The world of sales tax is convoluted and challenging to navigate, which is why it’s a thorn in the side of small business owners across the United States. But, like it or not, if your business sells goods to consumers, you need to know and understand all the in’s and out’s of it—like which transactions qualify for it, where you need to pay, and how to calculate your sales tax obligations.
Why is it so tough to figure out? The short answer is that sales tax is assessed on the state level, meaning that state governments set their own sales tax laws. So what should be a relatively simple business tax becomes much more complex when you’re doing business in multiple states.
In this post, we’ll cover everything you need to know about your tax obligations, from what exactly sales tax is to how to discover if you owe taxes somewhere—just in time for the holiday busy season.
What is Sales Tax?
In its most simplistic form, sales tax is a tax on transactions between you (the business) and your customer paid to a state government. Think about the last time you bought shoes. When you got to the checkout counter, you may have noticed that your total cost was about 5-10% higher than what was listed on the shoebox itself. Then again, maybe you didn’t notice because sales tax is all around us. We’re accustomed to it.
As consumers, we expect to pay sales tax, but we don’t always think about why we pay it or what happens to that money next.
Now, let’s switch roles and think about it from the retailer’s position. How do you know how much to pass on to the customer to cover this tax? The rate you use depends on where your business is located because there is no federal sales tax requirement in the United States. Each state’s rules and rates vary. So if your business is operated entirely in California, for example, you will need to collect a different amount than if it were run in Florida.
Of course, not all transactions are taxable. Some businesses do not need to collect sales tax on their sales at all.
Qualifying Transactions for Sales Tax
When we think about sales tax, the most common example of a taxable transaction comes from retail sales. When we go to purchase shoes or books, even couches, we expect to pay a tax on them. In short, we know this tax is coming when we buy tangible things.
What is considered “taxable” can vary slightly from state to state, but here are the main categories of taxable transactions:
- Tangible Personal Property: This category includes the shoes, books, and couches we’ve talked about so far. “Tangible personal property” can be defined as anything that can be touched and moved. If you can take it with you from one location to another (as opposed to land or buildings, which are fixed), it is likely eligible for sales tax.
- Consumable Goods: If you are selling food, tobacco, or alcohol for immediate consumption, you will likely need to pay sales tax. Notably, this does not usually include selling groceries, which are exempt from sales tax in all states except Arkansas, Tennessee, Virginia, and West Virginia. Instead, think of restaurants, where food is eaten immediately, as opposed to carried away to be prepared later.
- (Some) Software & Digital Goods: It’s true; not all software is cloud-based. Some software solutions that can be purchased outright and manipulated by the consumer are eligible for sales tax. As are some digital downloads, like music and e-books. The digital goods area is hazy and evolving quickly, so you’ll want to refer to specific state tax laws on it.
So, what is not eligible for sales tax?
In most cases, service-based companies do not need to pay sales tax. However, as more and more service companies are started, some states have begun requiring it on certain kinds of services. For example, Texas’ sales tax laws say that you should collect taxes on things like telephone answering services and tangible goods restoration services.
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How is Sales Tax Different From Use Tax?
When talking about sales tax, the term “use tax” comes up frequently. While sales tax and use tax deal with transactions between a seller and a buyer, the main difference between them is who then pays the tax to the state.
When it comes to sales tax, the seller is responsible for paying; whereas, with use tax, the buyer pays the taxes. Use tax commonly takes place when a business does not have a physical presence in the state where the buyer lives (more on this in the next section) and when a purchase is over a certain price threshold.
For example, if a consumer in Florida buys a television from a retailer in Georgia (and that retailer does not have a physical presence in Florida), the burden of paying taxes on the television may fall to the consumer. The use tax rate typically mirrors the sales tax rate in the region where the consumer lives.
Luckily for most consumers, states aren’t monitoring these transactions between everyday consumers and businesses very closely. Some states have lines in their income tax returns where consumers can input use taxable transactions, but it’s rare.
States are, however, closely watching business-to-business transactions. If a business purchases inventory or supplies from a vendor in another state, you can bet they’re paying a use tax on it—assuming that the vendor isn’t responsible for sales tax.
