Online Retailer’s Use of In-State Fulfillment Company Did Not Create Nexus in Arizona

By: Tracey Stewart, SALT Associate

At a glance

• The main takeaway: Years after the Wayfair decision, physical presence nexus is alive and well, especially with the rise in remote employment post-pandemic.   
• Assess the impact: Companies need to consider whether their business activities may establish sales tax nexus, even in states where sales revenues and volumes do not exceed economic nexus thresholds.
• Take the next step: Aprio’s State and Local Tax (SALT) team can help your business understand and determine your sales tax nexus footprint, both physical and economic.  

Schedule a free consultation today to learn more!

The full story:

It has been five years since the United States Supreme Court’s decision on South Dakota v. Wayfair, in which it overturned more than 50 years of precedent in ruling that physical presence was not required to establish sales tax nexus.¹ To be clear, the Court’s ruling did not hold that physical presence does not create nexus, only that physical presence was not required. In other words, physical presence and economic presence are alternative paths to establish sales tax nexus, and therefore, a business can establish sales tax nexus in a state through physical presence even if that business does not meet the state’s economic nexus threshold(s).

In the years following the Wayfair decision, all states that impose a sales tax established their own economic nexus rules, with Missouri being the last state whose economic nexus rules became effective on January 1, 2023.² Given the variety of effective dates, it is still likely that there are sales tax nexus disputes between taxpayers and states for audit periods that pre-date the state’s adoption of its economic nexus rules. For example, a recent Arizona Tax Court ruling focused solely on whether the taxpayer had a physical presence in the state. 

A closer look at the case

The taxpayer, RockAuto (or the “Company”), an online auto-parts retailer based in Madison, Wisconsin, disputed the Arizona Department of Revenue’s (DOR) assessment of sales tax for the audit period from April 1, 2013, through April 30, 2019. Since Arizona’s economic nexus rules did not become effective until October 1, 2019, this case addressed whether RockAuto had physical presence nexus in Arizona.

The Company did not have any office or employees in Arizona, however, it contracted with at least six in-state suppliers (i.e., independent contractors) that fulfilled customer orders. When a customer orders a part on the website, the customer is given the option to select “Choose for Me to Minimize Cost,” where different brands of the same auto part might be selected among suppliers in a way to minimize total cost of the part plus shipping cost. As a result, 89% of orders that RockAuto placed with Arizona suppliers shipped to customers outside of Arizona, while 83% of the Company’s sales to Arizona customers came from suppliers outside of Arizona.

The ruling explained

Under sales tax physical nexus principles, while the presence of a taxpayer’s own property and/or employees in a state generally creates nexus, when the presence in a state is an independent contractor performing activities on behalf of the taxpayer, those activities must be “significantly associated with the taxpayer’s ability to establish and maintain a market in this state for the sales.”³

The DOR argued that the presence of the suppliers in Arizona that fulfilled orders on behalf of RockAuto was effective at creating and maintaining the in-state market for the Company. However, the court disagreed, noting that the DOR’s argument failed to take into account that the suppliers did not generally or significantly direct their activities towards establishing or maintaining the Company’s Arizona market.

The court was persuaded by the fact that RockAuto does not control whether an Arizona customer is served by an Arizona supplier; rather, it is the customer that decides by selecting the “Choose for Me to Minimize Cost” option. As the court stated:

Simply, Arizona suppliers are not selected to help RockAuto establish a market in Arizona as Defendant asserts. Instead, suppliers are selected on their ability to fulfill an order at the lowest price and ship it in the quickest manner. Imposing a pre-Wayfair nexus finding on RockAuto here would require a legal basis for implying a volume element to that analysis, simply based on the facts that approximately eleven percent of RockAuto’s orders placed with Arizona suppliers are shipped to Arizona customers and resulted in [over $70 million in audit gross receipts] during the audit period. The [DOR] presents no legal basis for such an element.

In other words, since the audit period at issue pre-dated the establishment of economic nexus in Arizona, nexus could only be found if the physical presence requirement was satisfied, and in this case it was not.

The bottom line

Despite most of the sales tax nexus news focusing on the Wayfair case and state economic nexus rules, it is important to remember that physical presence nexus is alive and well. Companies need to consider whether their activities may establish sales tax nexus, even in states where sales revenues and volumes do not exceed economic nexus threshold(s). This is especially true following the COVID-19 pandemic where more companies find themselves with employees working in different states due to the growth of remote employment.

Aprio’s SALT team has experience helping companies understand their sales tax nexus footprint, both physical and economic. We will assist your business to determine its state tax compliance obligations so that you do not incur any unexpected tax liabilities and penalties. We constantly monitor these and other important state tax topics, and we will include any significant developments in future issues of the Aprio SALT Newsletter.

This article was featured in the July 2023 SALT newsletter.

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¹ 138 S. Ct. 2080 (2018). For a summary of that decision, see our SALT Newsletter article.

² To see each states economic nexus threshold(s) and their effective dates, see our Sales Tax Economic Nexus Compliance Map.

³ Tyler Pipe v. Wash. Dep’t of Rev., 483 U.S. 232, 250 (1987).