Sales tax management is one of the most common pain points for small business owners and online merchants. It’s time consuming, confusing, and risky. Most business owners we speak with aren’t certain where to begin, don’t have much free time to devote to research, and, as a result, often turn a blind eye to sales tax compliance.
Ignoring online sales tax won’t make things better for you. Quite the opposite, actually. Every tax dollar you fail to collect is another dollar you are on the hook for. State and local taxing authorities do not take not collecting tax on taxable sales lightly. Small business owners are strongly advised to understand their level of risk and take the necessary steps to achieve sales tax compliance.
We’ve created this guide to help small business owners like yourself quantify the risk of not collecting sales tax, understand sales tax fundamentals, and set up a plan to achieve sales tax compliance.
Sales Tax Risks
The business risk of not collecting sales tax is great enough that we have decided to speak to it directly. Other than property and income tax, sales tax is the largest source of state tax revenue, and one frequently leveraged to fill budget gaps. In short, state governments want their sales tax dollars.
As a small business owner, you, not your buyers, are responsible for the sales tax associated with the goods you are selling. Yes, businesses typically pass responsibility on to buyers by charging sales tax at the point of sales, but failing that, it’s the seller who will be held accountable by state and local tax authorities.
What this means is, every dollar of sales tax you fail to collect is a dollar you will be held accountable for by state and local tax authorities. Beyond this, late payment penalties, interest, and collection fees, may also be assessed. At the extreme, criminal charges may be brought if it is determined tax evasion has taken place.
If you miss your filing deadline or payment deadline, you may be assessed a penalty of up to $50 in some states. This may even apply if you have collected no sales tax during the filing period. Once you commit to collecting sales tax, you need to be organized. We recommend you set several calendar alerts the week your sales tax is due to help you remember to file.
If a state auditor determines you have outstanding sales tax liability, they may outsource the collection to a collection agency. This will come at a cost to you and may impact your personal credit rating.
Outstanding sales tax liability isn’t a free loan. State and local tax authorities charge interest. Depending on how much sales tax you owe, this can add up fast. Moreover, if you haven’t collected any sales tax, you’re dealing with a double-edged sword. First, you are responsible for paying your buyers’ sales tax out of your own pocket. Second, you are responsible for the interest on those late payments.
When to Start Collecting Sales Tax
The most common question we hear from small business owners is, “When do I need to start collecting sales tax?” While we wish we could offer a concrete response, the answer is complicated.
If you are running your business by the letter of the law, you need to begin collecting sales tax on your first taxable sale. State and local tax authorities don’t offer a grace period wherein sales tax can be ignored. We understand, however, that most small business owners are looking for a magic number. For that, consider the following statement from Michael Fleming of Peisner Johnson,
“A number we have seen some companies use is $250 a month in taxable sales. This equates to $3000 a year or $12,000 over a 4-year period. The tax on $12,000 in sales would be approximately $960 and you may have an additional 50% or so in fines and penalties which bring your risk into the $1,500 range.”
We can’t stress this enough, deciding when to get started with sales tax is the responsibility of the business owner. However, putting your head in the sand and pretending sales tax laws don’t apply to you is not a prudent option. We talk to many small business owners who are in this exact situation. It isn’t uncommon for these individuals to have neglected their sales tax collection responsibilities for so long that late fees, penalties, and interest payments threaten to bankrupt their business.
Beware of Myths
As mentioned above, sales tax management is complicated. That shouldn’t come as a surprise. All taxes are complicated. Why should sales tax be any different?
There are those online who would have you believe they are tax experts simply because they too are wrestling with compliance—and they may be very knowledgeable. But, it’s very difficult to discern the experts from the charlatans and consequently, when the advice you are getting is sound versus wrong.
We encourage the business owners we speak with to strike a balance between online research and professional advice. Always consult an accounting professional, or government websites when you have questions that go beyond the fundamentals of sales tax compliance.
Sales Tax Nexus
Once you have decided to get started collecting sales tax, you will need to know in which states you are required to collect sales tax. This depends on what is known as nexus.