You can see why the two concepts go hand-in-hand, and they both hinge on a concept called “nexus.”
What is Nexus?
Nexus means that a business has a substantial enough physical presence in a state to collect sales tax. Where nexus is not established, consumers in that state may be responsible for paying use tax instead. So what do we mean by “physical presence”?
A physical presence may entail:
- An office or storefront in a state.
- An employee who works in that state.
- A warehouse in the state.
What constitutes nexus varies from state to state, making knowing whether you owe taxes to any state outside of your primary business location particularly tough.
Making it even more difficult is the addition of local taxes. While a state will often set a state-wide general sales tax rate, many states also have local sales tax rates based on city or county lines. For example, New York’s state rate is 4% and the local sales tax rate can vary between 0-4.75% depending on the local government’s choices. So if you run a business in New York City, sales tax would be 8%, but if your business were in Buffalo, it would be 8.75%.
Some regions also have special tax-exempt rules. New Jersey, for example, has established Urban Enterprise Zones, or economically distressed areas, where sellers can charge half the state-wide sales tax rate.
Confused yet? Well, hold on to your hat because recent lawsuits have introduced more changes to regulations to help deal with the recent rise of online sales and e-commerce.
New Rules for Online Sellers: South Dakota vs. Wayfair
In the not-so-distant past, most consumers purchased most tangible goods from stores near their homes. Shopping malls were booming. There was no Cyber Monday—only Black Friday. Those days stand in stark contrast to today’s world of ordering groceries from an app or signing up for a monthly subscription of cleaning supplies.
The question of how to tax businesses with no physical presence, however, did not begin with online sales, though it was made more urgent by them.
In 1992, the state of North Dakota filed a lawsuit against Quill Corp, a mail-order company that had no physical presence in North Dakota. In the lawsuit, Quill argued that the state had no right to require sales tax from them because they did not have nexus in the traditional sense, and the Supreme Court ruled in their favor, establishing a precedent that reinforced the importance of a physical presence for years to come.
The next major Supreme Court case on this issue was South Dakota v. Wayfair, which reversed the precedent set by North Dakota vs. Quill. According to this court ruling, states had the right to claim sales tax from remote sellers that did not have a physical presence in their state.
As you might imagine, this ruling changed a lot—especially for online sellers.
One of the biggest changes had to do with how online seller who use a third-party intermediary to sell goods deal with sales tax. Small businesses selling through Amazon’s FBA program now had to take the location of Amazon’s many warehouses into account. If their goods are being routed through a warehouse in New Jersey, for example, the seller will likely need to pay sales tax (for both state and local jurisdictions) in that area.
Another big change was the introduction of a concept called “economic nexus.”
What is Economic Nexus?
Before the Wayfair verdict was even reached, many states introduced new regulations that established a revenue threshold for sales tax. Once the trial was complete, these regulations were upheld and more states began implementing them.
Now, if a business earns enough qualifying revenue in a state, the state may collect sales tax from them. Rather than a physical presence, the business would have an economic presence, or economic nexus. The threshold for economic nexus can range from $10,000 to $500,000, though some states have opted not to enact economic nexus laws at all.
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My Business May Have Nexus. What’s Next?
If you think your business may have traditional or economic nexus in a state, it’s good practice to get a second opinion from an experienced professional. As a business owner, you’ve got a lot more on your plate than keeping up with the ever-evolving world of sales tax.
An accountant or accounting software company can help you determine where you owe taxes by performing a nexus study. During a nexus study, a professional will analyze your sales and compare them to the sales tax requirements for the states where nexus is suspected.
If your company has nexus, a professional will be able to guide you on the correct state sales tax rate, local sales tax rate, and relevant due dates.
After the recent Supreme Court ruling, the sales tax landscape is changing fast. Small businesses worried about staying compliant, especially those shipping inventory across the country, will experience quite the headache trying to keep up. Instead, enlist the help of a professional, like ScaleFactor.
Learn how ScaleFactor can help you manage your sales tax requirements and request a demonstration of our products today.