The Interstate Income Tax Act of 1959, also known as Public Law 86-272, prohibits a state from imposing its income tax on numerous multistate businesses. That federal limitation on state income taxation only applies, however, if six requirements are met: (1) the state tax being applied is a net income tax; (2) the business being taxed is an out-of-state business[1] (3) the only activity of the business in the state is the solicitation of orders; (4) all orders are accepted by the business outside the state; (5) the product being sold is shipped from outside the state; and (6) the product being sold is tangible personal property.

This article focuses on the tangible personal property aspect of P.L. 86-272 and whether the sale of digital goods by a business falls under its protection. It lays out the context, development, and importance of P.L. 86-272; explains the concept of digital goods; and evaluates the applicability of P.L. 86-272 to multistate sellers of digital goods. This article concludes with the legal and logical reasons why P.L. 86-272 should apply to sellers of digital goods.

What Is P.L. 86-272?

In 1959 the U.S. Supreme Court in Northwestern States Portland Cement Co. v. Minnesota[2] expanded the reach of states to impose income taxes on multistate businesses that solicited sales in those states. In response, Congress imposed restrictions on state taxing powers and passed P.L. 86-272 later that same year[3]. Congress originally designed this law as a stopgap measure to limit state taxing power on remote sellers until it could look at the issue more closely. As part of the new law, Congress created the Special Subcommittee on State Taxation of Interstate Commerce (commonly called the Willis Commission after its chair, then-U.S. Rep. Edwin Willis)[4]. The Willis Commission was tasked with reviewing the interstate taxation issue and reporting its findings to Congress.[5]

In 1965 the Willis commission provided the last volume of its four-volume report to Congress. The Willis Report discusses P.L. 86- 272 and various multistate tax issues facing the country at the time. However, Congress made no changes to P.L. 86-272 after the report was issued and has not updated or modified the language of the prohibition contained in P.L. 86-272 in the 59 years since its enactment. Moreover, P.L. 86-272 never defined the term "tangible personal property." So there is little to no guidance from Congress on how it should be applied in the digital-centric marketplace.

P.L. 86-272 is a short and sweet law that states in pertinent part:

No state, or political subdivision thereof, shall have power to impose, for any tax year ending after September 14, 1959, a net income tax on the income derived within such state by any person from interstate commerce if the only business activities within such state by or for such person during such tax year are either, or both, of the following:

(1) the solicitation of orders by such person, or his representative, in such state for sales of tangible personal property, which orders are sent outside the state for approval or rejection, and, if approved, are filled by shipment or delivery from a point outside the state; and

(2) the solicitation of orders by such person, or his representative, in such state in the name of or for the benefit of a prospective customer of such person, if orders by such customer to such person to enable such customer to fill orders resulting from such solicitation are 6 orders described in paragraph (1).[6]

Simply put, P.L. 86-272 bars a state from imposing a net income tax on a business located outside that state that sells tangible personal property located outside that state for delivery to customers in that state - as long as the business's activities in that state are limited to the solicitation of orders, and all orders are approved by the business outside that state. As a result of the recent explosion of digital goods, the question is whether P.L. 86-272 should apply to businesses that sell digital goods in today's e-commerce environment.[7]

What Are Digital Goods?

Digital goods are generally referred to as "any goods that are sold, delivered and transferred in digital form."[8] Unlike physical goods, sellers deliver digital goods electronically to consumers via email or internet downloads. Digital goods include "media files, including music files, video files containing movies or television programming, branded multimedia files and other similar types of products."[9] The Digital Goods and Services Tax Fairness Act of 2015, introduced in the Senate, similarly defines a digital good as "any software or other good that is delivered or transferred electronically, including sounds, images, data, facts, or combinations thereof, maintained in digital format, when that good is the true object of the transaction, rather than the activity or service performed to create such good, and includes, as an incidental component, charges for the delivery or transfer of the digital good."[10]

States have similar definitions of digital goods. For example, Washington defines them as "sound, images, data, facts or information or any combination thereof, transferred electronically."[11] Common types of digital goods are ebooks, downloaded movies or music, streaming media, digital photos, mobile apps, prewritten software, and e-games.[12]

While the understanding of digital goods appears relatively consistent, whether they are or should be considered a type of tangible personal property for tax purposes is an open issue in many states. Yet most states have taken a stand on the treatment of prewritten computer software - a digital good - for tax purposes. Those states classify software as either tangible personal property or a service for sales tax and, in some cases, income tax purposes, depending on whether it is prewritten software or custom software.[13]

