The challenges of use tax compliance

Avalara Whitepaper

Use tax audits are on the rise

More and more states are increasing audits to collect consumer use tax. All states that charge sales tax also charge use tax. Use taxes are meant to minimize unfair competition between sales made in and out-of-state. A company buying goods outside the state or online is required to report and remit consumer use tax for the storage, use, or other consumption of tangible personal property (TPP) that was not subject to sales tax. Use tax must also be paid when a business withdraws goods from inventory for its own use. It is a business’ responsibility to self-assess when, and if, use tax is accrued and to pay the state and/or local tax authority on a tax return.

The overall state budget deficit in 2012 is estimated at approximately $125 billion,1 which has undoubtedly caused much of the increased attention on use tax compliance. States are trying to boost revenue by towing the line on use tax, while also offsetting tax dollars lost to e-commerce and changes in the definition of TPP, such as electronic music or software downloads, which have historically not been taxed in the past.

As use tax compliance grows in importance, businesses suffer the consequence of having to manage cumbersome manual tax calculation. Many smaller businesses lack the staff or resources needed to streamline this task and instead rely on manual processing of each and every invoice, which is inefficient, inaccurate, and costly. Inaccuracies attract auditors, placing a further burden on companies. Audits can hamper productivity and small companies lack the time and money to check auditors’ findings. Risks of non-compliance are worse, including penalties, interest, and even jail time if fraud is proven. Calculating use tax is particularly complex for industries such as manufacturing and construction.

Technology offers a solution by automating the process of calculating, reporting, and remitting use tax. Human intervention is minimized, helping reduce the risk of over or underpayment. Most software solutions also feature dynamic, on-demand tools that deliver reports quickly and easily, improving accuracy and discouraging audits. Companies also enjoy rapid ROI from investments in technology solutions due to improved compliance.

Software solutions include unique features that further enhance the benefits of use tax automation. For example, AvaTax, by Avalara, features a sophisticated tax calculation engine that contains the most up-to-date taxability rules, jurisdictional assignments, and geo-spatial technology to determine sales tax rates at the invoice or Point-of-Sale (POS) level. Automated solutions like AvaTax prevent accounts payable staff from having to remember exactly what is taxed, when, and where. And AvaTax uniquely integrates with existing accounting systems, as well as any e-commerce, ERP, or POS application.

Unlike other solutions, AvaTax is offered as a cost-effective, Software-as-a-Service (SaaS) model. Small- to medium-sized businesses benefit from an enterprise-grade solution without incurring the costs of building, managing, and maintaining a tax management infrastructure. Updates occur automatically in the cloud—perfect for companies with multiple locations. In addition, AvaTax archives real-time tax information for seven years. As an end-to-end solution, AvaTax also offers a full suite of fully automated tax management solutions.

One reason online shopping is so favorable, is because of a tax loophole that does not require e-retailers and catalog companies to collect sales tax unless they have nexus in a state.

An introduction to consumer use tax

As the toughest economy since the 1930s causes many companies to tighten their belts, savvy business owners and procurement specialists are leveraging the Internet to find competitive pricing on goods. With frequent sales, and great deals such as free shipping, many small- to medium-sized businesses are using the Web to compare pricing and save time. One of the reasons that online shopping is so favorable is because of a tax loophole. According to federal law, e-retailers, and catalog companies are only required to collect sales tax if they have a physical presence, or “nexus,” in a state, such as a storefront, warehouse, or other facility. This definition may broaden if new legislation is passed.

The corresponding rise in e-commerce has caused many states to try to impose tax on Internet transactions in an effort to capture lost revenue. New York has already passed legislation requiring companies with affiliate relationships in New York State to collect sales tax. In addition, several large retailers, including Walmart, Best Buy, Sears, and Home Depot are jumping on the bandwagon to try to force Internet companies like Amazon to collect sales tax as a way for brick and mortar stores to stay competitive.

All states that charge sales tax also charge use tax. Use taxes are meant to minimize unfair competition between sales made in and out-of-state. To recoup lost tax revenue, many states are increasing audit activity to more aggressively collect consumer use tax. A business purchasing goods from another company within the same state pays sales tax, which the seller collects and sends to the appropriate tax agency. A company buying goods outside a state or online typically does not pay sales tax, but is required to pay consumer use tax for the storage, use, or consumption of tangible personal property (TPP). This also holds true if a company is charged less tax than appropriate—the buyer, or consumer of the goods, is ultimately responsible for paying the difference.

