It is estimated by the US Government Accountability Office that less than 10 percent of businesses that sell goods online are in compliance with current tax rules. The result is a $13-billion-dollar shortfall in sales taxes that states, which are struggling with budget deficits, are now eager to collect. If your business makes sales online, knowing which sales are taxable, when to collect, how to collect legally, and how to stay in compliance with the individual states in which you make sales is a must.
Sales and use taxes are state taxes. Understandably, from the states’ perspective, not knowing or understanding the law as a seller does not exempt a business owner from the responsibility to follow it. Penalties, fines, and fees for filing late can add up quickly, and not collecting and filing in the proper states is a criminal offense in some cases. We’ve put together this quick guide to arm you with the knowledge you need as an online business.
When you collect sales tax from an online buyer, the money is held in "trust" by you to be paid to the buyer's state.
When does the seller collect sales tax?
Sales tax is a “trust” tax, which means that as a business owner, you charge the tax to your customers on taxable sales, and then hold the money in trust until it’s time to pay the states for whom you collected it. Payments are often due on a monthly basis. Sales normally have to meet two basic criteria to be considered taxable:
- The goods or services sold qualify as taxable.
- The state to which they were sold is a state where your business has a tax relationship.
Taxable goods and services are defined at the state level. Most states define taxable goods as “Tangible Personal Property” (or TPP), and also tax certain services. While TPP applies to a pretty uniform group of items that a business might sell, taxable services can vary widely by state. Some states tax massage, tanning, and health-club type services, for instance, while others do not. As a rule of thumb, B2C services are more likely to be taxed than B2B services.
A seller should collect sales tax on sales to customers who reside in their home state, as well as to customers who reside in states with which the seller has a business connection. A minimal business connection for tax purposes is called “nexus.”
The storage of inventory in a distribution center is sufficient to create nexus in many states.
Traditionally, nexus is established with a state when one or more of the following apply:
- You have a business presence in the state, including an office, distribution center, or warehouse.
- You have employees operating in the state who solicit sales.
- You (the business) own or lease property in the state.
- You (the business) make deliveries within the state using company-owned vehicles.
If your business makes sales through Amazon, maintaining inventory in their distribution centers may qualify as a tax presence for your business.
Many states are now in the process of expanding their definition of what types of business activities meet the minimum guidelines for establishing nexus. The most common way that they do this is to include language in nexus laws that covers affiliate sales. At this time, if you enter into an affiliate relationship with a resident of another state, you may need to register with that state and collect the tax. Many states now consider affiliate relationships that result in a total of $10,000 or more in sales to customers in that state within a 12-month period (for some states, the total is $5,000) to be a business activity that is sufficient to establish nexus.
If you make sales through an affiliate in another state, that's often enough to establish nexus.
Which states do you need to register with?
Keep in mind that it is illegal to collect sales tax on sales for a state if you haven’t registered with that state’s government to do so. Often registration is free, though several states do require deposits. The best practice would be to check with each state where you make sales to determine if your business activities in that state establish nexus. Our individual state guides are a great resource as well.
If you make sales in a state and have nexus there, 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) and a tax account number. You’re required to notify customers that you are collecting sales tax on the state’s behalf. With a brick-and-mortar business this would mean displaying your permit, but for an online business, a notification upon check-out is usually sufficient. Each state has an online application, and in many cases you’ll be issued a tax account number in a matter of days.
How do you collect and remit sales tax?
To collect sales tax on taxable sales, you’ll need to know the rate (a percentage of gross receipts) to charge the customer. For an online sale, the rate is usually determined by the customer’s address. States set an overall state sales tax rate, and then local governments, school boards, and transportation departments often charge additional local tax rates. This practice varies by state. While some states, such as Maryland, do not allow local sales taxes, other state’s local rates can be as high as the state rate itself.
Most businesses are required to remit collected sales tax monthly.
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 local rates, which vary by parish, the total 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 update regularly and calculate sales tax automatically based on the customer’s address. You’ll want to set up your accounting with separate sales tax accounts so that running totals of the sales tax due each state are maintained and you aren’t hit with an unexpected drain on your cash flow at the last minute.
Once you’ve collected the correct amount from each sale, you must file a tax return and remit those taxes to the tax authority in your state (for sales to customers who live in your state) as well as to those states where you have nexus. Most states provide several options for doing this and you’ll usually file by the 20th of each month for the month prior. Options for filing returns and remitting taxes owed include:
- Online through the state tax portal
- By phone
- By mail
Many states require businesses to file online at this time.
A destination-based sale is taxed at the rate of the buyer's location, not the seller's.
What is tax sourcing?
Tax sourcing simply refers to determining the rate at which you tax a sale by tracing the sale’s “tax source.” Most states tax a sale and determine the rate to charge based on its destination, while 11 states determine the rate based on its origin or the business’s location. The good news is that this is only an issue when you sell to customers in your own state.
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 when you sell to a customer within your home state. In every other state, you will charge the sales tax rate that applies to the customer’s address because the tax is destination-based. Likewise, when you sell online to other states, the sale is considered destination-based and the rate is calculated based on the location of the buyer.
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 them shipped to you, you owe use tax on the sale to the revenue department in your home state. Like sales tax, these taxes should be calculated in a separate account and paid monthly to your home state. 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 time, states are not legally allowed to require online businesses to collect and remit use tax owed by its customers. South Dakota has challenged this federal law, however, and it seems likely to change.
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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