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How to manage exempt online sales

Online sellers that make sales-tax-exempt transactions face unique tax compliance challenges.

Most tangible personal property is subject to applicable state and local sales taxes in most states, so unless the tangible personal property you sell is statutorily exempt — meaning sales tax doesn't apply by law — you're required to substantiate all exempt sales of goods. It's the same with taxable services; most states don't tax services by default, but every state with a general sales tax taxes at least some services.

You wouldn't be required to collect California sales tax on a dozen grapefruit shipped to a consumer in Eureka because food for home consumption is statutorily exempt from California sales tax. However, clothes are ordinarily subject to California sales tax, so you'd likely need to either collect sales tax or collect a valid exemption certificate or resale certificate if you sold a pantsuit to the same Eureka customer.

In the event of an audit, the state taxing authority will want to confirm you had a valid reason for not collecting sales tax on any normally taxable transactions.

Before delving into the compliance challenges facing online sellers, it's helpful to review why some taxable transactions are sales tax exempt.

Why some taxable transactions are sales tax exempt

A taxable product or service could be sold tax free for a few reasons, including:

  • The seller is exempt
  • The customer is exempt
  • The goods or services are purchased for a qualifying purpose

The tricky bit for companies doing business in multiple states is that no two states' sales and use tax laws are exactly alike.

Many nonprofit organizations registered as a section 501(c)(3) entity with the federal government qualify for tax exemptions in many states, and many charitable organizations are nonprofits. But that doesn't mean all sales to a specific charity are necessarily exempt in all states, or that all charities get a pass on charging sales tax themselves. Whether a nonprofit is or isn't subject to sales tax and does or doesn't need to collect sales tax depends on the tax jurisdiction, and the specific situation.

Even within one state, laws related to sales tax exemptions can be specific and varied.

When the seller is exempt

Certain states allow certain types of businesses to make certain sales tax free. "Certain" because exemptions are highly situational.

Occasional sales tend to be exempt in most states, but not all states; Colorado has a sales tax return for occasional sales. The definition of "occasional sale" varies by state but as a general rule, an occasional sale is when the seller doesn't usually make retail sales. Garage sales come to mind.

Here are some other examples of when a seller may be able to make tax-free sales of ordinarily taxable goods.

Arizona law provides a general transaction privilege tax (TPT) exemption for retail sales made by a nonprofit charitable organization granted section 501(c)(3) status by the IRS. (TPT is Arizona's version of a sales tax.) Some other nonprofit organizations can also make exempt retail sales in Arizona under certain circumstances.

In Texas, exempt organizations and other nonprofits must obtain a sales tax permit and collect and remit sales tax when selling taxable goods unless they 1) sell taxable items during qualified tax-free fundraisers, 2) sell only nontaxable items, or 3) raise funds only by using a for-profit entity to sell taxable items. 

Specified sales made by some exempt organizations are exempt from sales tax in New York too, but other sales made by these sellers are taxable. Rules governing taxable sales often depend on the type of organization making the sale — there are different rules for charitable and educational organizations, government organizations, nonprofits, not-for-profit corporations, religious organizations, and so forth.

When the customer is exempt

In certain situations, the customer may be entitled to a sales tax exemption.

While being not-for-profit doesn't necessarily qualify an organization as sales tax exempt in New York, such entities may apply to obtain tax-exempt status. Once an organization has received its exempt organization certificate, it can purchase tangible personal property, services, and more tax free. The buyer must give the seller a properly completed Exempt Purchase Certificate (Form ST-119.1) at the time of sale. (More on exemption certificates in a bit.)

Florida also grants certain nonprofits certain sales and use tax exemptions. To name just a few: charitable organizations with 501(c)(3) status may make exempt purchases of items or services used in carrying out customary nonprofit activities; state or federally chartered credit unions may make certain purchases without paying sales tax; and the Florida Retired Educators Association may purchase office supplies and equipment tax free.

In Colorado, entities organized and operated exclusively for charitable, educational, religious, or scientific purposes can apply for tax-exempt status. If granted, they'll receive a Certificate of Exemption from the Colorado Department of Revenue, which authorizes them to purchase items and services without state or state-administered sales tax. Self-administered local tax may apply in some jurisdictions because Colorado is a home rule state.  

Again, specific requirements vary depending on the state, the type of business, and the transaction itself. Thus, sales to a nonprofit organization are typically subject to Arizona TPT unless the nonprofit is a qualified hospital or health care organization. And North Dakota specifically exempts purchases by government entities, but it doesn't exempt charitable, nonprofit, or religious organizations.

When goods or services are purchased for an exempt purpose

Finally, normally taxable products or services may qualify for a sales tax exemption because of how they’ll be used by the buyer. Items purchased for resale are generally exempt from sales taxes in all states. Items purchased to be incorporated into a product that will be sold may also be exempt from applicable sales taxes.

