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JOURNAL OF PASSTHROUGH ENTITIES 21

January–February 2014

State Law & State Taxation Corner By John A. Biek

New York and Illinois High Courts Take Divergent Views of the Constitutionality of State “Click-Through Nexus” Laws

John A. Biek is a Partner in the Tax Prac- tice Group of Neal, Gerber & Eisenberg LLP in Chicago, Illinois.

Introduction One of these columns from the spring of 20111 discussed two New York lower court decisions in Amazon.com, LLC v. New York State Department of Taxation and Finance that turned back facial Commerce Clause challenges to the New York “Amazon Law” or “click-through nexus” law.2 First enacted by New York in 2008, and subsequently adopted by another dozen states, these laws create a rebuttable presumption that an out-of-state re- mote seller is required to collect the state’s use tax on its interstate sales transactions with customers in the state if (1) the remote seller has contractual arrangements with in-state persons (referred to in the industry as “Internet affi liates”) to refer cus- tomers through a computer link from the Internet affi liate’s website to the remote seller’s website, (2) the remote seller is paying the Internet affi liate compensation based on the amount of sales rev- enue that the remote seller generates from these referrals and (3) the remote seller generates more than $10,000 of sales annually from such referrals from Internet affi liates.3 The theory of these click- through nexus laws is that these performance-based website referral arrangements are probably ac- companied by in-state physical sales solicitation activity by the Internet affi liate, which would give the remote seller use tax-collection nexus under well-established case law.4

Litigation is seldom a speedy endeavor and, in March 2013, some four years after the original New York Amazon.com decision, the New York Court of Appeals—the highest court in the state—affi rmed the

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constitutionality of the New York click-through nexus law.5 On December 2, 2013, the U.S. Supreme Court declined to review this ruling.

Meanwhile, the Illinois Supreme Court issued a somewhat surprising ruling on October 18, 2013, in Performance Marketing Association v. Hamer,6 upholding the circuit court’s determination in May 2012 that the Illinois click-through nexus law is preempted by the federal Internet Tax Freedom Act (the “ITFA”).7 The Amazon.com and Performance Marketing Association decisions are not necessarily in confl ict because of differences in the language of the New York and Illinois click-through nexus statutes and the legal theories on which these two cases were decided. Signifi cantly, the Illinois click- through nexus law conclusively presumes that the remote seller has estab- lished nexus in Illinois as a result of its contractual arrangements with in- state Internet affi liates to pay performance-based compensation for their website referrals to the remote seller’s website, whereas the New York click-through nexus only creates a rebuttable presumption of nexus that the remote seller can overcome by demonstrating that its instate Inter- net affi liates have not engaged in actual physical solicitation activity on behalf of the remote seller in New York. Moreover, the Illinois Supreme Court did not address the Commerce Clause argument in the Performance Marketing Association case, basing its decision solely on the ITFA. This appears to be the fi rst case fi nding a state tax to be preempted by that federal statute.

It is not really surprising that the U.S. Supreme Court denied a writ of certiorari in the New York Amazon.com and Overstock.com cases because of the absence of a confl ict between the New York and Illinois high court decisions and the fact that the New York courts only decided the facial Commerce Clause challenges to the New York click-through nexus law. The New York Department of Taxation and Finance is not asserting nexus against remote sellers that do not allow their New York-based Internet affi liates to engage in sales solicitation activity on behalf of the remote seller in New York. Nevertheless, these New York and Illinois court decisions have further mud- died the constitutional waters of state click-through nexus laws.

The New York Click-Through Nexus Law The New York click-through nexus stemmed from concerns in 2008 that online merchants like Amazon. com and Overstock.com were utilizing third-party retail stores in New York and the websites of New York-based youth sports clubs, schools, religious institutions and other so-called “Internet affi liates” with local audiences in the state to cross market the online merchant’s products. The online merchant would enter into a contract providing for the Inter- net affi liate to create and promote a computer link from its website to the on-line merchant’s website in return for performance-based commissions based on the volume of sales transactions that the online mer-

chant was able to make as a result of these referrals of the Internet affi liate’s audience to the online merchant’s website. On April 28, 2008, the N e w Yo r k A s s e m b l y amended the definition

of “vendor” in the New York sales/use tax laws to add the following Section 1101(b)(8)(vi):

a person making sales of tangible personal property or services taxable under this article (“Seller”) shall be presumed to be soliciting business through an independent contractor or other representative if the seller enters into an agreement with a resident of this state un- der which the resident, for a commission or other consideration, directly or indirectly refers potential customers, whether by a link on an internet website or otherwise, to the seller, if the cumulative gross receipts from sales by the seller to customers in the state who are referred to the seller by all residents with this type of an agreement with the seller is in excess of ten thousand dollars during the preceding four quarterly periods ending on the last day of February, May, August and November. This presumption may be rebutted by proof that the resident with whom the seller has an agree- ment did not engage in any solicitation in the state on behalf of the seller that would satisfy the nexus requirement of the United States Constitution during the four quarterly periods in question.8

State Law & State Taxation Corner

Nevertheless, these New York and Illinois court decisions have further muddied the constitutional waters of state click-through nexus laws.

