The growth of e-commerce has spawned an inconspicuous issue that may have grave consequences to real estate developers and Main Street merchants and the economic viability of their projects and businesses. To understand the problem, developers and Main Street merchants must focus on the link between retail sales and the funding of state and local community infrastructure and services.

Revenues generated from sales taxes largely fund such needed infrastructure and services. However, since most sale transactions over the Internet are untaxed, the more that goods are sold over the Internet, the less tax money will be available to local communities for things such as roads, parks, schools, libraries, firefighting and law enforcement. Although e-commerce constitutes only a small fraction of overall retail sales, a swing of a few million dollars (or billion dollars with respect to states and large metropolitan areas) in lost sales tax revenues could be devastating for a state or local community.

A real danger exists that state and local governments will look to commercial developers to make up the difference in lost sales tax revenue through the imposition of higher property taxes or additional development fees. Absent viable opposition, developers and Main Street merchants may be left to absorb significant additional financial burdens.

The waiting game

To better understand the history of Internet-related sales taxation, consider the brief history of the Internet Tax Freedom Act. Enacted in October 1998, this act established a 3-year moratorium on the imposition of state and local taxes on Internet access. The moratorium was intended to prevent access and other discriminatory taxes on the Internet, in an effort to grow the Internet as an instrument of commerce. However, the moratorium also had the practical effect of maintaining the status quo with respect to sales taxes, meaning that e-tailers are currently subject to the same basic state and local sales tax laws as mail-order retailers. If an e-tailer has a physical “nexus” in a state (i.e., a store, warehouse, distribution or other facility in that state), then it must collect sales taxes on sales to purchasers within that state.

On the other hand, if goods are purchased by a party in a state where the merchant has no such nexus, state and local sales taxes are not required to be collected by the merchant. Although most states do have a mechanism to recoup lost taxes on purchases from remote retailers (usually in the form of use taxes), collection depends on self-reporting by purchasers. For a multitude of reasons (namely, public unawareness and the self-reporting nature of the law), use taxes are rarely collected and taxes from these sales are largely lost. Without a legal requirement compelling remote retailers to collect sales or use taxes, the revenues from such taxes will likely remain uncollected.

As the 3-year moratorium draws to a close, Congress has been considering a 5-year extension. The extension has been approved by the U.S. House of Representatives, and was thought to have a high likelihood of passing in the U.S. Senate.

However, a strong lobbying effort by an unlikely coalition of groups, including developers, merchants, state and local lawmakers, teachers, police officers, firefighters and other government workers, caused the Senate to reconsider extension of the moratorium because of its practical effect on sales taxes.

This coalition is not opposed to an extension of the moratorium on access and other new or discriminatory taxes. Rather, its focus is on requiring e-tailers to collect sales taxes so as to prevent the deterioration of community services and the imposition of new real estate taxes and impact fees by state and local governments as a substitute for lost sales tax revenues.

Main Street merchants, one of the groups within the coalition, make the compelling argument that the failure of e-tailers to collect sales taxes at the time of sale is patently unfair, since bricks-and-mortar retailers must collect this additional expense when selling the same product. Such unfairness is exacerbated when considering who actually reinvests in local communities.

For example, Main Street merchants hire local citizens and sponsor community groups, while e-tailers use community infrastructure and reap the benefits of doing business in local communities, but are unlikely to reinvest in local communities in a manner similar to that of bricks-and-mortar retailers.

Developers at risk

Of all the groups within the coalition, developers may have the most to lose by an extension of the moratorium and the continued unwillingness to impose on e-tailers the obligation to collect sales taxes at the time of sale. State and local governments are unlikely to allow deterioration of their local infrastructure and services. The shortfall in revenues will likely be recouped through the imposition of new taxes and other governmental fees.

Developers (and tenants, through increased pass-through expenses) will bear the greatest share of this burden, as it is their projects that create the need for such increased infrastructure and services. Commercial developers may even face the risk of “split roll” taxation, where higher taxes may be imposed on commercial property, while the status quo is maintained with respect to residential property.

Interestingly, a perpetuation of the current treatment of e-commerce and the collection of sales taxes may create a greater incentive for traditional retailers to create or enhance on-line subsidiary businesses. As the cost of operating bricks and mortar outlets increases, more and more retailers may create subsidiary companies with limited warehouse and distribution facilities (limiting the number of states with which a physical nexus may be established) to sell goods online in an effort to compete more effectively. The shift to e-tail will further perpetuate the problem by increasing Internet sales and further reducing collected sales tax revenues.

The coalition has created a groundswell of support for required tax collection at sale inception. A bipartisan group of lawmakers (led by U.S. Senator Byron Dorgan of South Dakota) is taking this position. As an alternative to collecting sales taxes, Senator Dorgan's approach would impose an obligation on e-tailers to collect use taxes and remit them to the appropriate state following sale consummation.

This approach conceptually addresses the problem of minimizing lost sales tax revenue without imposing greater burdens on developers and retailers, while not affecting the moratorium on Internet use and access taxes.

Although the coalition has created an organizational base to oppose the continuation of the unfair tax treatment which e-tailers currently enjoy, by no means has the battle been won. If developers and their coalition partners are not able to persuade Congress to require remote e-tailers to collect sales or use taxes at the time of sale, real estate developers and bricks-and-mortar retailers face the prospect of more burdensome development requirements, in the form of higher taxes and development and impact fees. This may ultimately result in less commercial development and higher costs of goods for all consumers.

Gary Glick and Scott Grossfield are partners at Los Angeles-based Cox, Castle & Nicholson LLP, which provides a complete range of legal services to the real estate industry.