Truth be told, it’s not the math that is difficult. It’s understanding the what, where, and how of sales tax. In this article, we’ll walk you through the components of sales tax calculation, the most common mistakes, and the negative impact of incorrect sales tax calculations. Afterward, you’ll be able to confidently manage your sales tax processes so you can focus more on revenue and less on taxes.
One of the biggest challenges around sales tax starts with a lack of information about what sales tax is and how it applies to your business. Since every business is unique and so many different elements affect sales tax, there are dozens of places where you may be missing critical components to handle sales tax.
In its simplest form, sales tax is a government-imposed tax on goods and services represented as a percentage of the transaction value. Governments use the money collected from sales to fund government programs and public services. Your sales tax dollars might go towards:
Sales tax is an important form of revenue for local governments. Since sales tax is a local tax, not a federal tax, the rules and regulations around sales tax vary from state to state and even from county to county, or even city to city! It’s also a form of indirect tax. The retailer collects the tax from the customer at the time of sale and then remits the tax collected to the government.
Real estate agents may claim the phrase “Location, location, location,” but it also applies to sales tax. Location is everything for determining sales taxability. Five states don’t charge sales tax: Alaska, Delaware, Montana, New Hampshire, and Oregon (also known as the NOMAD states). However, you still have to do your research. Alaska recently passed legislation stating that local jurisdictions can opt to require e-commerce businesses with qualifying nexus to collect sales tax.
Nexus is the threshold that states and municipalities use to determine if your business is required to pay sales tax in their jurisdiction. Nexus can be determined by physical presence, volume of sales, or other ties to the jurisdiction. Knowing your nexus will keep your business compliant with all the sales tax obligations you need to meet.
What makes calculating sales tax so difficult? Not only do nexus and location play a key role, sales tax is subject to change due to sales tax holidays, exemptions, or qualifying items. For example, in some states, groceries and food items may be taxed at a lower rate. And with the surge in digital products, the sales tax laws around them also vary. As you assess your sales tax responsibilities, review the following areas:
Whether or not you need to pay sales tax on shipping costs depends on the state. Connecticut, for example, requires businesses to charge sales tax on shipping costs for taxable sales but not on exempt sales. In Kansas, you no longer have to pay sales tax on shipping if it is separate from the product price on the invoice. To ensure you comply, check local sales tax laws to correctly calculate sales tax for shipping.
With an understanding of what components make up sales tax calculations, we can put it into practice with a simple algebraic equation.
Sales Tax = Transaction total x (Sales tax rate / 100)
The bulk of your time will be spent researching sales tax rates by state to determine the amount to charge on taxable sales.. States may also pass updated legislation affecting sales tax rates, so staying vigilant about rate changes is important. This is just one reason why having sales tax professionals, and tax calculation technology, on your side can alleviate some pressure around sales tax compliance.
As you assess your taxability, you’ll become more familiar with what to look for to stay compliant. Let’s look at two examples of how businesses successfully calculate their sales tax.
Then add the sales tax to the sale price of the saunas.
Installation should be billed separately or as a separate line item.
As you can see, the company still needs to charge for installation ($30,000), but if they calculated the sales tax on the transaction total of products + services, they would be overcharging on sales tax. That’s a fast track to unhappy customers. The best way to avoid this is to have everything on a separate line item on your invoices or invoice separately for taxable and non-taxable items.
However, if the crew was sent to Orlando, Florida, the sales tax rate drops to 6.5%. So don’t assume you know the sales tax rate even if you’ve worked in the state or area.
Statewide, there is a sales and use tax of 6.25% applied to SaaS. Additionally, local jurisdictions can increase the tax by up to 2%. So in some areas, the tax rate could be up to 8.25%.
For our example, let’s look at sales in the Houston area. The sales tax rate in Houston is 8.25%. If our SaaS company had $750,000 worth of sales in the preceding 12 months, they’ve met the economic nexus and need to be prepared to collect and remit sales tax. If they did $60,000 in sales last month, they would be responsible for charging sales tax on 80% of that total.
To determine their sales tax responsibility for the month:
The same equation applies if you want to see the sales tax on individual transactions. If your SaaS retails for $100, only $80 would be taxable.
Sales tax is not a “set it and forget” type of tax. We know it’s challenging to keep up with all of the changes and regulations surrounding sales tax, but getting complacent, instead of staying compliant, with your sales tax process could cost you, especially if you get audited. Here are some of the biggest risk areas when it comes to accurately collecting and remitting sales tax:
Simple as it may be, miscalculations from basic math are among the most common sales tax mistakes. Business owners often use the wrong sales tax rate if they aren’t current with new legislation. Failing to catch these changes can result in over/undercharging customers. The same goes for rate changes from one jurisdiction to another. Knowing how to properly apply sales tax rates, even if it’s just one city over, is critical to getting your sales tax process right.
Miscalculating sales tax can also come from improperly applying discounts, coupons, or shipping charges. Sometimes, it’s just a series of rounding errors that can throw off your sales tax calculations.
Misclassifying products and services is another common sales tax miscalculation. This can be difficult because different products and services can be taxed at different rates. Business owners must understand the taxability of their products and services and how they should be taxed. It may even vary from product to product.
Missing when you reach nexus in a jurisdiction can lead to a failure to collect sales tax. Whether it’s a physical footprint or meeting the economic nexus qualifications, you have to recognize when you will be responsible for collecting and remitting sales tax.
Another element of staying sales tax compliant is regularly updating and checking exemption certificates. Exemption certificates document your non-exempt status for certain transactions. Neglecting to obtain and maintain valid certificates can result in uncollected sales tax liabilities during audits.
Just like poor bookkeeping can hold up accurate financial reporting, poor recordkeeping can leave you vulnerable to big mistakes with your sales tax. Keeping accurate records can help track changes and tax responsibilities. In the event of an audit, an accurate record of your sales tax process is practically priceless.
The final contender for how you might miscalculate your sales tax is missing special circumstances. This can look like special taxation districts (like tourist areas) or sales tax holidays. Missing these could result in financial liabilities and non-compliance.
When you have a pulse on all of the elements of how sales tax is calculated, you can confidently grow your business into new areas without the pressure of miscalculations. This can all be assisted with reliable sales tax software, regular self-audits, and checking in with the sales tax people to keep your business compliant.
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