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States’ Drive to Collect Taxes on Internet Sales Is a Blow to Marketers

California Attorney General and democratic candidate for governor Jerry Brown.
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California Attorney General and democratic candidate for governor Jerry Brown.

On a dreary day last April, Tim Storm, the founder of FatWallet, and his 54 employees formed a convoy of some 30 cars, three moving trucks and a trailer laden with two fiberglass cows (one purple, one black), and drove five miles north from their old corporate home in Rockton, Ill.. to the new FatWallet headquarters in Beloit, Wis.

The move certainly seemed to be an odd business decision: it cost $100,000, and the company left behind a $5 million, three-year-old, custom-built office building in Rockton, whose maintenance would continue to cost $30,000 a month until it finds a tenant. But Mr. Storm felt he had to do it for his business to survive.

One of the country’s biggest bargain hunter Web sites, FatWallet publishes coupons and deals from about 1,000 companies that range from small shops like PennyWise.biz to retail giants like Amazon. Since 2005, the company has acted as the middleman in more than $1.2 billion in Internet sales. (It says its own revenue was $12 million in 2010.)

But last March, Gov. Pat Quinn of Illinois signed House Bill 3659, a so-called affiliate nexus tax that would require out-of-state retailers that advertise through Illinois-based Internet marketing “affiliates” like FatWallet to collect and remit Illinois sales tax.

Mr. Storm, 43, calculated that he had until last April 15 to move his business or risk losing as much as 40 percent of his revenue when big Internet retailers like Amazon.com and Overstock.com would cut off FatWallet to avoid the expense and irritation of handling Illinois sales tax. “We didn’t really have a choice about relocating the business,” Mr. Storm said. “It was relocate or become irrelevant.”

It is hardly surprising that states are taking it upon themselves to increase their sales tax income. Residents are supposed to declare and pay sales tax on goods they buy from out-of-state retailers, but few do, which deprives states of tax revenue and gives Internet retailers an advantage over physical stores. California hoped to collect some $200 million the first year after passing an affiliate nexus tax, and the large brick-and-mortar retailers that support nexus bills hope that the bills will level the playing field with Internet competitors.

But these laws have collateral damage. Caught in the crossfire of the nationwide fight — New York and other states have also passed nexus laws — are a large but rarely examined part of the Internet economy, affiliate marketers.

These third-party Web sites, which contract with retailers to advertise their wares, come in many forms. There are coupon clearinghouses with multimillion-dollar revenues, like FatWallet and Ebates, which some online shoppers visit religiously to track down daily bargains, and there are tiny mom-and-pop blogs that run affiliate marketing ads related to their content — a pet blog, for example, might carry advertising for pet shops.

The advertisements the affiliates run contain embedded codes indicating which affiliate is sending traffic to the retailer, and when a click leads to a sale, the affiliate receives a commission. According to a report from Forrester Research, spending on affiliate marketing is expected to rise to $4 billion in 2014, from $1.9 billion in 2009. Scot Wingo, chief executive of ChannelAdvisor, a retail consulting firm and software company in Morrisville, N.C., said that about 5 percent of all Internet commerce runs through affiliate marketers.

The field is not without controversy. Some affiliates have been caught rigging the system by posting fake ads or buying Web ads that purport to be directly from the retailers they are advertising. And retailers often wonder if the sales they get from affiliates are sales they would have gotten even without them.

Mr. Wingo notes that his retail clients say that only about 5 percent of affiliate marketers have sites with content that adds value and increases sales. “Many retailers are decreasing the number of affiliates,” Mr. Wingo said. “There’s a lot of fraud. And some create channel conflict. They may buy search terms and compete with you.”

Still, that 5 percent constitutes a hardy industry, and while it is impossible to know exactly how many affiliate marketers and other businesses have been affected by the nexus laws, it is clear that the fight has had an impact.

Year-over-year revenue growth for affiliate marketing at ValueClick, the parent company of Commission Junction, one of the giant middlemen that manage transactions between hundreds of retailers and their affiliates, fell to 9 percent from 17 percent from the first quarter to the third quarter of 2011 in large part because of the California nexus law, according to Colin Sebastian, a stock analyst who covers ValueClick for Robert W. Baird & Company.

Thousands of marketers in the affected states have been cut off by Amazon and other retailers. Others, like FatWallet, have had to move.

But the big losers of this battle are small affiliates that cannot afford to move, many of them one- or two-person shops that support a family. Each time a state passes a nexus law, said Scott Allan, vice president for marketing at LinkShare, another of the companies that serve as middlemen between retailers and affiliate marketers, retailers sever relations with thousands of affiliates to avoid having to collect sales tax.

Mr. Wingo of ChannelAdvisor said, “It shows the huge gap behind the government thinking and small-business thinking.”

When Gov. Jerry Brown of California signed nexus tax legislation into law last June, Amazon terminated its relationship with some 10,000 California affiliates. One of them was MyBargainBuddy.com, a 12-year-old affiliate-marketing-based shopping portal based in Murrieta, Calif., owned by Karen Hoxmeier, 38. As a result, more than 60 percent of the 3,000 or so retailers whose products Ms. Hoxmeier advertised decided to drop her, leaving Ms. Hoxmeier to post links only to the small group of retailers with physical stores or other operations in the state. “My sales immediately went down by about 50 percent,” she said.

In Colorado, Invisible Shoes, a two-year-old maker of huarache-style running sandals based in Boulder, lost out two ways in a similar sales tax battle. Because of a Colorado nexus law passed in 2010, Amazon canceled the company’s affiliate account, which meant Invisible Shoes could not run affiliate advertising for the third-party products like books and creams that it sold to its shoe customers. That cost Invisible Shoes several thousand dollars a month, said Steven Sashen, its founder and chief executive. But the law’s larger effect was to stifle the company’s growth plans.

Mr. Sashen, who expects the company to surpass $1 million in sales this year, had created an in-store kiosk that would allow shoppers to custom-design running sandals inside client stores. That way the client stores could offer custom shoes without carrying inventory. But Mr. Sashen’s accountant told him that the kiosk would constitute a nexus that could force Invisible Shoes to collect and pay sales tax in states where it had client stores.

“Given the size of our company, the accounting cost alone makes this prohibitive,” said Mr. Sashen, 49, who shelved the kiosk plans. “It’s not collecting sales tax that’s the hard part; paying taxes in the jurisdictions is an accounting nightmare.”

National legislation could save affiliate marketers and retailers like Mr. Sashen. Twenty-four states have signed on to the Streamlined Sales and Use Tax Agreement, a plan to simplify sales taxes. Congress is currently considering three federal bills that would give states that simplify their sales tax systems the right to make out-of-state retailers collect taxes.

While the national bills are far from becoming law, affiliate marketers are breathing a little easier, at least in California. Since September, when Governor Brown signed a compromise law that gave Internet retailers a one-year reprieve on sales tax collection, Ms. Hoxmeier’s MyBargainBuddy site has bounced back to 2,500 advertisers.