Nexus is broadly defined as “a physical connection to a state or local taxing jurisdiction”. However, nexus is not limited to a physical presence in the plain English sense of the words. The actual interpretation of the standard created in Quill Corp vs. North Dakota is more esoteric.
While nexus is commonly triggered by such events as an office, a warehouse, or employees within a state, businesses should be aware there are a lot more ways a company can find themselves having to defend a claim of nexus by a jurisdiction. Perhaps more importantly, nexus is often determined by a combination of items that can lead to a determination of nexus, so while any one of these activities may trigger nexus on their own, several will usually sink your ship if you are trying to avoid nexus.
A business will always have nexus in the state in which it is headquartered (its home state). A home state is more than just the state in which the business is located. In fact, home state is defined as “the state where your company exists, either in physical form or by virtual existence based on business registration, dba name registration, or banking activity.”
This makes the home state the most common nexus trigger and applicable to nearly every business. We recommend small business owners use their home state as an opportunity to develop a sales tax management process. Develop a plan, get the right tools, and learn to be efficient with your sales tax filing. That way, when you’re ready to begin filing in other states, the task will not appear as daunting.
Should you be traveling to other states for business (conference, meetings, sales calls, etc.), you will likely be on the hook for nexus. Be sure to manage your travel accordingly so you don’t unwittingly trigger nexus and fail to collect sales tax.
If you’re utilizing a fulfillment service with warehouse locations throughout the United States, you likely have triggered nexus in those states. This is very common for Amazon sellers participating in the Fulfillment by Amazon (FBA) program or other 3rd party fulfillment service. If that includes you, be sure to learn how to monitor where your inventory is being stored.
It should be noted the FBA network is large and growing. Moreover, their service is cutting-edge and utilizes data to better understand which warehouses are the optimal for your products to be stored in. This means the states in which you have inventory could change frequently as Amazon moves inventory to improve shipping efficiency and reduce costs. You’ll want to check which warehouses your goods are being stored in periodically to stay up to date on your overall sales tax nexus profile.
Communication services like Skype, Slack, and Google Hangouts make it incredibly easy for companies to leverage a distributed workforce. However, it also makes it incredibly easy for companies to trigger nexus across the country. An employee located within a state triggers nexus everywhere in the United States.
While a company can focus on finding remote employees within their home state, it’s more important to recognize that remote employees outside of your state are likely to trigger nexus. This will keep you from getting behind on sales tax collection requirements and being caught off-guard by unexpected sales tax deficiencies.
A common way for small businesses to leverage the marketing power of the internet is through affiliate marketing. Affiliate marketing typically involves working with individuals or companies who have an internet presence like a blog or online store. Advertisements for your business are set up by the affiliate to drive relevant traffic and, in turn, product sales. The affiliate marketer gets a small cut of the revenue as compensation for their advertising efforts.
Amazon Associates and Google Adsense are the most widely used examples of affiliate marketing programs. In fact, the Amazon Associates program is most responsible for creating what is widely known as “Click-through Nexus” or “The Amazon Law.”
Click-through Nexus applies when a company without nexus in a state is working with an affiliate marketer located within the state. In such cases, the relationship with the affiliate marketer has been determined to trigger nexus.
Dealing with Exemptions
It is highly likely that a business owner will make a tax exempt sale sooner or later. Taxable goods may be eligible for sales tax exemption depending on the type of buyer or the manner in which the goods will be used.
It is incumbent on the vendor to collect and keep on file a valid exemption certificate for each business, organization, or individual making an exempt purchase.
It is also up to you to ensure that exemption certificates are valid for each sales transaction. This requires your business to keep a copy of each exemption certificate and ensure that they are renewed when they expire.
Sales Tax Holidays
Many states offer limited periods where purchases can be made tax-free. These are commonly referred to as “sales tax holidays”. They typically coincide with two events: back-to-school and disaster preparedness.