For example, a company that buys laptops from an out-of state supplier must ensure that use tax is paid correctly wherever the computers are shipped or stored. Companies with multiple business locations in several states, or with a remote sales force selling into numerous states are especially vulnerable to the intricacies of consumer use tax. Consumer use tax must also be paid when a business withdraws goods from inventory for its own use. This might occur, for example, when a retailer selling office supplies removes copy paper and pens from inventory for employee use, or when items are used as displays or product samples.

In addition to losing money from e-commerce, the recession has hit state budgets particularly hard with 2012 deficits estimated at $125 billion. To make up this lost revenue, many states are increasing audit activity to recoup lost use tax. Pennsylvania’s Department of Revenue has been targeting businesses that failed to pay use tax in recent years, suspecting items have been purchased out-of-state. This is part of the agency’s effort to offset a budget deficit close to $4 billion. The State Department of Revenue estimates that as much as $356 million in annual use tax revenue is being lost on products and services purchased online.

States are also losing tax revenue on products that have morphed into a different definition of TPP. Most states have traditionally taxed TPP, including music sales on LPs, cassette tapes, or CDs. However, as MP3 players have become popular and an entire generation now downloads music from iTunes, the definition of TPP in regard to music has grown blurry. Illinois, for example, collects sales taxes on CDs sold in stores but not on downloaded music files. As people buy more music online, the state loses valuable revenue because MP3 files are considered to be non-taxable, digital goods. As of last year, state projections showed that Illinois could bring in about $10 million if iTunes downloads were taxed.

A company buying goods outside a state and online would typically not pay sales tax and is therefore required to pay consumer use tax for the storage, use, or consumption of TPP not subject to sales tax.

Accounting personnel have to manually research tax rates that vary from state to state, and between different counties, cities, and districts. In the U.S. alone, 17,000 different taxing jurisdictions currently exist.

Some high risk industries include:

  • Manufacturing
  • Construction
  • Retail
  • Hospitality
  • Distribution
  • Service or repair
  • Medical or dental

Use tax and its increasing impact on business operations

Companies are responsible for self-assessing when, and if, use tax is accrued, and to self-report on tax liabilities.

Any errors discovered in computing use tax must be reported to the appropriate jurisdiction on a business’ balance sheet as an open liability. The company must then remit the correct amount with their next tax return. The burden is on the company to prove that the tax has been reported and paid.

Many businesses today calculate and resolve tax compliance manually, although this process proves to be inefficient, time-consuming, and cumbersome. Accounting personnel have to manually research tax rates that vary from state to state, and between different counties, cities, and districts. In the U.S. alone, 17,000 different taxing jurisdictions currently exist. A maze of tax exemptions and other rules must also be addressed on an invoice by invoice basis. Unfortunately, most small to medium-sized businesses lack tax professionals on staff, and instead rely on accounts payable personnel to memorize and apply tax laws and keep up with the constantly changing product taxability rules. These employees are also tasked with determining where an item was consumed, and properly documenting in case the company is audited. Companies that cannot adequately manage this process must hire additional accounting resources on a monthly basis to maintain tax schedules, verify tax rate accuracy, examine accounting logs for errors, and manually correct invoices.

Reliance on human knowledge and manual processing results in inaccuracies which are further compounded by staff turnover. Inaccurate record-keeping in turn attracts tax auditors. This year, the Oklahoma Tax Commission increased its auditing staff for sales tax collections by 20 percent, which directly correlated with an increase in tax closure notices in that state. Aside from risk of closure, audits also cost companies lost productivity—especially small firms that lack the staff to work with auditors and to check auditors’ findings. Some companies over-assess their tax liability to compensate—paying more money in an attempt to prevent an audit. Others are forced to set aside large sums of money, just in case they are penalized for non-compliance. Companies that under-assess taxes face the more serious risk of penalties and interest due on outstanding tax payments, and even jail time, if it is proven that use tax was willingly withheld, which constitutes fraud.

Industry specific sales tax challenges

Some industries risk non-compliance more than others. For example, manufacturers are not required to pay use tax on equipment used in the manufacturing process. Forklifts used to transport products around a plant facility may not be taxable, however forklifts used in a parking lot to transport finished goods for shipment may be taxable in some states or jurisdictions. Because equipment can be costly, the tax implications are significant. Unfortunately, every state differs in how they assess use tax. Some states claim the manufacturing process begins and ends at the loading dock, while others believe it begins with the first machine in a manufacturing process. In manufacturing, a mistake in determining taxability can cost a company thousands of dollars.

Construction companies also face problematic tax issues because the nature of the trade involves buying materials to be assembled into a new product. For example, in a construction contract, the contractor is deemed the consumer of any TPP purchased that is incorporated into real property and, thus, pays tax on the property purchase. In this case, the contractor is the “consumer,” even though he may subcontract the actual labor to incorporate the materials into the real property.