JOURNAL OF PASSTHROUGH ENTITIES 23

January–February 2014

Crafting the New York click-through nexus law as a rebuttable presumption that the in-state Internet affi liates were acting as sales representatives of the remote seller proved to be clever because it allowed the New York courts to uphold the constitutionality of the statute. Indeed, within two weeks of the fi ling of Amazon’s declaratory judgment action alleging that the New York click-through nexus law was unconstitutionally imposing a use tax collection ob- ligation on out-of-state vendors without any physical presence in New York, contrary to the holding of the U.S. Supreme Court in Quill Corp. v. North Dakota,9 the New York Department of Taxation and Finance clarifi ed the scope of the New York click-through nexus law in Technical Services Bureau Memoran- dum TSB-M-08(3)S.10 This document explained, fi rst, that the rebuttable presumption of nexus in Section 1001(b)(8)(vi) would be triggered only by the pay- ment of commission-based fee compensation to the New York-based Internet affi liate, as opposed to a fl at-fee advertising arrangement that did not take into account the dollar amount of sales that the Internet affi liate’s referral activities were generating for the remote seller.

TSB-M-08(3)S went on to explain that “[f]or pur- poses of administering the new presumption, the Tax Department will deem the presumption rebut- ted where the seller is able to establish that the only activity of its resident representatives in New York State on behalf of the seller is a link provided on the representatives’ Web sites to the seller’s Web site and none of the resident representatives engage in any solicitation activity in the state targeted at potential New York State customers on behalf of the seller.” Indeed, Example 6 in TSB-M-08(3)S described a fact pattern in which several New York ski clubs that main- tained links to remote seller XYZ’s website were paid commissions based on the amount of sales resulting from those links, but none of the ski clubs referred potential customers to XYZ through the distribution of fl yers, newsletters, telephone calls or emails to club members or any other means of in-state solicitation targeted at potential New York customers on behalf of XYZ. Under those circumstances, TSB-M-08(3)S con- cluded, XYZ had successfully rebutted the statutory presumption that XYZ had established use tax collec- tion nexus in New York as a result of its performance marketing arrangement with the in-state ski clubs.

On June 30, 2008, the Department issued a second Technical Services Bureau Memorandum, TSB-M-08(3.1)S, explaining that a remote seller

could avoid the presumption of nexus under Sec- tion 1101(b)(8)(vi) if (1) the remote seller included a provision in its business referral agreements with Internet affi liates prohibiting them from “engaging in any solicitation activities in New York State that refer potential customers to the seller” and (2) the remote seller obtained annual signed certifi cations from the Internet affi liates that they had not actually engaged in such solicitation activities in New York during the previous year.11

On January 12, 2009, Judge Eileen Bransten of the Supreme Court for New York County (the trial court) granted the department’s motion to dismiss all of the counts in Amazon’s complaint for failure to state a claim. Judge Bransten rejected Amazon’s claim that the New York click-through nexus law is facially in- valid under the Commerce Clause, concluding that:

The statute is targeted at requiring tax collection when an out-of-state seller avails itself of the benefi t of in-state contractors compensated for referrals. As an added safeguard the Commis- sion-Agreement Provision makes plain that a seller does not have to collect taxes so long as its New York contractors “did not engage in any solicitation in the state [on its behalf] that would satisfy the nexus requirement of the United States Constitution.” Thus, a seller is afforded the op- portunity to prove that none of its contractors actively sought sales on its behalf in New York.12

Judge Bransten was not persuaded by Amazon’s argument that the New York click-through nexus law creates nexus out of “simple advertising by in-state advertisers.” Rather, Judge Bransten found that the New York statute “imposes a tax-collection obligation on sellers who contractually agree to compensate New York residents for business that they generate and not simply for publicity.”13 Judge Bransten believed that what was really happening under these performance marketing arrangements was that “Amazon chooses to benefi t from New York Associates that are free to target New Yorkers and encourage Amazon sales, all the while earning money for Amazon in return for which Amazon pays them commissions. Amazon does not discourage its Associates from reaching out to customers or con- tributors and pressing Amazon sales.”14

Judge Bransten determined that the New York click-through nexus law would not violate the Com- merce Clause as applied to Amazon, either, even if

Amazon could show that its Internet affi liates were not soliciting business in New York at Amazon’s di- rection or behest. In Judge Bransten’s view, because Amazon gave its Internet affi liates an economic incentive to engage in local solicitation activity on behalf of Amazon, that solicitation activity was prob- ably occurring on behalf of Amazon.15 Indeed, Judge Bransten observed, Amazon had made no allegation in its complaint that its in-state Internet affi liates were not physically soliciting sales orders from New York customers for Amazon in New York.16

For similar reasons, Judge Bransten dismissed all of the claims in Overstock’s complaint.17

On November 4, 2010, the Supreme Court, Appel- late Division, affi rmed Judge Bransten’s conclusion that the New York click- through nexus law does not facially violate the Commerce Clause. The three-judge Appellate Di- vision panel found that the New York click-through nexus law “imposes a tax collection obligation on an out-of-state vendor only where the vendor enters into a business-referral agreement with a New York resident, and only when that resident receives a commission based on a sale in New York.”18 The Appellate Division added:

