Editor's Note: Post updated for accuracy on September 12, 2018.
Internet sales tax laws have been vague (and in many cases, non-existant) for years. But this summer brought a day of reckoning for online sellers across the nation as a landmark Supreme Court case changed everything.
In June, the court ruled to eliminate decades-old 'physical presence' criteria for establishing sales tax nexus and deemed the concept of 'economic threshold' nexus constitutional. The court agreed that this new approach was a much better fit with web-based retail on the rise, and with the stroke of a pen, states were allowed to collect sales tax on specific interstate internet sales for the first time in history.
As a result, deficit-laden states across the US are now eagerly eyeing the estimated $13-billion-dollars of unclaimed internet sales tax generated by online retail last year. Not surprisingly, every state from Florida to California wants their cut.
As states scramble to snag their share of the cash, small business owners and online resellers are left trying to make sense of it all. Don't worry; we're here to help.
Know What You Owe - Back to Basics
According to the US Government Accountability Office, less than 10% of businesses that sell goods online are fully compliant with current tax laws. But as a small business owner, it's absolutely critical that you understand your state sales tax responsibilities.
Sellers who neglect to comply with sales tax regulations for any reason - whether intentional or not - are not exempt from paying up. In fact, states typically punish late and nonfiling business owners by charging hefty fines. When you're working with a shoestring budget, the last thing you need is extra costs - especially when they're entirely avoidable.
So now that you understand the why, let's talk details.
When is a seller required to collect sales tax?
Sales tax is considered a 'trust' tax - because states are trusting you to:
- Determine if you're legally required to pay sales tax in their state
- Collect sales tax on all applicable transactions at the correct rate
- Hold tax money in a trust until it's time to send it to the state tax authorities
- Remit taxes on a specific schedule, as defined by the state
Generally, a sales transaction must meet two basic criteria to be considered taxable:
- The goods or services sold in the transaction qualify as taxable
- Your business has nexus in and is required to pay tax to the buyer's state
When you collect sales tax from an online buyer, the money is held in a trust until it's remitted to the state. Every state that collects sales tax revenue has its own filing schedule.
Taxable goods and services are defined at the state level. Most states define taxable goods as “Tangible Personal Property," or TPP. States also tax certain services.
While TPP applies to a pretty uniform group of product categories that a business might sell, taxable services can vary widely by state.
For example, some states tax health and wellness services (i.e.. massage, tanning, and health-club fees), while others do not. As a general rule of thumb, business to consumer (B2C) services are much more likely to be taxed than business to business (B2B) services.
Understanding Taxable Internet Goods
Traditionally, nexus was established with a state when one or more of the following 'physical presence' criteria applied:
- You have a business presence in the state, including an office, distribution center, or warehouse
- Your business has employees operating in the state who solicit sales
- Your business owns or leases property in the state
- Your business makes deliveries within the state using company-owned vehicles
But in June of 2018, everything changed.
Before 2018, storing inventory in a state warehouse would have established 'physical presence' nexus in a state. But after a recent Supreme Court ruling, everything changed.
Before this year's South Dakota v. Wayfair Supreme Court case ruling, physical presence was the primary means of establishing nexus between a seller and a state.
However, the Supreme Court decided that the idea of using physical presence to establish nexus is unfit and unsound in today's economic climate. Here's a snapshot of what happened from one of our prior blog posts:
Now the decision has been made to overturn the 1992 Quill Corp. v. North Dakota ruling, allowing South Dakota to throw out the physical-presence determination and institute a threshold rule for online businesses who make sales to residents of their state.
The outcome of this case means online sellers have legal nexus and must collect sales tax in South Dakota if they exceed the state's economic threshold by:
- grossing more than $100,000 in sales of tangible personal property to residents of South Dakota in a given year OR
- conducting more than 200 such separate transactions
With Quill no longer in the way, other states are free to expand their definition of nexus beyond physical presence as well.
When you think about the amount of unclaimed tax money involved, it makes a lot of sense that states would be aggressive in pursuing the opportunity to generate more sales tax revenue.
Many states are now in the process of putting new economic threshold nexus laws in place that will allow them to collect money on internet sales. Check out 5 Ways New Nexus Laws Affect Your Business Now for a detailed account of what changed and how to stay compliant.
Nexus laws and regulations changed dramatically in 2018. Stay current (or hire expert help) to avoid costly penalties.
Where to Register
It's illegal to collect sales tax for a state if you haven’t registered with that state’s government to do so. Registration is often free, though several states do require a deposit. Simplify the process with our state-by-state sales tax guides. Learn about each state's nexus criteria, get links to each state's sales tax registration page, verify tax rates, and more.