That state tax treatment of prewritten software as tangible personal property is consistent with how prewritten computer programs are treated under the U.S. Department of Treasury regulations, which likewise consider those prewritten programs to be tangible personal property.[14] Treasury Reg. section l.861-18(g)(2) makes it clear that how the program is transferred does not change the character of the transaction for federal income tax purposes. Therefore, the sale of a computer program using the worldwide web is considered by Treasury as the sale of a "copyrighted article" rather than an intangible license.[15]

Following that federal treatment, some courts have held that the sale of downloaded prewritten software is the sale of tangible property for state income tax purposes. For instance, in American Business Information Inc. v. Egr, the Nebraska Supreme Court ruled that the sale of business data products electronically over telephone lines was the sale of tangible personal property for Nebraska income tax purposes.[16]

Looking from a sales tax perspective, and to bring some uniformity among its member states, the Streamlined Sales Tax Project addressed the state sales taxation of some types of digital products. The SSTP was formed to simplify the application of state sales taxes by way of the Streamlined Sales and Use Tax Agreement.[17] SSUTA's 23 member states are required to adopt specific definitions to tax the digital products referenced in the agreement. The agreement defines "specified digital products" - a subset of digital goods - for sales and use tax purposes.[18] Specified digital products under SSUTA encompass digital audio-visual works, digital audio works, and digital books transferred electronically.[19] These include recorded or live music, songs, reading of books or other written materials, speeches, ringtones, or other sound recordings; digital books (but not periodicals, newspapers, magazines, or other news or information products); movies; motion pictures; music videos; news  and entertainment programs; and live events.[20]

Under the agreement, member states that impose sales taxes on specified digital products cannot do so by classifying those products as
tangible personal property.[21] Significantly, however, SSUTA does not address whether digital goods can or should be classified as either intangible or tangible personal property for income tax purposes.

Why Is P.L. 86-272 Important?

Without P.L. 86-272's limitations on state income taxation, multistate sellers of goods would likely be taxed by virtually every state where they solicit business and send goods to customers - because the presence of representatives or independent contractors soliciting in a state is more than enough to create state income tax nexus under the due process and commerce clauses.[22] Moreover, the widespread use by many states of economic nexus and factor presence nexus means most multistate sellers of goods, which may not be subject to various state and local income taxes, would be subject to those taxes if not for P.L. 86-272. [23]

Neither economic nexus nor factor presence nexus requires physical presence for a state to impose its income tax jurisdiction over a seller. So without the protections of P.L. 86-272, a state that uses economic nexus could require a remote seller with no physical presence to pay its income tax. Economic nexus generally occurs when a remote business has "purposefully avail[ed] itself of the benefits of an economic market" in a state.[24] Economic nexus may be created by a multistate seller in numerous ways, such as simply directing its advertising or other solicitation to customers in a state, then generating substantial sales or revenue based on that solicitation - or even by the purposeful use of trademarks in a state that generates income from that state.[25] The issue in most economic nexus states comes down to how much state-directed activity, how many transactions, or how much related revenue is needed to establish nexus.

Similarly, factor presence nexus has been adopted by a few states such as New York, California, and Tennessee. Under factor presence nexus, income tax nexus is created if a multistate seller has sufficient sales, property, or payroll in a state.[26] The laws of each state set the amounts of sales, property, or payroll necessary for nexus, which have thus far complied with the Multistate Tax Commission's nexus thresholds of $50,000 in property or payroll, $500,000 in sales, or 25 percent of the business's total property, payroll, or sales in the state.[27]

As demonstrated above, P.L. 86-272 provides the only protection many multistate sellers of goods have from being inundated with the crush of state and local income taxes that would otherwise be imposed throughout the country. Thus, the importance of P.L. 86-272 to multistate sellers of goods cannot be understated, and determining the extent of the application of P.L. 86-272 to digital goods is critical to understanding the income tax exposure of such multistate sellers.

Does P.L. 86-272 Apply to Digital Property?

Two observations must be made before analyzing the application of P.L. 86-272 to digital goods. First, P.L. 86-272 does not apply to sale of services, so financial institutions and transportation, communication, and insurance companies cannot claim its protection. Then again, at that time in history, sellers of goods were "clearly the major source" of state income tax revenue.[28] Also, sellers of services may have been excluded from P.L. 86-272 protection since they were generally subject to special taxes or apportionment rules that affected them differently from sellers of goods when it came to state income taxes.[29]  As a result, Congress apparently decided that it was only crucial to design P.L. 86-272 to protect multistate sellers of goods from the confusion and economic burden of complying with various nonuniform state income tax laws.