However, subcontractors who purchase items for a construction job must pay tax on the materials. Determining tax liability can be tricky when the line between real or personal property becomes vague. Contractors may request owner certification to classify the property before executing the contract. Difficult sales and use tax issues are particularly tough if a construction firm operates in several states. In addition to the usual issues of complying with different law bodies, numerous state and local tax rates, various tax agencies, and the demands of record keeping further complicate an already complex task.

Technology solutions to sales and use tax challenges

Audits are on the rise and because many smaller companies are struggling to comply with use tax requirements, a solution is clearly needed to improve the speed and accuracy of tax collection and filing. Technology offers a solution by automating the laborious task of use tax management. By leveraging software applications, accounting departments and accounts payable staff can relieve the burden of manual processing. Small- and medium-sized companies especially stand to benefit from automation. Although enterprise solutions have existed for years, smaller firms have not, to date, had pre-built, affordable technology options available.

Automated solutions dramatically improve efficiency by assessing, calculating, and accruing use tax when invoices are originally processed. All transactions occur in real time without disruption to existing workflow, and a process that typically took hours or days can now be accomplished with a few mouse-clicks.

Geo-spatial technology determines sales tax rates at the invoice level, and a tax calculation engine, or database, holds tax information for every state and local tax jurisdiction in the U.S. instead of relying on people to remember this information. For this reason, automated solutions dramatically increase remittance accuracy, which discourages the need for audits. Companies can keep accounting personnel focused on revenue generation, or value-added activities instead of compliance, creating an immediate return on technology investments.

Most software solutions also offer tools that deliver the reports necessary to prove compliance. In this way, accounting staff can quickly and easily generate reports without having to build them from scratch. Also, the best use tax management solutions integrate seamlessly with a business’ existing accounting system, ERP, POS, or e-commerce applications.

AvaTax, by Avalara, provides an affordable, web-based tax management solution via Software-as-a-Service (SaaS). Avalara’s users simply logon to the service through an online portal—a perfect solution for businesses with multiple locations, as web-based transaction data is available company-wide. Users access the shared portal to view transactions and reports in real time. Auditors can also use the online interface to check tax information, and run reports from a central console. Because the tax engine is hosted in the cloud, updates occur automatically, and manual software updates to the desktop are not needed. This is especially relevant for tax information, which changes frequently.

The SaaS model is particularly cost-effective for small- to medium-size businesses that can now benefit from an enterprise-grade solution without incurring the costs of building, managing, or maintaining their own in-house infrastructures. AvaTax also archives real-time tax information for seven years for full compliance with retention standards. All systems are secure with the appropriate, built-in redundancies for managing transactional tax data.

Automated solutions dramatically improve efficiency—a process that typically took hours or days can now be accomplished with a few mouse-clicks.

With SaaS, users simply logon through an online portal—a perfect solution for businesses with multiple locations, as web-based transaction data is available company-wide.

Use tax and its increasing impact on business

Companies face multiple challenges to comply with tax requirements, so Avalara provides an end-to-end suite of fully automated tax management solutions:

  • AvaTax — Provides a transactional tax solution to calculate and manage sales and use tax.
  • Returns — Provides a single source, automated return, filing, and tax liability remittance service.
  • CertCapture — Provides an e-compliant, intelligent, automated solution for collecting, maintaining, and accessing exemption certificates

Avalara’s automated tax management solutions are certified by the Streamlined Sales and Use Tax Agreement (SSUTA or SST)—a national effort to simplify sales and use tax processes for both businesses and states. An additional goal of SST is to reduce the cost and administrative burdens on retailers who collect sales and use tax, particularly businesses operating in multiple states. Avalara is a SST Certified Service Provider (CSP). An SST CSP is certified to file and remit sales tax liabilities in SST states. Where a business is registered under the SST, voluntary state filing services using a CSP may be free.”

Sales tax use tax automation helps companies stay competitive

As a Certified Service Provider (CSP), Avalara allows businesses participating in SST to fully outsource their sales and use tax management processes.

Implementing an automated consumer use tax management solution offers several advantages to companies that are trying to stay competitive in the midst of a recessionary economy. In addition to saving time and streamlining workflows, automated solutions such as AvaTax can catch mistakes before monthly filing occurs—a proactive, cost-effective way to comply with state use tax filing requirements. Automated solutions increase the accuracy of a company’s invoicing and are especially helpful to small- and medium-size businesses that have previously been unable to afford enterprise-grade solutions. With new delivery options being developed, like SaaS, and with end-to-end suites of tax management solutions available, such as Avalara, today’s companies can streamline tax management, reduce compliance risk, and instead, focus time, money, and innovation on growing their business.


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