Of equal importance to the requirement that the out-of-state vendor have an in-state presence is that there must be solicitation, not passive adver- tising. While Tax Law §1101(b)(8)(vi) creates the presumption that the in-state agent will solicit, it provides the out-of-state vendor with a ready es- cape hatch or safe harbor. The vendor merely has to include in its contract with the in-state vendor a provision prohibiting the in-state representative from “engaging in any solicitation activities in New York State that refer potential customers to the seller,” and the in-state representative must provide an annual certifi cation that it has not engaged in any prohibited solicitation activi- ties as outlined in the memorandum. Thus, an in-state resident which merely acts as a conduit for linkage with the out-of-state vendor will be presumed to have not engaged in activity which would require the vendor to collect sales taxes. Presumably, there are vendors which will be able

to execute the annual certifi cation without fear of making a misrepresentation.19

Indeed, the Appellate Division was not able to reconcile Amazon’s argument that its Internet af- fi liates were only engaging in passive advertising in New York with the statement in the company’s own Associates Program marketing materials that “[o]ur compensation philosophy is simple: reward Associates for their contributions to our business in unit volume and growth. Amazon is a fast growing business and we want our Associates to grow with us. . . . The performance structure allows you to earn higher fees when you generate a suffi cient volume of referrals that result in sales at Amazon.com during

a month. The higher your referrals, the greater your earnings will be.”20

However, the Appel- late Division remanded the Amazon.com and Overstock.com cases to the trial court for further development of the tax- payers’ claims that the application of the New

York click-through nexus law to them violated the Commerce Clause. Because no discovery had yet been undertaken regarding Amazon’s and Overstock’s referral arrangements with their in-state affi liates, the Appellate Division was unable to conclude, as a matter of law, that the in-state Internet affi liates were “engaged in suffi ciently meaningful activity so as to implicate the State’s taxing powers,” particularly “whether their in-state representatives are soliciting business or merely advertising on their behalf.”21 While this remand kept Amazon’s and Overstock’s cases alive, these vendors may not have relished the prospect of detailed discovery into their sales prac- tices in New York.

Indeed, Amazon and Overstock abandoned their as-applied Commerce Clause challenges when they appealed the Appellate Division’s decision to the New York Court of Appeals. On March 28, 2013, the Court of Appeals affi rmed the conclusion of the two lower courts that the New York click-through nexus law constitutionally presumes that the remote seller’s Internet affi liates are engaging in physical solicitation activity in New York on behalf of the remote seller in order to increase the amount of performance-based compensation the affi liates receive from the remote

State Law & State Taxation Corner

Crafting the New York click- through nexus law as a rebuttable

presumption that the in-state Internet affi liates were acting as

sales representatives of the remote seller proved to be clever[.]

JOURNAL OF PASSTHROUGH ENTITIES 25

January–February 2014

seller.22 The Court of Appeals noted in its opinion that “no one disputes that a substantial nexus would be lacking if New York residents were merely engaged to post passive advertisements on their websites.23 However, the Court of Appeals agreed with the De- partment’s argument that the New York click-through nexus law was targeting physical solicitation activity of the in-state Internet affi liates, which would consti- tute more than mere advertising:

[T]hrough this statute, the legislature has at- tached signifi cance to the physical presence of a resident website owner. The decision to do so recognizes that, even in the Internet world, many websites are geared toward predominantly local audiences—including, for instance, radio stations, religious institutions and schools—such that the physical presence of the website owner becomes relevant to Commerce Clause analysis. Indeed, the Appellate Division record in this case contains examples of such websites urging their local constituents to support them by making purchases through their Amazon links. Essentially, through these types of affi liation agreements, a vendor is deemed to have established an in-state sales force.24

The Court of Appeals concluded that:

Viewed in this manner the statute plainly satisfi es the substantial nexus requirement. Active, in-state solicitation that produces a signifi cant amount of revenue qualifi es as “demonstrably more than a ‘slightest presence’” under Orvis. Although it is not a dispositive factor, it also merits notice that vendors are not required to pay these taxes out- of-pocket. Rather, they are collecting taxes that are unquestionably due, which are exceedingly diffi cult to collect from the individual purchasers themselves, and as to which there is no risk of multiple taxation.25

The Court of Appeals drew on the same rationale to reject Amazon’s and Overstock’s argument that the New York click-through nexus law facially violated the Due Process Clause by creating an irrational and essentially irrebutable presumption of nexus. Accord- ing to the Court of Appeals, “[i]t is plainly rational to presume that, given the direct correlation between referrals and compensation, it is likely that residents will seek to increase their referrals by soliciting

customers, more specifi cally, it is not unreasonable to presume that affi liated website owners residing in New York State will reach out to their New York friends, relatives and other local individuals in order to accomplish their purpose.”26 Moreover, the New York click-through nexus law affords the remote seller some opportunity to rebut the presumption of nexus by contractually prohibiting affi liates to engage in physical solicitation activity in New York on behalf of the remote seller and obtaining annual certifi cates from all of the affi liates that they have not undertaken such solicitation activity. The Court of Appeals concluded that “[o]btaining the necessary information may impose a burden on the retailers, but inconvenience does not render the presumption irrebuttable,” in violation of the Due Process Clause.27

