How to manage exempt online sales
The COVID-19 pandemic has underscored our collective reliance on ecommerce. In some parts of the country and world, in-person business dealings have been restricted to such an extent that ecommerce is the most effective (and sometimes the only) way to do business. For businesses handling exempt transactions, this poses some unique challenges.
Unless a sale is statutorily exempt — meaning sales tax doesn’t apply by law — exempt sales must be validated. A retailer generally isn’t required to collect California sales tax on a can of beans because most sales of food for home consumption are statutorily exempt from sales tax in California. However, because books are ordinarily subject to California sales tax, a retailer would need to validate an exempt sale of a book with an exemption certificate or resale certificate.
Economic nexus imposes new compliance obligations on businesses making exempt sales
Ecommerce businesses with customers in multiple states may be required to validate exempt sales in multiple states because of the U.S. Supreme Court decision in South Dakota v. Wayfair, Inc. (June 21, 2018) and subsequent state action. In overruling a long-standing physical presence rule, the Wayfair decision enabled states to require out-of-state businesses to comply with sales tax laws.
Physical presence in a state still triggers a sales tax obligation in all states with a sales tax. Thanks to Wayfair, 43 states, the District of Columbia, and some local governments in Alaska (which has no statewide sales tax but allows local sales tax) also now enforce economic nexus laws that base sales tax solely on a remote seller’s sales and/or transaction volume in the state — the economic nexus threshold.
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 need to validate exempt sales with the proper exemption certificate.
When can a taxable sale be exempt?
There are several reasons why a taxable sale could be exempt. Typically, an exemption is due to the nature of the customer or the purpose of the purchase (e.g., for resale or incorporation into a final product).
In Colorado, for example, 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 and state-administered sales tax (self-administered local tax may apply in some jurisdictions).
Taxable items purchased for resale are exempt from Texas sales tax as long as the retailer accepts a properly completed Form 01-339 Texas Sales and Use Tax Resale Certificate (PDF) from the buyer instead of collecting the sales tax due.
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. The seller must collect Form ST-587 Exemption Certificate (for Manufacturing, Production Agriculture, and Coal and Aggregate Mining) to validate these sales.
Validating exempt sales
Whenever a seller doesn’t collect tax on a taxable sale, tax authorities need proof tax wasn’t collected for a legitimate reason. Thus, the retailer must validate the exemption by collecting the proper certificate from the consumer. There are often specific certificates for different purposes, though some allow retailers to use other forms or accept certificates from other states.
With in-person transactions, retailers typically ask for proof of a customer’s exempt status at the register, whereupon the customer must furnish a valid certificate. Retailers are required to retain a copy of the certificate, and auditors like to examine them during audits.
In states where certificates 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 essential: Missing or expired exemption certificates are a common cause of negative audit findings.
The challenge of validating exempt online sales
Ecommerce can throw a wrench in the validation process for businesses used to collecting exemption certificates at the register. While some ecommerce platforms allow for 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. This can expose the seller to audit risk for not being able to validate an exempt transaction.
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.
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.
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, especially given the circumstances of the COVID-19 pandemic. And since exempt sales are an everyday occurrence for many businesses, ecommerce systems must be able to handle exempt sales.
Learn more about optimizing sales tax compliance in Tax compliance for ecommerce sellers.
The 2021 sales tax changes report: midyear update
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