Last year we released a short video highlighting a situation we refer to as “the biggest tragedy in sales tax.” Essentially a business which has a tax obligation, or “nexus”, to a state fails to collect sales tax from customers at the time of purchase and is audited. The state assesses the business for the tax, plus heavy penalty and interest charges. What once would have been willingly collected from paying customers now comes directly out of the company’s pocket. And sadly, the penalty and interest charges from these audits can balloon even relatively small assessments into business crippling amounts. Such was the case in the state of Washington1 just recently.
Up until late 2009, Mattress World, a seven store mattress retailer based out of Portland, Oregon operated without complaint. Though business hadn’t been booming in recent years, owner Sherri Hiner was “anticipat[ing] opening new stores.” That’s when the WA Department of Revenue appeared. Asserting that Mattress World qualified as a WA business, the DOR audited and assessed the company to the tune of $2 Million in unpaid sales taxes, penalties and interest dating back to 2002. And now after two years of struggling to stay ahead of the payments to the state, and increasing legal and other expenses, Mattress World has decided to close its doors.
It’s hard to blame Hiner for the disaster. Sales tax nexus is not a well understood concept. Outside the small contingent of professionals who deal with sales taxes each day, most of the public, including many very savvy business professionals, don’t understand how it works. In Hiner’s case, she did have a number of things on her side. Mattress World did not operate any stores in WA, and as Hiner explained, they “used third-party delivery services to transport bed sets north of the border during the period covered by the audit.” But as WA DOR representative Mike Gowrylow explained, “Because Mattress World delivers products [to WA], it must still pay sales and other applicable taxes.”
Let’s take a step back and figure out why Mattress World found itself in this position. The term nexus has been floating around the sales tax world since the US Supreme Court first used it in 1968, and has been the primary argument by which states make decisions on which businesses they tax and do not tax. The arguments surrounding nexus center around essentially two clauses of the Constitution—the Due Process Clause, and the Commerce Clause. The Supreme Court’s rulings about nexus mainly follow the Commerce (or Interstate Commerce) Clause of the Constitution. They have stressed the real power to regulate commerce lies with Congress. However absent congressional action, the Court has upheld the idea that there should be no barriers, or at least very few to interstate commerce.
This means that in order for a state to be justified in levying a tax on a business, it must first show that the tax does not create a barrier to interstate commerce. This requirement provides that some minimum connection must exist between the business and the state that seeks to tax it. And current sales tax nexus law dictates there must be some kind of significant physical presence, whether it be a brick and mortar store, an employee, third party agent or affiliate, etc.
Now back to our story. In this case, it is not clear where or how WA found nexus with Mattress World. Since we don’t have all the details it would at best be speculation to guess. What we can say is that with as complex as nexus law has become, and with states asserting nexus more aggressively than ever, it doesn’t surprise us too much that Mattress World found itself in such hot water. At our last count, WA state employed over 200 full-time sales tax auditors, whose express purpose was to find and audit companies in these situations.
Probably the most unfortunate circumstance in this situation is that the entire problem was preventable. As we mentioned before, we feel the biggest tragedy in sales tax is a situation where a company fails to collect tax or obtain an exemption or resale certificate (no matter the reason) at the time of purchase. We always caution our clients and really anyone who will listen, to be proactive, or conservative in the collection of sales taxes. Whether or not they follow our counsel is another story. But if you sell something taxable, and you aren’t sure if you have nexus, you will almost always be better off simply collecting the tax, so you can avoid the painful, and sometimes business sinking assessments down the road.