As a retailer, you may be presented with a request for tax exemption during these periods by residents of participating states.
If a buyer is not the end consumer of a taxable good, they may make the purchase tax-free. It is up to the buyer to provide the necessary paperwork to verify they are a reseller. As a seller, you are expected to get this documentation and keep it on file and produce it upon request. This is common in the unfortunate case of a sales tax audit.
The purchase of raw materials to be incorporated into an end product prior to resale may qualify for tax exempt status. In some cases, the tools and machinery used in the manufacturing process may also be tax exempt.
It is common for people to think non-profit organizations are exempt from sales tax on all purchases. Not true. What is true is that for certain sales, sales tax is waived for transactions relating to the charity’s “charitable mission.” Again, the non-profit organization must provide the necessary paperwork verifying their status. It is up to the seller to manage this paperwork.
Steps to Sales Tax Compliance
The steps necessary to manage sales tax properly are as follows: determination, registeration, collection, filing, and remittance. We’ll walk through each of these steps recognizing that the details specific to your situation are unique.
A sales tax object may be a good, a service, a digital object, or a combination of each. Understanding the taxability of objects is critical as under-collections result in audit assessments and over-collection can result in potential class action suits (or aggravated customers!)
It’s important to remember every state may view the same object differently. As such, the taxability answer in state A may or may not be applicable in state B.
The first step toward establishing sales tax compliance involves registering your business in the states in which you have nexus. Depending on the size of your business, this may involve a brief review of your operations or a professional nexus study. Furthermore, the type of registration can vary based on the facts and circumstances of your business. Applying for a state’s sales tax registration accurately is most important for compliance for the life of your business, so take your time, do the necessary research, and get it right.
Registration gets your business an official sales tax license. All states require a business selling taxable goods in their state to register at least 1-2 weeks prior to selling.
Once registered, the state taxing authority will assign you a filing frequency. This can be a monthly, quarterly, or annual filing frequency.
Once you’ve registered for a business license in the states in which you have nexus, the next step is to begin collecting sales tax. Every major ecommerce selling platform offers this functionality natively. It’s up to you to set things up from your dashboard.
Once you have started collecting sales tax you will need to file a sales tax return based on the filing frequency assigned during registration. Filing a sales tax return involves breaking down the sales tax you have collected by jurisdiction (state, county, city, special, etc.) and submitting this information to state and local taxing authorities.
Contrary to what many think, the process of filing sales tax returns does not involve remitting sales tax. Think of the filing step as reporting your numbers. You are completing the paperwork necessary to report to state and local authorities exactly how much sales tax you have collected.
Sales Tax Tips for Online Sellers
- Invest Time: While there are lots of complicated aspects to sales tax law, establishing a foundation to get compliant is not overly complicated. Take the time to learn what your business is on the hook for.
- Learn About Nexus: Document every touch your business has with another state. Stay on top of your business planning so you don’t trigger nexus inadvertently.
- Know Your Platform: Read everything your ecommerce or accounting platform(s) has published regarding sales tax collection setup and management. If you can get this set up correctly from the start, it will make your life much more simple as your company starts to grow.
- Respect Collected Tax: All too often small business fail to sequester the sales tax they’ve collected spending it along with company funds. Create a separate bank account to hold the sales tax you’ve collected.
- Set Reminders: Tax deadlines and due dates vary by state. Once a state has assigned you a tax filing frequency, set calendar reminders to help prevent filing late and incurring penalties. Sync your calendar with your phone to have text message alerts sent the week sales taxes are due.
- Leverage Technology: Utilize tools like Avalara TrustFile to save time and avoid costly errors by processing your sales tax data for you.
Sales tax compliance is a very real concern for any online seller who is serious about growing their business and building for long-term success. Failure to collect, file, and remit sales tax in states where you have nexus is a risky path for business owners to take. Late payment penalties, collection fees, and interest payments can put your business at risk.
Take the time to learn how to achieve and sustain online sales tax compliance. Contact Avalara TrustFile for more information.