State taxation and the Supreme Court
State taxation and its relationship with the Supreme Court is a complex area of law involving the need for state revenue collection through various tax types, including income, sales, and property taxes. The U.S. Constitution imposes certain restrictions on a state's right to tax, which has led to numerous legal challenges brought before the Supreme Court. Historically, the Court has upheld states' authority to tax in many instances, allowing for differential treatment of various property types and taxpayer classifications, while simultaneously enforcing limits under the equal protection clause and the commerce clause.
Key cases have established important principles, such as the requirement of a "substantial nexus" between a state and the taxpayer for taxation to be deemed constitutional. The Court has also differentiated between due process and commerce clause requirements, with some rulings affirming that economic nexus can exist without physical presence in the state. The evolution of this legal landscape has prompted legislative responses, most notably Public Law 86-272, which restricts state taxation of businesses that only solicit sales in other states.
Recent cases, particularly in the context of remote work due to the COVID-19 pandemic, have raised new questions about a state's ability to tax income earned by residents working for out-of-state companies. Until the Supreme Court addresses these modern challenges, the application of state taxation rules remains a pertinent and evolving issue.
State taxation and the Supreme Court
Description: System used by state governments to raise revenue.
Significance: The Supreme Court has heard cases involving constitutional issues related to state taxation, often involving the state’s right to tax.
State governments rely on a variety of taxes to collect revenue, primarily income, sales and use, and property taxes. Because the U.S. Constitution restricts states’ right to tax, challenges to the taxing jurisdiction of states have come before the Supreme Court.
States have the latitude to tax, and few taxes have been overturned under the equal protection clause, which prohibits states from denying any person within its jurisdiction the equal protection of the laws. The Supreme Court has consistently allowed states to tax types of property and classes of taxpayers differently. In San Antonio Independent School District v. Rodriguez (1973), the Court refused to invalidate a system of public school financing that relied on local property taxes for financing. However, the Court has held that imposing a higher tax on out-of-state companies than in-state companies violated the equal protection clause in Metropolitan Life Insurance Co. v. Ward (1985).
The primary constitutional limitations on a state’s right to tax are the commerce and due process clauses, which have been the subject of many Court cases. The Fourteenth Amendment to the Constitution provides that no state shall “deprive any person of life, liberty, or property without due process of law.” The Court, in Miller Brothers Co. v. Maryland (1954), interpreted this clause to mean that a minimal degree of contact, or nexus, must exist between a state and a person to establish jurisdiction. This minimal degree of contact, according to Wisconsin v. J. C. Penney Co. (1940), requires that the state has provided benefits for which it can ask return. These benefits include an orderly government, a legal and judicial system, and any public good, facility, or service that creates a good business environment. Another way to establish due process is by economic nexus, in which an out-of-state corporation exploits the marketplace by directing commercial activities toward the state’s residents. The Court, in Burger King Corp. v. Rudziewicz (1985), held that economic nexus exists even if the corporation has no physical presence within the state.
Commerce Clause
Article I of the Constitution gives Congress the power to regulate commerce among the states. This clause empowers the federal courts to invalidate a state tax that unduly burdens interstate commerce. These challenges to state taxation under the commerce clause were first raised in the late nineteenth century when interstate commerce was starting to grow as fast as the states’ need for revenue. New means of production and transportation fostered controversy over taxing power and resulted in hundreds of Court opinions concerning the constitutionality of taxes on commerce clause grounds.
As interstate business expanded, the Court’s interpretation of the commerce clause evolved into four basic tests as stipulated in Complete Auto Transit v. Brady (1977). A state tax is constitutional only if it “(1) is applied to an activity with a substantial nexus with the taxing state; (2) is fairly apportioned; (3) does not discriminate against interstate commerce; and (4) is fairly related to the services provided by the state.” With this four-prong test in place, the struggle began over application.
The Necessary Contact
Most of the debate focused on the degree of contact that must exist to establish substantial nexus. A landmark case, National Bellas Hess v. Department of Revenue of the State of Illinois (1967), established the physical presence test. This requirement of a physical presence in the state has been criticized as being outdated but was reaffirmed by the Court in Quill Corp. v. North Dakota (1992). In Quill, the Court distinguished due process nexus from the commerce clause requirement of substantial nexus. An economic presence, but not necessarily a physical presence, is required under the due process clause. A use tax on an out-of-state mail-order company was in violation of the commerce clause because Quill had no physical presence in the state as required for the more substantial nexus test. The Court invited Congress to act on this matter.
Throughout the battles between states and taxpayers, Congress stayed out of the fray. However, in 1959, the Court, for the first time, in Northwestern States Portland Cement Co. v. Minnesota, held that an income tax on an out-of-state corporation exclusively engaged in interstate commerce did not violate the commerce clause. The Court found sufficient nexus because the corporation leased a sales office in the state and employed salespersons who solicited business throughout the state. The business community was alarmed over this expanded latitude to impose a direct tax on a fair apportionment of income from interstate commerce.
Congress responded by enacting Public Law 86-272, which was the first federal legislation restricting the power of states to tax interstate activities. This law prohibits a state from imposing an income tax on a business whose only connection with the state is soliciting orders for sales of tangible personal property. The orders must be sent outside the state for approval and, if approved, are filled and shipped from a point outside the state. Solicitation was not defined in the law, but the Court, in Wisconsin Department of Revenue v. William Wrigley, Jr., Co. (1992) held that solicitation of orders includes any explicit verbal request and any speech or conduct that implicitly invites an order. Wrigley contained a de minimis rule, providing immunity from nexus where a limited amount of solicitation occurs.
In 2021, the Supreme Court decided not to hear arguments in the case of New Hampshire v. Massachusetts, in which the ability of states to continue to collect income tax for people who worked from home but for out-of-state companies was called into question. This case was extremely relevant during the COVID-19 pandemic and remained relevant as more people worked from home in the twenty-first century. Until the Supreme Court hears a case involving this new issue of state taxation, the circumstances around it will remain unclear.
Bibliography
Christopher, Mark, and Barbara Janaszek. “Limitations on State Income Taxation of Interstate Business After Wrigley and Quill.” Journal of State Taxation (Spring, 1992): 9-21.
Hellerstein, Jerome. State Taxation. Boston: Warren Gorham Lamont, 1998.
Hellerstein, Walter. Federal Constitutional Limitations on State Taxation. Washington, D.C.: Tax Management, 1994.
Hemel, Daniel. "Supreme Court Punts on State Tax Question About Remote Work.” Tax Policy Center, 28 June 2021, www.taxpolicycenter.org/taxvox/supreme-court-punts-state-tax-question-about-remote-work. Accessed 9 Apr. 2023.
Pogue, Thomas. State Taxation of Business: Issues and Policy Options. Westport, Conn.: Praeger, 1992.