How to collect and pay sales tax for your small business

Collecting and reporting sales tax is a confusing time suck for many small business owners. It has to be done, and it has to be done right, but the requirements are so vast and varied that it can quickly become overwhelming.

If you only do business in one of the handful of states with no sales tax (New Hampshire, Oregon, Montana, Alaska, or Delaware, also called the NOMAD states) you may be able to breathe a sigh of relief. There are other tax obligations in those states, to be sure — and Alaska has local sales taxes — but you may not need to keep sales tax top of mind. 

However, if you make sales in one or more of the 45 states with a general sales tax (plus Washington, D.C., Puerto Rico, and parts of Alaska), you’ll need to get sales tax right. The first step is to learn exactly what sales tax is, and then how to manage sales taxes for your small business. 

What is sales tax?

As its name suggests, sales tax is a tax on a sale. Specifically, it’s a tax on the sale, transfer, or exchange of goods or services. For a deeper dive, read What is sales tax? Definition and examples.

Once you have a good understanding of what sales tax is, you need to prepare to manage it properly.

There are five key tasks:

  1. Figure out where you’re required to collect sales tax
  2. Register for sales tax where required
  3. Calculate and collect sales tax on taxable transactions
  4. Validate tax-exempt transactions
  5. File returns and remit the sales tax due

1. Figure out where you’re required to collect sales tax

Whether a business has to collect sales tax in a particular state depends on sales tax nexus, which is a connection that allows a taxing authority, like a state or a city, to tax a business.

Sales tax nexus used to be dependent on physical presence: A state could require a business to register for sales tax if the business had a physical connection to the state, but not if it didn’t.

Physical presence in a state still establishes nexus, but it’s no longer requisite because the Supreme Court of the United States overturned the physical presence rule in South Dakota v. Wayfair, Inc. (June 21, 2018).

Thanks to the Wayfair ruling, states can require out-of-state sellers with no physical presence in the state (remote businesses) to register for sales tax if their sales into the state exceed a certain threshold (e.g., $100,000 in taxable retail sales in the current or previous calendar year). Basing a remote sales tax obligation on economic activity is known as economic nexus, and every state with sales tax now has an economic nexus law.

While physical presence and economic activity tend to be the most common ways for a business to establish nexus, nexus can also be created through:

  • Ties to affiliates in a state (affiliate nexus)
  • Referrals from in-state entities (click-through nexus)
  • Applications placed on in-state computers (cookie nexus)

So, there’s a lot to keep track of. Learn more about sales tax nexus.

2. Register for sales tax where required

Businesses that establish sales tax nexus must register for a sales tax permit (also called a sales tax license or seller’s permit). Sales tax permits never expire in some states but must be renewed every one to five years in other states.

As a general rule, businesses shouldn’t start collecting sales tax without a permit in hand. That’s one reason to closely monitor sales activity in every state: Some states require remote sellers to register for sales tax as soon as they cross the economic nexus threshold, as in before the next sale. Other states give remote sellers a bit more time, but all expect businesses to register once they’ve established nexus.

Sales tax registration is generally handled by the state tax department, such as the California Department of Tax and Fee Administration, the Florida Department of Revenue, the New York State Department of Taxation and Finance, or the Texas Comptroller. However, there are a few exceptions. For example:

3. Calculate and collect sales tax on taxable transactions

After obtaining a sales tax license or permit, businesses must apply the correct sales tax rate to all taxable transactions.

How do you calculate sales tax?

Sales tax is always based on a percentage of the sales price and added to the sales price at checkout, but the percentage varies depending on the location, and sometimes also on the product or service sold.

For example, the sales tax rate for most transactions is currently 6.25% in Massachusetts and between 7.25% and 10.25% in California, depending on the location of the sale. The general sales tax rate in Connecticut is currently 6.35%, but the sales tax rate for software sold to a business for business purposes is 1%.

The first step toward determining the proper sales tax rate is to find out which goods and services are subject to sales tax. Then you can worry about which rate applies and how to collect sales tax.

Determine which goods and services are subject to sales tax

When states first started taxing sales back in the 1930s, they primarily taxed tangible goods — stuff you can touch. At that time, according to the Tax Foundation, goods made up more than 60% of consumption.

With services accounting for more than 60% of sales today, states are starting to expand their tax base. The Tax Foundation thinks broadening the sales tax base is the way to go. Nonetheless, while most goods are subject to sales tax in all states with a sales tax, many services remain exempt from sales tax in many states.