The Illinois Click-Through Nexus Law The Illinois Supreme Court took a very different tack in its review of the constitutionality of the Illinois click-through nexus law in Performance Marketing Association, Inc. v. Hamer.28 Enacted on March 10, 2011, as Public Act 96-1544, the Illinois click-through nexus provision in Section 2 of the Illinois Use Tax Law expanded the defi nition of a “retailer maintaining a place of business in this State” to include:

a retailer having a contract with a person located in this State under which the person, for a com- mission or other consideration based upon the sale of tangible personal property by the retailer, directly or indirectly refers potential customers to the retailer by a link on the person’s Internet website. The provisions of this paragraph 1.1 shall apply only if the cumulative gross receipts from sales of tangible personal property by the retailer to customers who are referred to the retailer by all persons in this State under such contracts exceed $10,000 during the preceding 4 quarterly periods ending on the last day of March, June, September, and December.29

Whereas the New York click-through nexus law establishes a rebuttable presumption that the in-state Internet affi liates are engaged in localized physical sales solicitation activity in New York on behalf of the remote seller, this Illinois click-through nexus law conclusively presumes that such nexus has been established as a result of the existence of the contrac-

tual performance marketing arrangement between the remote seller and the Internet affi liate in Illinois.

The Illinois Department of Revenue did not have much of an opportunity to develop administra- tive guidance on how it would apply the Illinois click-through nexus law because the Performance Marketing Association (the “PMA”), a nonprofit trade organization in Camarillo, California, that represents the interests of businesses, organizations and individuals using and supporting performance marketing methods, including performance mar- keting on the Internet, promptly fi led a lawsuit in the Circuit Court of Cook County challenging the constitutionality of the Illinois click-through nexus statute. The PMA’s complaint for declaratory and injunctive relief alleged that the Illinois click-through nexus law violated the Commerce Clause because the statute imposed a use tax collection obligation on remote sellers lack- ing the physical presence in Illinois required by the U.S. Supreme Court’s decision in Quill Corp. v. North Dakota.30 The PMA’s complaint further alleged that the Illinois click-through nexus law violates the federal Internet Tax Freedom Act by affording more onerous nexus treatment to Internet-based performance marketing arrangements than performance marketing by print or broadcast methods.31

The PMA and the Department entered into a de- tailed joint stipulation of facts that described the sorts of performance marketing activity that could trigger sales and use tax nexus under the Illinois click-through nexus law. The parties stipulated that “[o]ther Internet retailers affected by P.A. 96-1544 have no physical presence in Illinois, but maintain websites offering goods and/or services to consumers throughout the country, and sell products and services to consumers in Illinois and elsewhere from facilities located outside the state, by using instrumentalities of interstate commerce, including the Internet, and also enter into contracts with Internet affi liates located in Illinois, and make sales to consumers who access their websites through links on the websites of such Illinois Internet affi liates.”32 Much of this performance marketing was directed at a regional, national or international audience on the Internet rather than specifi cally at Illinois consumers.33

The Department also stipulated that:

Under P.A. 96-1544, a retailer will be included within the defi nition of a ‘retailer maintaining a place of business in this State’ if: (1) the retailer has a contract with an Internet affi liate with a physical presence in Illinois for placement of text or images on its (the Internet affi liate’s) website that include a link that connects an Internet user to the retailer’s website; (2) the Internet affi liate receives compen- sation based upon sales by the retailer to such customers; and (3) the retailer receives more than $10,000 total gross receipts in the previous four quarters from sales to customers who are referred to the retailers by Internet affi liates in Illinois. Under the amendments to 35 ILCS 105/2 and 35 ILCS 110/2 set forth in P.A. 96-1544, the retailer does not

need to have a physical presence in Illinois; the retailer’s contracts with Internet affi liates alone are suffi cient.34

Thus, whereas in the Amazon.com case the New York Department of Taxation and Finance ar-

gued that the rebuttable presumption of nexus in the New York click-through nexus law was justifi ed by the in-state physical solicitation activity that in-state Internet affi liates were presumably conducting on behalf of the remote seller, the Illinois Department of Revenue took the forthright position in the Per- formance Marketing Association case that the mere existence of the contractual performance marketing arrangement between the remote seller and its in- state Internet affi liate gives the remote seller nexus in Illinois. The department agreed this was the case even though “[c]onsumers generally do not know, and have no way of knowing, the physical location, including the state or even the country, where the computer servers hosting a website are located. This includes the websites of Internet affi liates and retailers engaged in performance marketing.”35 This was hardly the traditional face-to-face sales solicitation activity that courts have considered over the years in their cases fi nding use tax collection nexus.

The PMA and the department also stipulated that performance marketing is not unique to the Internet. It is commonly used in online sales because of the ease of tracking consumer purchases and the role that a

State Law & State Taxation Corner

The Illinois Supreme Court’s opinion in the Performance

Marketing Association cases leaves a hollow feeling for many state tax

practitioners and taxpayers.

