Does the Illinois PetMeds Case Threaten Economic Nexus?

Ever since Louisiana eliminated its economic nexus transaction count threshold and rendered the Halstead Bead challenge to its remote collection requirements moot, the sales tax community has been anticipating whether any new litigation would spring up. Indeed, it has. This newest case was recently filed in the Illinois Independent Tax Tribunal by PetMeds Express. This re-opens the million-dollar question: can a taxpayer win a Constitutional argument against economic nexus?

What is PetMeds complaining about?

PetMeds Express is an online pharmacy that sells pet medications, pet food, dietary supplements, and other taxable items. They market directly to consumers throughout the United States through a website, mobile app and toll-free number.

Following the South Dakota v. Wayfair Supreme Court decision in 2018, Illinois enacted a remote seller collection law. Companies making over $100,000 in sales annually or engaging in more than 200 separate transactions became obligated to collect Illinois tax. This new rule took effect on October 1, 2018, but this case is not about whether PetMeds exceeded those thresholds (they did). It’s all about whether the Illinois remote seller collection rules are unconstitutionally complex or illegally discriminatory.

Are Illinois sales tax requirements complex?

Illinois sales tax rules are different from other states. Its sales tax is called the “Retailer’s Occupation Tax” or ROT. It’s properly charged at the state and local level when the buyer and the seller are both physically present in Illinois. Since Illinois is an origin-based state, local-level ROT is derived from the location of the seller, not the buyer.

Additionally, Illinois imposes a seller’s use tax that is properly charged when the item being sold originates from an out-of-state location. Importantly, there is no local-level seller’s use tax. This meant, prior to Wayfair, sales originating from outside Illinois were taxed at a decidedly lower total rate than in in-state sales.

Leveling the playing field

When Illinois first adopted an economic nexus requirement, the rule for qualifying remote sellers was the same as for sales by in-state sellers that originated out of state. Both charged state sellers use tax. No local tax applied. This changed when Illinois enacted new rules intended to “Level the Playing Field” between in-state sellers, remote sellers and marketplace facilitators. These rules became effective on January 1, 2021, and substantially changed the requirements for remote sellers. In an attempt to provide clarity, the Illinois Department of Revenue (DOR) published a flowchart explaining the type of tax each seller was required to collect.

As explained below, it’s this adjustment that likely creates the biggest legal exposure for Illinois.

Does PetMeds Express have a point?

In its petition PetMeds makes two basic arguments. First, it alleges that the Illinois requirements discriminate against interstate commerce. In making this case, PetMeds explains that remote retailers are compelled to collect local tax based on the customer’s location while in-state retailers selling from in-state locations collect local tax based on their place of business. This means that remote sellers must manage more local rates. This argument is not particularly compelling because the same requirements exist in all the other states that have origin-based local tax sourcing. These states include Arizona, California, Missouri, Ohio, Tennessee, Texas, Utah and Virginia. In fact, only one state changed its in-state sourcing rules subsequent to the Wayfair decision, that being New Mexico. This disparate requirement existed before the Wayfair decision and still exists today. The only thing that’s changed is that post Wayfair, far more remote sellers now have a collection obligation.

What seems more compelling is an argument that PetMeds mentions but gives a little less attention to, that being the disparate treatment between remote sellers and in-state sellers selling from a remote location. If you trace the “Leveling the Playing Field” flowchart, you see that in-state sellers selling from out-of-state locations only charge state level use tax at the rate of 6.25%, while similarly situated remote sellers are obligated to charge both state and local ROT.

As an example, a fully remote seller like PetMeds, selling from their Florida headquarters to a customer in Springfield, Illinois must charge a total ROT rate of 9.75% (6.25% state tax, 1% county tax and 2.5% city tax). However, an Illinois company selling to the same customer from from a Florida office only charges 6.25% state use tax, assuming that with respect to this sale, no “selling activity” occurs in Illinois.

It’s hard to comprehend how this disparate treatment “levels the playing field” and it’s even more difficult to discern how it’s not discriminatory against the out-of-state seller.

PetMeds makes the secondary argument that the Illinois rules are unduly burdensome because it requires remote retailers to “manually determine, register, and report each destination to which sales are delivered and its specific local tax rate.” Granted, reporting local tax on the Illinois state sales tax return is complex but fundamentally, requiring a retailer to apply the correct local rate based on their customer’s location in a state like Illinois where local tax is largely administered by state government, is readily addressed through robust tax automation.

What will happen next?

The Illinois Tax Tribunal is an independent agency created by the legislature to resolve disputes between taxpayers and the DOR. The case will be heard by an administrative law judge who will ultimately author a written decision. This ruling can be appealed to the state appellate court system.

It seems likely that this case will find its way to the courts and it’s an open question as to whether Illinois can justify the disparate requirements between similarly situated taxpayers. Although it will require new legislation, it’s possible that Illinois could take a page from Louisiana and attempt to render the case moot by re-leveling the playing field by treating remote sellers and in-state companies alike.

Stay tuned for further developments…