On June 1st, 2008, New York lawmakers put into effect a law that narrows the online tax exemption and sends a clear message to online retailers: You’re either in or you’re out.  New York wants retailers "in" so that they can collect NY sales tax.  Retailers want to remain "out" in order to keep the online tax exemption and avoid the costs associated with collecting sales taxes from customers.

Prior to the New York law, an online retailer had to do more than just sell goods in a state in order to be responsible for collecting sales taxes on goods sold in that state.  In 1992, the US Supreme Court held a retailer must have a “physical presence” within the state in order to be responsible for collecting sales taxes.  Quill Corp. v. North Dakota By and Through Heitkamp (1992) 504 U.S. 298.  The Supreme Court explained that a retailer must have a "substantial nexus" with the state in order to have a "physical presence."  This traditionally has meant that retailers have some physical operations, such as its headquarters, a warehouse, or a distribution center, in the state.

With the advent of the internet, retailers can open an online store based in one state, and customers from the other 49 states can browse its selection and make purchases tax free.  Thus, the "physical presence" standard created an online tax exemption that benefited online retailers and consumers, alike.

The NY law substantially narrows this online tax exemption.  The NY law eases the Supreme Court’s definition of “physical presence” and makes it more likely that an online retailer will be found to have a “physical presence” in New York.  The law targets online retailers’ relationships with affiliate sites based in New York.  If an online retailer uses affiliate sites to promote its online store, the NY law deems that retailer to have a "physical presence" in New York.  Affiliate sites are any internet sites that receive some form of commission for directing sales to an online retailer.  For example, a fashion blogger that directs its readers to an online retailer that sells handbags becomes an affiliate when a reader buys a purse and the online retailer pays the fashion blogger a commission.  According to E-tailing Group Inc. of Chicago, many online retailers have affiliate programs that account for 9% of online sales.

The New York law has made online retailers nervous for two significant reasons.  First, one of the major draws to shopping online is getting the sales tax break.  In many instances, the break on sales tax balances out the cost of shipping.  Without this tax break, online shoppers may abandon their online stores and return to their local shops.  Second, online retailers will have to create an infrastructure and adapt technology in order to collect the sales tax.  This means increased costs.

The combination of potential decreased sales and unavoidable increased costs have made online retailers scramble over the past few months in order to maintain the online tax exemption.  Online retailers have essentially three options: 1. Remove New York-based affiliates from their affiliate programs in order to maintain their "out" status; 2. Change the terms and conditions of their affiliate contracts in order to satisfy an exception to the New York law; or 3. Accept "in" status and collect sales tax.  Additionally, some online retailers who have taken one of these routes have also sued the state of New York alleging the law is unconstitutional.

The New York law raises some complicated legal issues and challenges online retailers to determine what it means to be "in" and to find ways to maintain being "out."