Sales tax compliance is essential to managing liability and protecting your business from regulatory penalties. But the complexity of sales tax regulations can make getting compliant feel overwhelming. In this post, we break down the six concepts you need to understand to get compliant.
What Is Physical Nexus?
Nexus is the qualifying criteria for a seller to be required to collect and pay taxes on sales in a state. Physical nexus is when your business has a physical presence in a particular state. Established by the Supreme Court in Quill Corp. v. North Dakota in 1992, physical nexus enables states to tax the sales of businesses that do business in their state, even if they’re headquartered elsewhere.
In most cases, physical presence means an office or a retail location. But a warehouse, remote employee, payroll or even a contractor can all trigger physical nexus. You can also develop physical nexus through inventory that’s stocked in a marketplace fulfillment center.
The concept of physical nexus has been around for nearly three decades, serving as the primary way states taxed the sales of businesses. It’s also pretty intuitive to understand. If you have people, buildings or objects in a state, you probably need to collect and remit sales tax there.
But in 2018, a new form of nexus made things much more complicated.
What Is Economic Nexus?
In 2018, the Supreme Court decision South Dakota v. Wayfair, Inc. established the concept of economic nexus. This gave states the right to force out-of-state sellers to collect and remit sales and use tax if they meet or exceed a state’s economic threshold. In the last several years, this has dramatically increased the taxability of businesses, making them liable in states where they don’t have a physical presence.
Since the Supreme Court armed them with this new tool, nearly every state that has sales tax has passed legislation establishing economic nexus. Because of this, complying with state sales tax has become really complicated.
So far, of the 45 states and DC that impose a sales tax, 43 have passed Economic Nexus laws (FL and MO are the holdouts).
Every state has its own economic threshold. Some states apply the law retroactively. Some don’t. States can define their thresholds based on retail, gross, taxable or marketplace sales.
Each state also has completely different rules for when you need to register after exceeding the economic threshold. It could be for the next transaction, like in South Dakota. Or it might be on “the first day of the second calendar month after economic nexus is established,” like South Carolina.
In addition to being complex, economic nexus legislation changes constantly.
What Are Marketplace Facilitator Laws?
After the Wayfair decision, there was one big question that needed clarification: who is responsible for calculating, collecting and remitting tax for marketplace sales? Marketplace facilitators and marketplace sellers both thought the other should be responsible.
To clarify this issue (and capture more revenue), a vast majority of states have passed new legislation.
Marketplace facilitator laws require marketplace facilitators to collect and remit sales tax for marketplace sellers on their platform. Put simply, if you sell goods through marketplace facilitators like Amazon, Walmart and eBay, they are responsible for sales tax on your transactions.
So far, we can say of the 43 that passed Economic Nexus laws, 42 have passed laws requiring the Marketplace Facilitators to collect and remit the tax.
If you sell through a marketplace facilitator, these laws have the potential to drastically decrease your sales tax liability. In some cases, you might even be able to cancel your sales tax accounts. But the only way to take advantage of this opportunity is to know how facilitator laws impact your business.
How Do These Laws Vary State by State?
Much of the complexity surrounding sales tax comes from the fact that states have total control over how they choose to define it. This inevitably means that every state has a unique set of sales tax laws you need to keep track of.
The difference most people are familiar with is that each state has different tax rates. But, there’s also other differences, like the varying economic thresholds we mentioned above.
In addition to these numerical differences, state sales tax laws contain many unique exemptions and anomalies that have a direct impact on your business.
For example, Arizona tax law holds that software-as-a-service isn’t a service. They tax SaaS providers under asset rental laws.
In some states, cooking food is considered manufacturing. Therefore, convenience stores that make food, or even use soda machines, would qualify for that state’s manufacturing exemption.
With so much volatility, there’s a lot of room for error. It’s easy to underestimate your taxability, or to miss out on exemptions that could save you thousands of dollars. The only way to make sense of it all is through thorough due diligence.
What About Local Sales Tax?
In addition to the state sales tax rate, many local municipalities impose their own sales tax rates on top of each sale. So within a single state, you could be liable to collect sales tax at a few dozen different rates. When you have nexus in multiple states with local sales tax, the complexity quickly becomes unmanageable.
In practice, this means you could have to worry about hundreds of different tax rates. Fortunately, automation software makes keeping up with local sales tax much more manageable.
How Do Sales Tax Audits Work?
So far, we’ve review the legal frameworks behind your sales tax liability. But what happens if you don’t comply with this liability?
You might get by for a few years without issues. But, eventually, you’ll get a letter informing you of a sales tax audit.
Sales tax audits are the real deal. They’re tough, prolonged affairs that can cost your business hundreds of thousands of dollars in unpaid taxes, interest and penalties. All of this cuts into your profits and your income. And if you’re a sole proprietorship, it could even swallow your retirement.
Despite these high stakes, most companies have no clue what their liabilities are. They don’t spend the time or money to stay compliant and prepared. By failing to understand what they could lose, they unknowingly increase the risk that they will lose everything.
The best way to protect yourself from six figure liability and penalties is through compliance and education. Sales tax compliance is complex, but it’s easier and more cost-effective to address sooner rather than later. We also recommend reading up on how sales tax audits work. Many businesses also work with sales tax specialists for help with their audit defense.
By preparing to fight an audit now, you’ll enjoy peace of mind knowing you’re prepared when the time comes.
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