JOURNAL OF PASSTHROUGH ENTITIES 27

January–February 2014

link from an Internet affi liate’s website to the remote seller’s website played in generating that sale.36 How- ever, the parties agreed that “[o]ffl ine, performance marketing is often used where some other method permits the retailer to track the promotion and deter- mine the level of response to and/or sales resulting from the promotion. Examples would be the use of promotional codes in print and on radio.”37

On May 7, 2012, the Circuit Court of Cook County issued a brief order granting summary judgment to the PMA on both its facial Commerce Clause claim and its Internet Tax Freedom Act claim.38 The Illinois Department of Revenue was able to appeal the Circuit Court’s decision directly to the Illinois Supreme Court because the decision had invalidated the Illinois click-through nexus law on constitutional grounds.

The Illinois Supreme Court surprised many observ- ers when it punted on the Commerce Clause issue and instead affi rmed that the Illinois click-through nexus law is federally preempted by the ITFA.39 En- acted by Congress in 1998, section 1101(a)(2) of the ITFA prohibits a state from imposing “discriminatory taxes on electronic commerce.”40 Section 1104(2) (A)(iii) of the ITFA defi nes a “discriminatory tax” in part as any tax “imposed by a State or political subdivision thereof on electronic commerce that . . . imposes an obligation to collect or pay the tax on a different person or entity than in the case of transac- tions involving similar property, goods, services, or information accomplished through other means.”41

The PMA claimed that the Illinois click-through nexus law presents such a federally preempted dis- criminatory tax on electronic commerce because the express language of the Illinois click-through nexus law only describes performance compensated sales referrals via a computer link from the Internet affi liate’s website to the remote seller’s website. Per- formance marketing via more traditional media such as catalogs, magazines, newspapers, television and radio were not, according to the PMA, covered by the Illinois click-through nexus law. The Department responded that another provision of the “retailer maintaining a place of business in this State” defi ni- tion in Section 2 of the Illinois Use Tax Act applies to a “retailer, pursuant to a contract with a broad- caster or publisher located in this State, soliciting orders for tangible personal property by means of advertising which is disseminated primarily to con- sumers located in this State and only secondarily to bordering jurisdictions.”42 That, argued the Depart- ment, subjects remote sellers utilizing performance

marketing through radio and television broadcasters and newspapers or magazines to the same Illinois use tax collection obligation on their offl ine sales to Illinois consumers as that remote seller would incur as a result of its use of online performance marketers.

The Illinois Supreme Court rejected this analogy, however, because of the inherently broader reach of Internet-based performance marketing compared with performance marketing by radio, television or print media. The Illinois Supreme Court pointed out in its Performance Marketing Association opin- ion that the Illinois Use Tax defi nition of a “retailer maintaining a place of business in this State” does not capture performance marketing via national or international radio, television or print media, whereas all Internet-based performance marketing regardless of its geographic scope, are picked up by the Illinois click-through nexus law:

Under paragraph 3 of the defi nition section of the Use Tax Act, retailers who enter into contracts with Illinois publishers and broadcasters for ad- vertising “disseminated primarily to consumers located in this State,” i.e., locally, are obligated to collect use tax. But Internet advertising is differ- ent. As the parties’ joint stipulation of facts states: “The home page and other publicly-available pages of any Internet website can be accessed from a computer, or other digital device, located anywhere in the world that is connected to the Internet via wire or radio signal. Thus, information appearing on a webpage is available and dissemi- nated worldwide.” (Emphasis added.) Illinois law does not presently require out-of-state retailers who enter into performance marketing contracts for “offl ine” print or broadcast advertising which is disseminated nationally, or internationally, to collect Illinois use tax. However, under the Act, out-of-state retailers who enter into such contracts with Illinois Internet affi liates for the publication of online marketing—which is inherently national or international in scope and disseminated to a national or international audience—are required to collect Illinois use tax. In this way, by singling out retailers with Internet performance market- ing arrangements for use tax collection, the Act imposes discriminatory taxes within the meaning of the ITFA.43

Based on this perceived difference in the tax treatment of online versus offl ine performance

marketing arrangements, the Illinois Supreme Court concluded that:

In short, under the Act, performance marketing over the Internet provides the basis for imposing a use tax collection obligation on an out-of-state retailer when a threshold of $10,000 in sales through the clickable link is reached. However, national, or international, performance marketing by an out-of-state retailer which appears in print or on over-the-air broadcasting in Illinois, and which reaches the same dollar threshold, will not trigger an Illinois use tax collection obliga- tion. The relevant provisions of the Act therefore impose a discrimina- tory tax on electronic commerce within the meaning of the ITFA.44

Having found that the Il- linois click-through nexus law is federally preempted by the ITFA, the Illinois Supreme Court did not address the PMA’s facial Com- merce Clause argument.45

Analysis The Illinois Supreme Court’s opinion in the Perfor- mance Marketing Association cases leaves a hollow feeling for many state tax practitioners and taxpayers. While a taxpayer victory is always appreciated, the Illinois Department of Revenue appeared to have overstepped the accepted boundaries of Commerce Clause nexus case law by applying the Illinois click- through nexus law based on the mere existence of an Internet-based performance marketing arrangement, even if the consumer would have no idea whatsoever that the Internet affi liate’s computer server or offi ce is physically located in Illinois. The Commerce Clause nexus case law has so far generally dealt with remote sellers that maintained their own place of business, employees or property in the taxing state or that utilized third-party sales or service representatives to interact face-to-face with customers in the taxing state. Under such circumstances, the remote seller could clearly be viewed as using its physical presence in the taxing state to develop a marketplace for its goods or services with customers in the taxing state.

