao.gov/products/GAO-18-114.
[16] Magnus Bjornsson, The History of eBay (Spring 2001) http://www.cs.brandeis.edu/~magnus/ief248a/eBay/history.html.
[17] IRS Notice FS-2007-23, Internal Revenue Service, https://www.irs.gov/newsroom/reporting-auction-income-and-the-tax-gap.
[18] 26 U.S.C. § 6050W.
[19] Internal Revenue Service, IRC Section 6050W: Frequently Asked Questions (July 23, 2011) https://www.irs.gov/pub/irs-utl/irdm_section_6050w_faqs_7_23_11.pdf.
[20] IRS Notice 2014-21 at 1 (2014), https://www.irs.gov/pub/irs-drop/n-14-21.pdf.
[21] Id. at 1-2.
[22] Quill Corporation v. North Dakota, 504 U.S. 298, 311 (1992).
[23] Joseph Bishop-Henchman, What Does the Wayfair Decision Really Mean for States, Businesses, and Consumers?, (July 2018) https://taxfoundation.org/what-does-the-wayfair-decision-really-mean-for-states-businesses-and-consumers/#4.