Illinois Judge Strikes Down State’s Internet Affiliate Tax Law

Published June 4, 2012

A Cook County Circuit Court judge has struck down Illinois’ Internet affiliate tax law, handing a victory to thousands of Internet entrepreneurs across the state.

The ultimate outcome is likely to rest with the Illinois Supreme Court, which hears cases in which a statute has been held invalid on direct appeal. For the time being, though, supporters of the challenge to the law view the ruling as an important step in thwarting a barrage of oppressive taxes that are driving jobs out of Illinois and diminishing the state’s revenue.

“We were surprised, very pleasantly surprised, not at the ruling itself but at how quickly the judge made the ruling. Our attorneys tell us it’s quite rare for a judge to issue a bench ruling, especially on a Constitutional basis,” said Rebecca Madigan, executive director of the Performance Marketing Association, the plaintiff in the case. “However, he said this was such an obvious violation of the Constitution that the law does not pass legal muster.”

The law took effect July 1, 2011, and targeted retailers who had contracts with businesses in Illinois that posted links on their Web sites to the retailers’ Web sites. The law compelled those retailers to charge a use tax on any products purchased after a consumer was “linked through” to the retailer’s site from an Illinois affiliate.

One-Third of Businesses Gone
When the General Assembly passed the law, it was sold as a revenue generator but Madigan said approximately 3,000 of the state’s estimated 9,000 Illinois-based online affiliates have either closed their doors or moved to neighboring states with friendlier business climates. Illinois-based online affiliates generated as much as $744 million last year and paid $22 million in state income taxes.

Judge Lopez Cepero on April 25 ruled the law unconstitutional on two grounds:

One, it violated the Commerce Clause of the United States Constitution, which limits what entities a state can tax; and

Two, it conflicted with the federal Internet Tax Freedom Act, which prohibits states from directly targeting and taxing internet commerce.

Pain in the Nexus
Regarding the Commerce Clause, Judge Cepero said the state failed to establish the retailers maintained the requisite “nexus” or connection to Illinois commerce necessary to tax out-of-state retailers. Traditionally, for a state to exercise its taxing power over a foreign company, that company must have some physical presence within the state, whether it be an office, a factory or even salesmen who pitch the company’s products directly to residents of Illinois.

An advertisement on an Illinois-based Web site does not create a significant enough presence for the state to tax the company doing the advertising, the judge ruled. A Web page ad simply does not mean the company maintains a place of business in Illinois such that it must register with the Department of Revenue and charge customers a use tax.

Federal Moratorium
The Illinois law was also fatally flawed in attempting to tax Internet commerce, the judge ruled. It directly conflicts with the federal Internet Tax Freedom Act, which prohibits states from imposing a discriminatory tax on electronic commerce.

Because the Illinois affiliate tax law imposed an obligation to collect Illinois use taxes on retailers who completed sales transactions through Internet-based advertising, rather than other forms of advertising, it violated the federal statute that prohibits such discriminatory taxes against Internet commerce. Judge Cepero ruled this Internet tax “moratorium” applies here, and therefore the Illinois law must be struck down.

The Illinois Department of Revenue has 30 days to appeal to the Illinois Supreme Court.

Madigan said the PMA is “waiting to see when the law will be suspended and how. We’re hoping at the very least it is suspended or ignored through the appeals process.”

Peter White ([email protected]) is an attorney with the Liberty Justice Center, a litigation center started by the Illinois Policy Institute. This article originally appeared in The Heartland Institute’s Budget & Tax News.