The Illinois Department of Revenue probably would have been on more tenable Commerce Clause terrain

if it had taken the administrative position, as the New York Department of Taxation and Finance did in the Amazon.com case, that a remote seller entering into performance marketing arrangements with in-state Internet affi liates may be encouraging the Internet affi liates to engage in sales solicitation activity on behalf of the remote seller in the taxing state, but then provide the remote seller an opportunity to dem- onstrate that the Internet affi liates have not actually undertaken such sales solicitation activity on behalf of the remote seller. The Illinois Department of Rev- enue may have believed that without the rebuttable presumption language of the New York click-through nexus law, the Illinois click-through nexus law has to

be interpreted as creating a conclusive presumption of nexus based on the ex- istence of the contractual performance marketing arrangement between the remote seller and the in- state Internet affi liate. The Department did acknowl-

edge in its briefs that “there may be some internet performance marketing arrangements that do not establish a suffi cient nexus for Illinois to impose a use tax collection obligation on an out-of-state internet retailer” and that “nothing in Public Act 96-1544 prevents an out-of-state retailer from proving that its arrangement with an in-state retailer [sic] transgresses the constitutional boundaries of state taxation.”46 But the Illinois Department of Revenue appeared to be setting itself up for a decision by the Illinois Supreme Court that the Illinois click-through nexus law, as in- terpreted by the Department, violated the Commerce Clause. Such a holding would have provided much needed guidance regarding the constitutional scope of state click-through nexus laws. Moreover, it would have been well within the boundaries of Commerce Clause case law.

What the state tax community received instead was an opinion that the Illinois click-through nexus law violates the ITFA because of the Illinois Supreme Court’s conclusion that a remote seller having a per- formance marketing arrangement with national or international (as opposed to local) radio, television or print media would not be treated as a “retailer maintaining a place of business in this State” under the Illinois Use Tax Act. It is not clear from the Illinois Supreme Court’s Performance Marketing Associa-

State Law & State Taxation Corner

The Supreme Court did not have much incentive, then, to join the fray over the constitutionality of state click-through nexus laws.

Continued on page 45

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fect the S corporation status of the corporation and they are reviewed for tax purposes. A shareholders’ agreement can be an effective tool to develop the relationship among the shareholders. However, be- fore it is used and implemented, the tax advisor to the corporation should make sure that it does not jeopardize the S corporation status of the corporation. Good inten- tions toward the relationship of the shareholders should not deny the tax benefi ts available to the shareholders. The three rulings discussed in this column show just how easy it is to implicate the one-class-of-stock rule and the dire consequences if the rule is violated.

ENDNOTES 1 Code Sec. 1361(b)(1)(D). 2 Reg. §1.1361-1(l)(1). 3 Code Sec. 1361(c)(4). 4 Reg. §1.1361-1(l)(2)(i). For these purposes, the

“governing provisions” include the articles of incorporation, bylaws and agreements relat- ing to distribution and liquidation proceeds.

5 Reg. §1.1361-1(l)(2)(iii)(A), italics added for emphasis.

6 Reg. §1.1361-1(l)(2)(iii)(A). 7 Reg. §1.1361-1(l)(2)(iii). 8 Reg. §1.1361-1(l)(2)(iii)(C). 9 Reg. §1.1361-1(l)(2)(iii)(B). 10 Reg. §1.1361-1(l)(2)(vi) Example (8). 11 Reg. §1.1361-1(l)(2)(vi) Example (9). 12 LTR 201309003, March 1, 2013. 13 LTR 201306004, Feb. 8, 2013. See also the

similar LTR 201306005, Feb. 8, 2013. 14 Reg. §301.7701-3(a) provides that a partner-

ship with two or more members can elect to be treated as an association taxable as a corporation for income tax purposes.

15 LTR 201337001, Sept. 13, 2013 16 The members fi le a Form 2553 with the

Internal Revenue Service. 17 Reg. §1.1361-1(l)(2)(i). 18 Rev. Proc. 93-27, 1993-2 CB 343.

Illinois,” a factual predicate for the remote seller to be treated as having a representative operating in Illinois. Indeed, if the Illinois Department of Revenue would treat the appearance of a promo- tional code in an advertisement in THE WALL STREET JOURNAL as giving the remote seller nexus in Illi- nois, that arguably would ignore U.S. Supreme Court Commerce Clause cases holding that out-of- state vendors may disseminate advertisements in the taxing state without establishing use tax-col- lection nexus in that state.47

Nor does it appear that tradition- al “bricks-and-mortar” retailers would have faced a less onerous use tax collection obligation than electronic commerce retailers did under the now invalidated Illinois click-through nexus law if both types of retailers utilized Internet- based performance marketing by an affi liate in Illinois. The Illinois Supreme Court focused its opin- ion not so much on the perceived differences in the Illinois use tax collection treatment of different types of retailers (online versus bricks-and-mortar merchants) as on divergent tax consequences of marketing methods (online versus offl ine performance marketing).

