According to eMarketer, online sales in 2009 are likely to reach $133 billion. It shouldn’t come as any great surprise to discover that cash-strapped states all across the country are trying to figure out ways to convert these sale dollars into tax revenues. Well, some states have figured out a way, but at what cost?

From the dawning of e-commerce, affiliate marketing has been a fundamental, cost-effective and ubiquitous vehicle for marketing and lead-generation in the vast digital marketplace. Moreover, these affiliates were almost universally likened to advertising channels (i.e., no different from a local radio station or regional magazine) than employees or contractors. Aside from entering into affiliate agreements, complying with a retailer’s affiliate marketing policies, and receiving commission checks, little, if any, relationship has traditionally existed between retailers and affiliates. The universe of affiliate marketing, however, has been shaken by recent developments within various state tax regimes.

Before going further, let’s understand some basic principles of State Sales Tax 101: Retailers are generally required to collect and remit sales tax to the state in which a sale of products or services occurs. A state may generally not impose a sales tax on sales made outside of its borders, unless the retailer has a sufficient taxable nexus in the state. Although each state will apply its own nexus standards, the answer will generally depend on an application of an inherently imprecise facts-and-circumstances analysis that asks whether the seller has “sufficient” contacts with a state to be subject to its jurisdiction. Traditionally, “nexus” was established where an out-of-state retailer had employees or agents physically present in the state, or where the out-of-state retailer engaged in-state, third-party contractors to perform certain activities on its behalf.

On June 1, 2008, the state of New York passed groundbreaking legislation that expanded the definition of “nexus” by imposing tax obligations on retailers that engaged the services of affiliates situated in New York to help promote and market their products. The New York Department of Taxation decided, under what would later be dubbed the “Amazon Tax,” that retailers that have no physical presence in New York, have no employees in the state, and are not meaningfully engaging the services of any third parties to sell their products or services—except in the limited and minimal capacity of affiliates—were found to have satisfied the nexus test, and therefore, were subject to New York state sales tax.1

This method of taxation has caught on in several other states, most recently in Rhode Island and North Carolina, between June and July 2009. When this tax was instituted in New York back in 2008, it was met with both the state of New York having to defend the constitutionality of the Amazon Tax against both Amazon and Overstock, as well as Overstock immediately terminating its affiliate activities in New York soon after the tax was instituted. Similarly, in the case of Rhode Island and North Carolina, three web retail giants—Amazon, Overstock, and the jewelry site Blue Nile—each recently pulled the plug on their affiliates in those states.

Attempting to ride this same wave and navigate the recessionary currents, California and Hawaii both tried to pass the Amazon Tax earlier this year, only to have it vetoed by each of their respective governors. In June, following California’s attempt to pass its version of the Amazon Tax, Amazon sent a stern warning letter threatening to end its business with marketing affiliates throughout the state of California if it would be required to collect sales tax from its California customers. In Amazon’s letter to California Gov. Schwarzenegger and the other leaders of the state assembly and senate, Paul Misener, Amazon’s vice president for global public policy, wrote that the proposed law “ultimately would require sellers with no physical address in California to collect sales tax merely on the basis of contracts with California advertisers.” In an almost unprecedented move, Schwarzenegger vetoed the bill before it even reached his desk in final form.

The implications of the Amazon Tax are both far and wide for retailers and affiliates alike. For example, both groups are taking a wait-and-see approach as to the outcome of the case brought against the state of New York. Should Amazon and Overstock prevail, it’s likely that other states will soon find themselves having to defend the same tax in other courtrooms around the country. On the other hand, if the state of New York finds itself in the winner’s circle, how many more states will be motivated to roll out their own version of the Amazon Tax?

Moreover, those retailers that have chosen to remain in states like New York, for example, have modified their affiliate agreements and incorporated both express prohibitions on marketing activities beyond merely linking, and express requirements on the part of affiliates to comply with any and all mandatory disclosures and reporting requirements. Lastly, by certain states expanding the relationship between retailer and affiliate to almost that of a contractor or employee for tax purposes, is it unreasonable to foresee a day when retailers in those same states may find themselves responsible for the actions of their affiliates?

In response to the Amazon Tax, a well-known blogger/affiliate wrote on her blog: “Affiliates are not employees, they are advertisers. Does contracting with a radio station to buy advertising make them your employee? Heck no!”

Bottom line: This is a very important development with serious consequences that needs close monitoring if you are an online seller, big or small, that uses affiliates to market products or services on the web, or a business that earns commissions or referral fees by sending web traffic that results in sales by out-of-state retailers.

1Upon further guidance from the Department of Taxation in a somewhat conciliatory gesture, the state decreed that an affiliate would be required to do more than merely link to a retailer’s website in order for a nexus to be established.