Sales tax essentials for small businesses

Nexus is a relationship that your business has with a state that obligates you to collect sales taxes in that state, and it's the most important thing you need to know in order to get sales tax right. Figuring out where you have nexus is the first step you need to take toward sales tax compliance.

The foundation of sales tax nexus law in the United States is a 1992 Supreme Court ruling, Quill Corp v. North Dakota, that businesses are only required to collect sales tax for a state if they have a physical presence there. However, in recent years, states have come up with many different ways to incur nexus, and that list is growing as states seek new sources of tax revenue.

If your business has a physical presence in a state, you will be required to collect and remit sales taxes there. "Presence" can mean branches, stores, warehouses, drop-shipping facilities or any real estate or property that belongs to your company. This can also apply if you are using a distribution service such as Fulfillment by Amazon (FBA) that stores your goods in warehouses for you. The presence of your products can trigger nexus in the state in which they are stored, even if you didn't put them there yourself.

As services become a greater part of the economy, more states are applying sales taxes to services as well as product sales. Some common types of services that are taxed include services to tangible personal property, services to real property, business services, personal services, professional services and amusement/recreation. However, taxation of services is unique to each state.

The sales tax rate that you charge your customers is a combination of a statewide rate plus any local rates. In most states, if you have nexus in the state, you will also have nexus in any localities there. And in most of these states, you can collect local and state taxes together at one combined rate.

However, there are a handful of states that let local jurisdictions not only levy sales taxes, but independently regulate and administrate those sales taxes as well. These are known as "home rule" states. The states that allow total home rule are Alabama, Arizona, Colorado and Louisiana. Not all localities in home rule states take this option, but when they do, they can create sales tax rules and processes that are completely separate from the state's. In Alaska, there is no statewide sales tax, but local jurisdictions can independently levy and collect sales tax according to their own nexus rules.

Home rule can be tricky for online sellers, as each locality can potentially define nexus differently as well as also require a separate registration, filing and payment process.

Take Colorado, for example, the most complex home rule state, with 70 cities that administer their own sales tax. Say you are an online retailer based in Denver (a home rule city). You would have nexus in Colorado as well as in Denver, so if you sell to a customer in Denver, you would need to collect Denver sales tax as well as state sales tax. Although the sales tax would be collected all at once from the customer, you would report and remit the two different sales taxes separately —the city tax to Denver and the state tax to the state. However, if you are based in Denver and have a customer in Boulder, but no nexus in Boulder, you would only need to collect state sales tax on that transaction since the tax is based on the location of the customer.

Understanding "sourcing" is important to getting sales tax rates right. Origin-sourced sales are taxed where the seller is located, while destination-sourced sales are taxed at the location where the buyer takes possession of the item sold. As a seller, it is important to know whether you are located in an origin-sourced state or a destination-sourced state.

Generally, if you are located in an origin-based state and make sales to customers within that state, you would charge sales tax based on your location, including any local and state taxes.

Meanwhile, in destination-based states, if you are making sales within that state, you will charge state and local taxes based on the location of the customer. However, the rules work differently if you are based in one state and are selling into another state where you have nexus. In this case, sales will generally be destination-based.

It's common for businesses to use ZIP codes to determine sales tax rates, but this may not always give you the right results. Tax jurisdiction and ZIP code boundaries do not necessarily align, so one ZIP code can include more than one city or taxing jurisdiction and multiple sales tax rates. In Colorado, for example, the ZIP code 80111 includes at least five different sales tax rates. The key to getting the right rate is geolocation, pinpointing the location of the transaction using data such as latitude and longitude coordinates.

Some states offer specific periods of time during which exempt items such as school supplies, clothing or footwear are exempt from sales tax for a specific period of time. These are known as tax holidays. In order to avoid overcharging customers, you need to keep current on the tax holidays that apply to your products in the states where you have nexus.

Sometimes, transactions that would normally be subject to sales tax are exempted. This could be because your buyer is a reseller rather than an end consumer, or because your customer is exempt from paying sales tax, such as a government entity.

When you make an exempt sale and do not collect sales tax, you need an exemption certificate to prove that no sales tax was due. Exemption certificates should be collected anytime a new tax-exempt customer is buying from you for the first time, or when a certificate you have on file for an existing customer is invalid or is about to expire. Exemption certificate requirements vary from state to state.

Before you can legally collect sales tax on behalf of a state, you need to register with that state. If you start collecting sales tax without being registered, you could face criminal penalties, so it's an important step.

The good news is that states want to give taxpayers incentive to register, so they make it relatively easy to do so. All states offer online registration, and it's free in the majority of states. Others charge fees ranging from around $5 to $100.

If you do business in several states, you may want to think about Streamlined Sales Tax (SST) registration. In the 24 states that participate, you can use one registration form to automatically register in all SST states. This can save you time and money, but if you are only doing business in a few SST states, it may not make sense.

Once you are registered with a state and any local tax jurisdictions, you'll be required to file sales tax returns and remit sales tax to the state. You'll be assigned a filing frequency ranging from biweekly to annually, depending on the amount of sales tax that you collect.

All states offer electronic filing and payment, and some require it. Others offer the option to file and pay manually with a paper return. In most states, you must file sales tax returns even if you didn't collect any tax for the reporting period. This is called zero-tax filing.

It's important to file and pay on time in order to avoid penalties, fines and increasing your chance of being audited. Many states offer incentives to taxpayers who file and pay early or on time by offering discounts on the amount of tax that must be paid. These can range from 0.5% to 5% with various maximum amounts.

If you cease having sales tax obligation in a state — for example, you're shutting down your business or you've stopped nexus-creating activities there — you'll need to deregister so that the state no longer expects you to file and pay sales tax. Keep in mind, however, that you may not immediately be free of sales tax obligations instantly when you deregister. For example, some states may consider you to have nexus for six months or longer after you request to cancel your registration. Make sure you know the requirements in your state in order to plan properly.

It's crucial to keep good records of your sales tax operations for filing your sales tax returns and in case of any questions from the tax authorities. Your records should clearly show where and when your transactions take place and how much tax you collected on those sales — and you should be able to find those records easily when you need them.

Even when you know what you need to do, sales tax compliance can be overwhelming for small businesses. Making sure you're using the latest rates, keeping updated on constant changes that can affect your compliance and meeting filing due dates are only the beginning.

Sales tax automation can be a huge boon to small businesses, decreasing the time you spend on sales taxes while ensuring greater accuracy. If you want to simplify filing and payment, Avalara Managed Returns offers a time-saving solution.

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