The Performance Marketing Association opinion is a narrow federal preemption decision that the Illinois General Assembly may be able to overcome by reenacting the Illinois click-through nexus law in a form that expressly applies to performance marketing activity through both online and off-line means. That would leave the De- partment and taxpayers having to relitigate the Commerce Clause nexus issue that was fully briefed in the Performance Marketing As- sociation case. Moreover, the ITFA is due to sunset on November 1,

2014, making this quite an ephem- eral opinion.48

The New York courts seemed to be on fi rmer ground in rejecting the facial Commerce Clause chal- lenge that Amazon and Overstock brought against the New York click-through nexus law. Amazon and Overstock theoretically had the opportunity to rebut the statu- tory presumption that they had nexus in New York by showing that their New York-based Internet affiliates were not engaging in sales solicitation activity in New York on behalf of those remote sellers. It was probably not lost on the New York courts that Amazon and Overstock decided not to pur- sue their as-applied Commerce Clause claims. Believing it was likely that the Internet affi liates were incentivized by their perfor- mance marketing arrangements with Amazon and Overstock to engage in physical sales solicita- tion activity on behalf of those remote sellers, it is understandable that the New York courts upheld the constitutionality of the New York click-through nexus law.

Nor is it very surprising that the U.S. Supreme Court declined to review the New York Court of Appeals decision in the Amazon. com and Overstock.com cases. As previously discussed, this New York decision was not re- ally in confl ict with the Illinois Supreme Court’s opinion in the Performance Marketing Asso- ciation case because these cases were decided on different legal grounds and addressed differently worded click-through nexus laws. The remote seller is afforded the opportunity under the New York click-through nexus law to dem- onstrate that its Internet affi liates are not operating as sales repre- sentatives of the remote seller in

State Law & Taxation Continued from page 28

tion opinion, however, that such national or international radio, television or print media would be considered to be “located in

New York, diffi cult as that may be to prove. Moreover, Congress came closer than ever in 2013 to passing the Marketplace Fairness Act, which would overturn the physical-presence nexus require- ment of the Supreme Court’s Quill Corp. case and render these state click-through nexus laws superfl u- ous. The Supreme Court did not have much incentive, then, to join the fray over the constitutional- ity of state click-through nexus laws. From this perspective, the Supreme Court’s denial of a writ of certiorari in the Amazon.com and Overstock.com cases should not be viewed as the open invitation for states to ignore the Commerce Clause’s physical-presence nexus standard that some commentators are making it out to be.49

ENDNOTES 1 John A. Biek, State Law & State Taxation Cor-

ner “Amazon Laws” Roil the Waters of State Sales and Use Tax Nexus, J. PASSTHROUGH ENTITIES, May-June 2011, at 33.

2 Amazon.com, LLC v. New York State De- partment of Taxation and Finance, 23 Misc. 3d 418, 877 N.Y.S.2d 842 (Sup. Ct., New York Cty. 2009), aff’d as modifi ed, 81 AD3d 183, 913 N.Y.S.2d 129 (App. Div. 2010), aff’d sub nom. Overstock.com, Inc. v New York State Dept. of Taxation and Finance, 20 N.Y.3d 586, 987 NE2d 621, 965 N.Y.S.2d 61 (2013), cert. denied SCt, Dec. 2, 2013.

3 See Ark. Cod §26-52-117(d); Cal. Rev. & Tax Code §6203(c)(5)(A); Conn. Gen. Laws §12-407(a)(12); Ga. Code §48-8-2(8)(M); Kan. Stat. §79-3702(h)(2)(C); Me. Rev. Stat., tit. 36, §1754-B(1-A)(C); Minn. Stat. §297A. 66, subd. 4a(b); Mo. Stat. §144.605(2)(e); N.C. Gen. Stat. §105-164.8(b)(3); N.Y. Tax Law §1101(b)(8)(vi); R.I. Gen. Laws §44-18- 15(a)(2) ($5,000 per year sales threshold for Internet affi liate referrals); Vt. Stat., tit. 32, §9701(9)(I). The Pennsylvania Department of Revenue has announced this is their rule, too, although it does not appear the state has actually enacted a click-through nexus statute. Pa Sales Tax Bulletin No. 2011-01 (Dec. 1, 2011). The Illinois click-through nexus law, 35 ILCS 105/2 (definition of “retailer maintaining a place of business in this State”), establishes a conclusive presumption of nexus.

4 See, e.g., Scripto, Inc. v. Carson, SCt, 362

US 207, 80 SCt 619 (1960); Tyler Pipe In- dustries, Inc. v. Washington Department of Revenue, SCt, 483 US 232, 107 SCt 2810 (1987).

5 Overstock.com, Inc. v. New York State Department of Taxation and Finance, 20 N.Y.3d 586, 987 NE2d 621, 965 N.Y.S.2d 61 (2013).