Of course, some tangible goods are exempt in some states, too. Many states provide an exemption for food purchased for home consumption (i.e., groceries). Textbooks and Bibles are exempt in some states, diapers and tampons in others. Most clothing is exempt from state and local sales tax in some states, while in others, some clothing is exempt from state sales tax but may be subject to local sales tax. It’s complicated.

How services are taxed can be even tougher to decipher. States may tax services related to tangible personal property, like car repair, but not professional services, like accounting. They may tax some personal services, like tanning, but not others, like therapeutic massage. Amusement and recreation services can be taxed differently than services performed on real property. It all depends on the state.

Then there are digital goods and services. Although Generation Alpha may not recognize a world without the internet, most sales tax laws were developed by the Silent Generation or its predecessors long before the World Wide Web and intangible goods came to be. As states scramble to update their policies to keep pace with evolving technology, businesses must scramble to update their point-of-sale systems.

Compliance is further complicated by sales tax holidays, days, weeks, or weekends when many normally taxable products are tax exempt. Popular among consumers, tax-free periods create more work for the retailers that have to adjust sales systems to temporarily suspend the tax. Sales tax holidays can be particularly burdensome on retailers selling eligible goods into more than one state with a tax-free weekend.

So, how can a business figure out what’s subject to sales tax in every state? Most state tax departments publish guidance on product taxability, and there’s a handy taxability matrix for each of the 24 states participating in the Streamlined Sales Tax (SST) program. Unfortunately, it can be hard to find accurate information on state tax department websites, and more than 20 states with a general sales tax don’t participate in SST.

Find the right sales tax rate

Once you’ve determined a transaction is taxable, you need to apply the right sales tax rate to each transaction.

Sales tax rates are generally governed by destination sourcing or origin sourcing rules. Most states use destination sourcing, meaning the sales tax rate is based on the location where the customer takes possession of the product or service sold. With online and mail-order sales, this is generally the delivery address.

A few states use origin sourcing, so the sales tax rate is based on the seller’s location. And some use mixed sourcing rules, a combination of destination and origin sourcing. Learn more about sourcing sales tax.

It’s pretty easy to figure out the sales tax rate in the states that have no local sales taxes. But in states like Missouri and Texas, which have thousands of local jurisdictions, it can be extremely difficult. In these and many other states, sales tax rates can vary from city to city or street to street; basing sales tax rates on ZIP codes doesn’t provide the rooftop-level accuracy required.

Finally, remember that sales tax rates and taxability laws are subject to change, and taxpayers like you are responsible for keeping abreast of changing requirements. Working with a trusted sales tax advisor or automating tax calculation can help.

4. Validate tax-exempt transactions

Every state or local district that imposes a sales tax provides a statutory exemption for certain sales, like prescription medicine. But normally taxable transactions can be exempt for a variety of reasons, too.

For example, the purchaser could qualify for an exemption, as often happens with government or religious institutions. A taxable good could be purchased by a reseller for resale. Or a product could be purchased by a manufacturer for incorporation into a final product, which will be sold.

Whatever the reason, any business that fails to collect sales tax on a normally taxable transaction must collect an exemption certificate or a resale certificate from the buyer. Tax authorities tend to be keenly interested in exempt transactions and therefore often ask to see these certificates to verify that they’re valid. If a business can’t validate the exemption, it could be held liable for the uncollected tax.

5. File returns and remit the sales tax due

All sales tax collected from consumers must be remitted to the proper taxing authority along with a sales tax return. Filing sales tax returns correctly and on time is critical, as of course is turning over the collected tax. Failure to file and pay sales taxes as required can result in the imposition of penalties and interest fees.

How often a business needs to file returns often depends on sales volume: Most businesses are required to file on a monthly basis, but small businesses may be put on a quarterly or annual schedule. Many states require businesses to file returns even if no sales tax is due for the collection period.

Sales tax return due dates vary from state to state, and in some states, from jurisdiction to jurisdiction. Learn more about sales and use tax returns.

Why businesses need to get sales tax right

Getting sales tax right is critical. According to the National Conference of State Legislatures, “After personal income taxes, general sales tax collections account for the second largest portion of state revenues.” State and local governments rely on general sales tax revenue to fund a host of essential services, including education, medical services, and roads.

With sales taxes accounting for nearly 30% of state tax revenue, state tax authorities are keen to ensure businesses are collecting and remitting it as required. That’s why businesses need to know how sales tax works: which sales are subject to tax; how to calculate and collect the tax due on each transaction; how to validate exempt sales; and how to file returns and remit sales tax. 

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