If you determine that you have nexus in a state, you’ll need to register with that state’s Department of Revenue. Upon registering, most states will issue a Retail Sales Permit (or something similar) that includes a tax account number. Every state has an online application process, and they are usually pretty expedient about issuing a tax account number... so they can start collecting money.
Please note, you’re required to notify customers that you're collecting sales tax on the state’s behalf. If you own a brick-and-mortar business, you can do this by displaying your permit in plain sight. If you're an online retailer, a notification at check-out is usually sufficient.
How do you collect and remit sales tax?
To collect sales tax on taxable sales, you’ll need to know the rate (what percent of the gross transaction total) to charge the customer. For an online sale, the rate is usually determined by the customer’s address.
Sales tax rates vary, but can include:
- State sales tax rate
- Local city and county tax rate(s)
- Additional local taxes voted into law that support schools, a city transportation department, etc.
- Local specialty taxes on things like dining out, etc
Tax rates and practices vary by state, city, and county - so do your homework. Some states, like Maryland, do not allow local sales taxes, while some areas have local tax rates that are as high as the state's rate.
Filing schedules can vary, but most states require businesses who have nexus to remit collected sales tax each month.
Here’s a quick rundown that gives you examples of the varying state and local tax configurations you can expect from state to state:
- Hawaii charges state sales tax at a rate of 4% and does not allow local cities and counties to charge local sales tax
- Delaware does not charge a state sales tax or local sales taxes
- Kansas limits all local tax rates to 1%
- Louisiana charges a state sales tax rate of 5%, but with added in local rates that vary by parish, the total rate can be as high as 10%
As you can see, the possibilities can seem endless when it comes to rates. Thankfully, many online shopping cart solutions now regularly update and calculate sales tax based on your customer’s address. It's always a good idea to use an accounting program that makes it easy to calculate sales tax by state to limit confusing errors and miscalculations.
To remit internet sales tax to your state, you must file a tax return with the tax authority in your state.
You'll file one of three ways:
- Online through the state tax portal
- By phone
- By mail
Some states require that you file online. Doing so can be an excellent option as it saves time, eliminates deadline issues due to unpredictable mail travel times, and provides a secure filing option.
What is tax sourcing?
Tax sourcing refers to the process of determining the rate at which you tax a sale by tracing the sale’s “tax source.” Most states determine sales tax rates based on a product's final destination. However, 11 states determine the rate based on the origin of the product (or the business’s location). This is only an issue when you sell to customers in your own state.
A destination-based sale (ex; a buyer in one of your nexus states orders a product from your online store) is taxed at the rate based on your buyer's location.
If you’re located in one of the 11 origin-based states (Arizona, California, Illinois, Mississippi, Missouri, New Mexico, Ohio, Pennsylvania, Tennessee, Texas, Utah, and Virginia), you charge the sales tax rate that applies to the seller’s location for in-state sales.
When you sell online to other states, the sale is considered destination-based, and the rate is calculated based on the buyer's address.
When do you owe use tax?
No article about sales tax would be complete without mentioning use tax. Use tax is the tax applied to a sale of taxable goods or services that have not been subject to sales tax. When would this happen?
If you order business supplies from a supplier without a tax presence in your state and have the items shipped to you. In this case, you owe use tax on the sale tax revenue to the department in your home state. Like sales tax, these taxes should be calculated in a separate account and paid monthly. The use tax rate is usually the same as the state’s sales tax rate.
When you order office supplies online and don't pay sales tax on the purchase, you owe use tax to your home state.
Do you collect use tax for your customers?
At this point, a few states have already taken action to pressure consumers and businesses to better comply with use tax laws, which have traditionally been easily ignored. Colorado, for instance, has passed legislation requiring online businesses to submit “Annual Purchase Reports” to their Colorado customers. Yet another administrative burden on the small business owner. For now, you’ll want to know the use tax laws in your customers’ states and check for any compliance issues you might face now or in the near future.
How do I find out about the individual states in which I sell?
As mentioned previously, every state has its own tax department website where you’ll be able to:
- Register to collect sales tax for the state and localities by creating a tax account
- File monthly, quarterly, or annual sales tax returns with the state
- Remit sales tax that you’ve collected during the filing period
- Look up sales tax rates by city, county, or zip code
- Find pertinent sales tax laws as they apply to your business
Check our individual state guides for more specific information and to find contact details. At a time when states are serious about collecting from online sales to their own residents, knowing the rules, determining your responsibilities, collecting the proper sales tax at the correct rates, and remitting taxes on time is an important aspect of running a successful business.
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