6 Performance Marketing Association, Inc. v. Hamer, 2013 IL 114496, 2013 Ill. LEXIS 1354 (2013).

7 Internet Tax Freedom Act, P.L. 105-277, Div. C, Tit. XI, §§1100-1104 (Oct. 21, 1998), 112 Stat. 2681-719 through 2681-726.

8 N.Y. Tax Law §1101(b)(8)(vi) (emphasis added), enacted by Ch. 57 (S.B. 6807), Laws 2008 (eff. Apr. 23, 2008).

9 Quill Corp. v. North Dakota, SCt, 504 US 298, 112 SCt 1904 (1992).

10 New York Department of Taxation and Fi- nance, TSB-M-08(3)S (May 8, 2008).

11 New York Department of Taxation and Fi- nance, TSB-M-08(3.1) S (June 30, 2008).

12 Amazon.com, LLC, 23 Misc. 3d 418, 425, 877 N.Y.S.2d 842 (Sup. Ct., New York Cty, 2009).

13 23 Misc. 3d at 426 (emphasis supplied by court).

14 Id. at 427. 15 Id. at 428. 16 Id. at 427. 17 913 N.Y.S.2d at 136. 18 81 A.D.3d at 196-97. 19 Id. at 197. 20 Id. (emphasis supplied by court). 21 Id. at 203-04. 22 Overstock.com, Inc. v. New York State De-

partment of Taxation and Finance, 20 N.Y.3d 586, 593, 987 NE2d 621, 965 N.Y.S.2d 61 (2013), aff’g 81 AD3d 183, 913 N.Y.S.2d 129 (2010), cert. denied SCt, Dec. 2, 2013.

23 20 N.Y.3d at 596. 24 Id. at 595. 25 Id. 26 Id. at 597. 27 Id. 28 Performance Marketing Association, Inc.

v. Hamer, 2013 IL 114496, 2013 Ill. LEXIS 1354 (2013).

29 35 ILCS 105/2(1.1). 30 Quill Corp. v. North Dakota, SCt, 504 US

298, 112 SCt 1904 (1992). 31 Performance Marketing Association, Inc.

v. Hamer, 2013 IL 114496, 2013 Ill. LEXIS 1354 (2013).

32 Joint Stipulation of Facts ¶18, Performance Marketing Association, Inc. v. Hamer, No. 2011 CH 26333 (Ill. Cir. Ct. of Cook Cty) (hereinafter referred to as the “Joint Stipula- tion”).

33 Joint Stipulation ¶19. 34 Parties’ Agreed Correction to Joint Stipula-

tion of Facts, Performance Marketing Asso- ciation, Inc. v. Hamer, No. 2011 CH 26333 (Ill. Cir. Ct. of Cook Cty.) (emphasis added).

35 Joint Stipulation ¶35.

36 Joint Stipulation ¶24. 37 Joint Stipulation ¶25. 38 Performance Marketing Association, Inc. v.

Hamer, Dkt. No. 2011CH26333, 2012 WL 2090791 (Ill. Cir. Ct. of Cook Cty., May 7, 2012).

39 Internet Tax Freedom Act (“ITFA”), P.L. 105- 277, Div. C, Tit. XI, §§1100-1104 (Oct. 21, 1998), 112 Stat. 2681-719 through 2681- 726.

40 IFTA §1101(a)(2). 41 ITFA §1104 (2)(A)(iii). 42 35 ILCS 105/2(3) (emphasis supplied). 43 Performance Marketing Association, Inc.

v. Hamer, 2013 IL 114496, 2013 Ill. LEXIS 1354 (2013).

44 Id. at ¶ 23. 45 Id. 46 Brief and Appendix of Defendant-Appellant

29, Performance Marketing Association, Inc. v. Hamer, 2013 IL 114496, 2013 Ill. LEXIS 1354 (2013).

47 See, e.g., Quill Corp. v. North Dakota, SCt, 504 US 298, 112 SCt 1904 (1992); National Bellas Hess, Inc. v. Illinois Department of Revenue, SCt, 386 US 753, 87 SCt 1389 (1967); Miller Brothers Co. v. Maryland, SCt, 347 US 340 (1954).

48 See Internet Tax Freedom Act Amendment Act of 2007, P.L. 110-108, §2 (Oct. 31, 2007), 121 Stat. 1024.

49 See, e.g., Richard Wolf, Supreme Court Won’t Rule on State Internet Sales Taxes, USA TODAY, Dec. 3, 2013, at 1A; Brent Kendall, Sales Tax Clears Hurdle— Supreme Court Declines to Hear Amazon, Overstock Challenge to New York Law, WALL ST. J., Dec. 3, 2013, at B8.

Further, and of great importance for tax practitioners, an assess- ment of penalties under Code Sec. 6707A may result in a referral to the IRS’s Offi ce of Professional Responsibility,38 which, based on its own review of the factual circumstances, may impose ad- ditional sanctions against the practitioner, including monetary penalties, censure or suspension or disbarment from practice be- fore the IRS.39

In addition to these harsh pen- alties for the mere failure to fi le the disclosure forms, if there is a “reportable transaction under-

Tax Controversy Continued from page 32

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