Second, the digital delivery of goods did not exist in 1959, so vendors of those products would not have been referenced in the debates on P.L. 86-272 or in the Willis Report. Today, however, sales of digital music and books are as ubiquitous as the sales of hard copies of those items were nearly 60 years ago. Thus, the goal of P.L. 86-272 - namely, to protect multistate sellers of goods - would logically apply equally to sellers of digital goods in today's digital age.

With that in mind, a review of state positions on the taxation of digital goods indicates that some already apply P.L. 86-272 protection to multistate sellers of digital goods.[30] And as previously noted, other states classify digital property as tangible personal property so they can tax it under their sales taxes or source that property or its sales to the state for income tax purposes.[31] Those states should logically then apply P.L. 86-272 to the sales of digital goods. Finally, some states have taken the position that sales of digital goods are sales of intangibles that are not protected by P.L. 86-272.[32] Consequently, these varying positions have resulted in the state income tax landscape becoming a maze of uncertainty when it comes to P.L. 86-272 and digital goods.

Notwithstanding the conflicting state positions, the fundamental question is whether P.L. 86-272 should apply to the sale of digital goods, which leads to the secondary question of whether multistate sellers should challenge any state that says otherwise. Regarding the primary issue, both the goal behind P.L. 86-272 and federal income tax treatment of digital goods as tangible personal property[33] would surely support the protection of sellers of digital goods under P.L. 86-272.

Looking at the underlying purpose of P.L. 86-272, the Willis Report provides insight,[34] stating that the law "was enacted in 1959 to protect from state tax liability, a business that does no more than solicit orders within the taxing state."[35] Moreover, the report repeatedly notes the uncertainty in income taxation that P.L. 86-272 was designed to address for those multistate businesses[36] - an uncertainty undoubtedly faced by digital goods vendors today.

Likewise, the Senate report on S.B. 2524, which became P.L. 86-272, explained that the reason behind the law was to reduce uncertainty and promote greater uniformity in state taxation.[37] The report expressly mentioned the burdens on businesses that had to comply with the wide array of nonuniform state income tax laws as one major reason behind P.L. 86-272.[38]

Also, in Wisconsin Department of Revenue v. Wrigley, the U.S. Supreme Court rejected an overly narrow interpretation of P.L. 86-272 when it came to the term "solicitation."[39] In doing so, the Court interpreted P.L. 86-272 consistently with its purpose and goal of creating some certainty in state taxation.[40] As with solicitation, businesses today face that same uncertainty in the interpretation of the term "tangible personal property" regarding digital goods.

Moreover, allowing each state to classify digital goods as either tangible or intangible property for P.L. 86-272 purposes, rather than following the federal income tax lead of treating those goods as tangible property, exacerbates the uncertainty. Consequently, it is reasonable to conclude that to be consistent with P.L. 86-272's goal of protecting sellers of goods, to create certainty and consistency in its application across the states, and to be consistent with the federal income tax treatment of digital goods, P.L. 86-272 should rationally be interpreted to apply to multistate sellers of digital goods.

Another factor to consider is that if P.L. 86- 272 only applied to multistate retailers of hard goods but not multistate sellers of digital goods, the latter would be at a substantial disadvantage compared with the former. It would also result in the odd situation of a state being able to tax a multistate vendor who sells downloaded digital goods over the internet (such as music, videos, and books) but not a multistate seller of hard copies of those goods for delivery through the mail, by common carrier, or through the seller's trucks. An unusual and illogical outcome indeed, and a sound policy reason for applying P.L. 86-272 to sales of digital goods. Moreover, it could be argued that if a state interprets P.L. 86-272 so as to apply its income tax to sellers of digital goods but not hard goods, it would discriminate against electronic commerce in violation of the Internet Tax Freedom Act.[41]

Another way of analyzing whether P.L. 86- 272 should apply to digital goods sales is from a purely common-sense standpoint. If a multistate seller of CDs starts selling the same music by download, the nature of the sale does not change - only the medium of transfer. To interpret P.L. 86-272 as applying to the seller on one day but not the next, because music is now downloaded, would appear illogical, since the same seller is selling the same basic product. Moreover, while some state sales tax laws may classify a digital download as a sale of an intangible, that should not prevent P.L. 86-272' s application to the multistate seller of those digital goods to protect it from the imposition of multiple nonuniform state income taxes, for the same reason it protected that seller before selling the digital downloads. Thus, consistency in the application of P.L. 86-272 should be sought.