For example, taxable goods purchased for resale are exempt from Texas sales tax. In California, manufacturers, research and developers, and certain other taxpayers may qualify for a partial sales and use tax exemption on the purchase or lease of qualified machinery and equipment. And Illinois provides a manufacturing, machinery, and equipment exemption for purchases of machinery and equipment that will be used primarily (i.e., over 50% of the time) in the manufacture and/or assembly of items for wholesale or retail sale.

In all such cases, the seller must ensure the buyers were entitled to not pay sales tax by collecting properly completed tax exemption certificates from the buyer.

How do you validate sales tax exemptions?

Whatever the cause, whenever a seller doesn't collect tax on a taxable sale, tax authorities need proof applicable sales taxes weren't collected for a legitimate reason. The retailer must validate the tax exemptions by collecting a complete exemption or resale certificate from the consumer.

Exemption documents must be taken in “good faith” in some states, and the good faith of the seller can be questioned. But this isn't always the case. Indeed, retailers in Illinois don't need to exercise "good faith" when accepting a resale certificate, meaning they don't need to try to determine whether the purchaser actually intends to resell the purchased items. They just need to confirm the buyer has a valid resale number at the time of purchase. The Multistate Tax Commission offers more details.

States generally don't use the same forms for all transactions. Some states may accept exemption certificates from other states, while others won't. About 36 states accept the Multistate Tax Commission's Uniform Sales & Use Tax Resale Certificate — multijurisdictional form. The 24 states that are members of Streamlined Sales Tax (SST) accept the Streamlined Sales Tax Exemption Certificate. And Illinois sometimes allows a buyer to make their own resale certificate.

With in-person transactions, the customer may be asked to furnish a valid exemption certificate at checkout. Retailers are required to retain a copy of the certificate, as auditors like to examine these documents during audits. 

Of course, many transactions don't take place in person. Sellers are nonetheless responsible for collecting the necessary exemption certificates. This task can be challenging for ecommerce businesses with sales tax nexus in multiple states.

What is sales tax nexus?

Sales tax nexus is a connection that creates a sales tax obligation for businesses. If you have nexus with a state, you need to register for a seller's permit, charge sales taxes on taxable transactions, validate sales tax exemptions, and pay sales and use tax on time.

Nexus is established through physical presence in a state, but remote sellers with no physical presence in a state can establish nexus as well. Economic activity in a state (economic nexus), in-state referrals (click-through nexus), and ties to in-state affiliates (affiliate nexus) can all create sales tax nexus for out-of-state ecommerce businesses.

Most states have affiliate and click-through nexus laws on the books, and all states with a statewide sales tax enforce physical nexus and economic nexus. In some home rule states, local jurisdictions may enforce economic nexus tax rules as well.

Keeping track of the different sales tax laws is a big job, but it's essential even for small companies doing very little business in a state. While every economic nexus law provides an exception for small sellers, the economic nexus threshold in many states is $100,000 or 200 transactions. In some states, businesses are required to register and start collecting sales tax as soon as they cross the threshold.

It's worth noting that economic nexus laws can affect businesses dealing primarily or only in exempt transactions, such as manufacturers, resellers, and wholesalers. Although such businesses may not need to collect and remit sales tax, they may be required to register and validate exempt sales with the proper exemption certificate.

The challenge of validating exempt online sales

If your ecommerce business makes exempt sales, you'll want an ecommerce platform that can obtain exemption certificates from customers, store them, and not apply tax to exempt transactions. If you sell through an online marketplace, you'll need to know how the marketplace facilitator handles different exemptions; as with ecommerce platforms, capabilities and services can vary widely.

Some ecommerce platforms allow customers to mark a transaction as taxable or exempt. That may be the extent of their capability; customers may not be able to digitally upload their exemption certificate, which can expose the seller to audit risk. Learn more about what ecommerce platforms do (and don't do) for sellers.

Alternatively, the customer may not be able to complete the sale without first contacting the seller and providing the necessary documentation. Rather than go through that hassle, customers may choose to abandon their cart and find a retailer that can provide a more streamlined experience for sales tax exemptions.

Of course, a customer may go ahead and pay the tax then seek a refund of the tax paid. This can start a frustrating cycle for both the retailer and the customer, one that entails issuing a credit and a new invoice as well as collecting the necessary exemption certificate.

In states where exemption documents expire, as resale certificates do every three years in Illinois, retailers need to ensure the certificates they have on file for recurring customers are up to date. It's a tedious process when done manually, but critical: Missing or expired exemption certificates are a common cause of negative audit findings.

Choose an ecommerce platform that can handle exempt transactions

Fortunately, there are easier ways to validate exempt ecommerce sales. Some ecommerce platforms offer add-on solutions for exempt sales; others integrate with external exemption certificate management solutions. Either option can improve the overall experience by allowing retailers to collect, validate, and store exemption certificates digitally.

It's hard to imagine any business succeeding today without an ecommerce store. And since exempt transactions are an everyday occurrence for many businesses, ecommerce systems must be able to handle exempt sales.

Learn more in our guide, 5 steps to managing sales tax compliance for exempt sellers.

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