Allowing each state to interpret P.L. 86-272 in a way that discriminates among interstate businesses is also inconsistent with the commerce clause. In South Dakota v. Wayfair Inc.[42], the Supreme Court was concerned about "economic discrimination" in the application of commerce clause nexus for sales and use taxes in the modern e-commerce economy.[43] The Court in Wayfair stated that "it is essential to public confidence in the tax system that the Court avoid creating inequitable exceptions."[44] Instead, the Court emphasized that the "basic principles of the Court's commerce clause jurisprudence are grounded in functional, marketplace dynamics."[45] Thus, even the commerce clause would cry out for equal treatment between sales of the same goods - delivered digitally or otherwise - when applying P.L. 86-272's nexus requirements nationally.

So what should a seller of digital goods do? First, it should review the state's income tax laws and rules to determine if that state already applies P.L. 86-272 to the sale of digital products. Unfortunately, the answer may not be that obvious. In Virginia, for instance, the Department of Taxation does not discuss digital property regarding P.L. 86-272, but it does say in a 2016 ruling that it applies P.L. 86-272 to the sale of both tangible and intangible items.[46] Hence, it follows that digital property would naturally be covered in Virginia. Likewise, other states classify digital goods as tangible personal property for sales tax or factor apportionment purposes, which should include those digital products under P.L. 86-272 protection. Nevertheless, an opinion letter to these states may be required to clarify the treatment.

Lastly, in states that classify digital goods as intangibles for sales tax purposes and suggest or indicate that they are not protected by P.L. 86-272, digital goods vendors should argue that this treatment for income tax purposes is not justified. As noted, such a position would conflict with the federal tax treatment of digital goods as tangible personal property (Treasury reg. section 1.861-18) and discriminate among similarly situated sellers of goods. It also would undermine national consistency and the underlying purpose behind P.L. 86-272 of eliminating uncertainty in state income taxation and promoting more uniformity in state taxation for multistate sellers of goods. So for those states, taxpayers will have to choose to pay the tax or to challenge the states' authority to impose their income tax as violating P.L. 86-272.

Conclusion

P.L. 86-272 was a milestone in Congress's protection of interstate businesses. Congress flexed its muscles to reduce the economic burdens, confusion, and complexity of businesses operating in interstate commerce. Congress, the states, and businesses have relied on P.L. 86-272 for some stability in the state income tax area for almost 60 years. To eliminate uncertainty in the marketplace, avoid economic discrimination among sellers of substantially similar goods, provide national consistency in the enforcement of federal law, promote the goals of P.L. 86-272, and be consistent with the federal income tax treatment of digital goods as tangible property, the protection of sellers of digital goods under P.L. 86-272 would appear not only appropriate - but the only sensible interpretation of P.L. 86-272 in today's digital society.

Stanley R. Kaminski is a partner in Duane Morris' Chicago office who concentrates his practice in the areas of state and local taxation.

Notes

1. Corporations with their corporate domicile in the taxing state and individuals who are domiciled in or residents of that state do not qualify for the protection of P.L. 86-272.
2. 358 U.S. 450 (1959).
3. 15 U.S.C. sections 381-384.
4. Special Subcommittee on State Taxation of Interstate Commerce of the House Judiciary Committee, "State Taxation of Interstate Commerce," H.R. Rep. No. 89-952, vol. 4 (1965); No. 89-565, vol. 3 (1965); and No. 88-1480, vols. 1 and 2 (1964) (hereinafter "Willis Report").
5. Id.
6. 15 U.S.C. sections 381-384.
7. Although not the focus of this article, P.L. 86-272 also contains provisions concerning independent contractors and the exclusion of some individuals and domestic corporations from the law. Many cases on what constitutes solicitation exist that affect the applicability of P.L.86-272.
8. "Digital Goods," Technopedia.
9. Id.
10. S. 851, 114th Cong., section 7 (2015).
11. Wash. Rev. Code section 82.04.192(6)(a).
12. "Digital Goods," Wikipedia.
13. See, e.g., New York State Tax Bulletin, TB-ST-128 (Aug. 5, 2014) (prewritten software is tangible personal property under sales tax); Louisiana's Tax regulations, La. Admin. Code, Title 61, section I.4301 (tangible personal property includes "digital or electronic products"); Illinois Department of Revenue Income Tax Letter Ruling No. 08-0031-GIL (Oct. 8, 2008) (crumed software is tangible personal property for P.L. 86-272 purposes); but see Illinois DOR Sales Tax reg. section 130.2105
    (unlike downloaded canned software, downloaded information or data such as downloaded books, music, or magazines are not sales of tangible personal property).
14. Reg. section 1.861-18.
15. See Norwest Corp. v. Commissioner, 108 TC 358 (1997) (a perpetual license of prewritten software was the sale of tangible personal property for investment tax credit purposes); and AccuZIP Inc. v. Division of Taxation, No. 004692-2002 (N.J. Tax Ct. 2009) (tax court followed reg. section 1.861-18 and held that the sale of prewritten software is the sale of tangible personal property in New Jersey for income tax purposes in applying P.L. 86-272).
16. American Business Information Inc. v. Egr, 650 N.W.2d 251 (Neb. 2002) (following federal case law, the Nebraska Supreme Court held that the sale of business data products by download was the sale of "tangible personal property for Nebraska income tax purposes").
17. See Strerunlined Sales Tax Governing Board, "About Us."
18. See SSUTA.
19. Rule 332.2 of the Streamlined Sales Tax Governing Board's rules and procedures. 
20. Id.
21. Id. at rule 333.
22. See Wisconsin Department of Revenue v. William Wrigley Jr. Co., 505 U.S. 23 214 (1992); and Scripto Inc. v. Carson, 362 U.S. 207 (1960).
23. See Scott D. Smith and Todd Faciana, "Questions for the Economic Factor-Presence Nexus Statutes in a Post-'Quil/' World," Daily Tax Report, March 14, 2017.
24. Quill Corp. v. North Dakota, 504 U.S. 298, 307 (1992), overruled on other issues by South Dakota v. Wayfair Inc., 138 S. Ct. 2080 (2018).
25. See Wayfair ("nothing unfair" about requiring an entity soliciting customers in the state to share the tax burden); and Geoffrey Inc. v. South Carolina Tax Commission, 437 S.E.2d 13 (S.C. 1993) (licensing intangibles for use in South Carolina and deriving income from their use creates substantial nexus).
26. See Smith and Faciana, supra note 23.
27. See Multistate Tax Commission, "Factor Presence Nexus Standard for Business Activity Taxes," 1 (2003).
28. Willis Report vol. 1, at 16. 29
29. Id.; see also section 17 of the Uniform Division of Income for Tax Purposes Act, National Conference of Commissioners on Uniform State Laws (now the Uniform Law Commission) (1957).
30. See, e.g., Virginia Ruling of Commissioner P.D. 16-135 (June 24, 2016).
31. See, e.g., Colorado Department of Revenue, GIL-11-014 (July 29, 2011); Arizona DOR, CCH Survey (May 25, 2000); and Grant Nulle, "Taxability of Digital Goods, Software and Other Electronic Items in Arizona," Arizona DOR, July 31, 2017; Graham Packaging Co. v. Commonwealth, 882 A.2d 1076 (Pa. 2005) (software delivered electronically was tangible personal property); South Central Utah Telephone Association v. Auditing Division, 951 P.2d 218 (Utah 1997) (software delivered electronically is tangible personal property); South Central Bell Telephone Co. v. Barthelemy, 643 So.2d 1240 (La. 1994) (same); and American Business Information Inc. v. Egr (supra note 16).
32. See, supra section titled "Why ls P.L. 86-272 Important?"
33. Reg. section 1.861-18
34. See generally Willis Report, supra note 4.
35. See id., vol. 1, at 27.
36. See generally id.
37. S. Rep. No. 88-658 (1959).
38. Id.
39. See Wrigley, 505 U.S. 214.
40. Id. at 280
41. The Internet Tax Freedom Act prohibits discriminatory taxes on electronic commerce. Section 151 of the act (47 U.S.C. section 151 note). Section 155 defines a discriminatory tax as" A) any tax imposed by a State or political subdivision thereof on electronic commerce that -
    
    

    (i) is not generally imposed and legally collectible by such State or such political subdivision on transactions involving similar property, goods, services, or information accomplished through other means ... or
    (iii) imposes an obligation to collect or pay the tax on a different person or entity than in the case of transactions involving similar property, goods, services, or information accomplished through other means."

42. Wayfair Inc., 138 S. Ct 2080.
43. Id. at 2094.
44. Id. at 2096.
45. Id. at 2095.
46. See, e.g., supra note 30.

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