Overview
Navigating the sales tax landscape in the United States can be a daunting task. The complexity arises from the fact that you have a US Income tax ‘and’ each state independently formulates its sales tax regulations, which results in big differences. Each state, therefore, operates under a unique tax framework, exhibiting variations in tax liabilities, rates, exemptions, and reporting conditions. Adding to this complexity, certain local tax jurisdictions wield the authority to set distinct rules applicable to their region.
So, how does this diverse tax environment influence your routine sales tax management if you are operating in numerous US states?
In this guide, we unravel the crucial sales tax factors you need to be aware of while conducting business in the US.
GOOD NEWS: There are online applications that will do this automatically for you, but you need to understand the basics.
Nexus - The Cornerstone of Your Sales Tax Obligations
The obligation to collect sales tax arises from the concept of 'nexus,' which denotes a business's link with a particular state.
Traditionally, this link has been based on a business maintaining a substantial physical presence within the state. The definition of nexus can vary by state and is subject to different understandings.
However, the groundbreaking 2018 South Dakota vs. Wayfair judgment by the US Supreme Court added a new dimension to this concept – the 'economic nexus'. This model allows states to establish a connection based on the level of sales activity directed towards customers within their jurisdiction. This ruling upheld South Dakota's newly introduced law, which required businesses like Wayfair to collect and remit sales tax despite lacking physical presence in the state. Following this judgment, all states imposing a sales tax have adopted various forms of economic nexus regulations.
Understanding Where You Establish a Nexus
When determining if your business has a nexus in a state, it's vital to consider whether your operations establish either a physical or an economic nexus—or both. The law doesn't mandate the establishment of both forms of nexus—either one will suffice. As of 2023, every state that imposes a sales tax, along with several local jurisdictions within Alaska (a state devoid of sales tax), has implemented economic nexus criteria.
Step 1 - Identifying Your Economic Nexus Locations
A logical first step would be to identify where your business could establish an economic nexus, as it is the most applicable type of nexus for businesses operating outside the U.S. The evaluation of economic nexus in a state depends on two aspects of business activity:
1. Sales revenue value, which can be considered as billed revenue rather than acknowledged revenue.
2. Number of transactions (note that each renewal counts as a transaction in a subscription model), which can be regarded as invoices.
In some states, just one of these parameters is employed, while others use a mix. A basic rule of thumb is $100,000 in revenue or 200 transactions, but it's important to note that this isn't applicable for all states.
Another complexity arises as individual states can potentially employ three different revenue figures and periods for calculating sales revenue value:
1. Gross sales revenue includes all sales, even those that are tax-exempt.
2. Retail sales revenue involves any sale that isn't for resale.
3. Taxable sales revenue includes only taxable sales, excluding tax-exempt sales.
The period for calculations can be the previous 12 months, the current calendar year, or the previous calendar year.
Only five U.S. states, known as the NOMAD states (New Hampshire, Oregon, Montana, Alaska, Delaware), lack a statewide sales tax, exempting sales within them from generating a nexus. Despite this, some local jurisdictions in Alaska have established economic nexus thresholds, potentially creating a sales tax obligation.
Regularly monitoring sales on a state-by-state basis is crucial, even if you don't meet the threshold for economic nexus in a state, as business growth could alter this situation. Keeping up to date with individual state legislative updates is equally important, given that the situation is constantly changing.
Step 2 - Identify Your Physical Nexus Locations
Physical nexus, determined by 'substantial physical presence', is not only relevant to in-state sellers. It can also apply to sellers without an in-state office or employees, based on a diverse range of activities, such as downloading cookies to a customer's computer or compensating individuals to establish and maintain a market in the state.
Each state interprets nexus rules individually, with some maintaining strict definitions of what constitutes physical presence while others are more flexible.
Establishing Physical Presence
The presence of physical assets in a state, such as office premises, employees (including remote workers), or inventory (physical goods or servers storing digital assets), can establish a physical nexus.
Nexus through Employee Travel
Even an employee traveling in and out of a state for business purposes can create a physical nexus. Notably, the nature of the activity doesn't matter; it's the frequency that counts, and as expected, each state has its own rules.
Michigan stands out as one of the strictest states in this regard. Even a single day of an employee's presence within the state during a 12-month period can trigger sales tax nexus. Other states are more flexible. As a general guideline, if an employee spends 3 or more days traveling in a state over a 12-month period, it will establish a physical presence for sales tax purposes.
Third-party contractors
Working with third-party contractors in a state, for tasks like sales, training, implementation, repair, or support services, can create a nexus just as having employees does. Similarly, participating in trade shows or engaging in online affiliate marketing can create a nexus in certain states.
Trade Shows
Trade show participation can establish a nexus, but regulations vary among states. Some states set thresholds for attendance days or sales volume during the event to trigger a nexus. For example, California requires 15 days of attendance, while Massachusetts only needs 3 days.
Online Affiliate Marketing
A click-through nexus can be formed when a remote seller pays a referral fee or commission to an in-state business that directs customers to them via a website link. A typical example involves an affiliate partnership, where an in-state blogger advertises a product or service for an out-of-state seller and receives a commission or other compensation in return.
Combination of Nexus-Creating Activities
It's important to remember that activities forming a nexus are not considered separately. States usually assess these activities to determine if their cumulative effect is significant enough to establish a nexus. A combination of a few days spent visiting potential clients, a day participating in a trade show, and a day or two conducting training at a client's site could be enough to establish a sales tax liability in a state within a single year.
Product Level Taxability
Product level taxability involves categorizing products (and services) to ensure each item is taxed correctly. Given an item falls under sales tax jurisdiction, it is then subject to the applicable tax rate. Various tax jurisdictions may decide to exempt particular classes of goods and services from taxation or impose a lower tax rate on certain items. Typically, tangible personal property is subject to tax unless specifically exempted, while services are generally tax-exempt unless explicitly listed. However, this broad categorization may lead to compliance complications.
As digital products and services continue to multiply, states are faced with the challenge of adapting their tax regulations to accommodate these emerging technologies. Traditional definitions fall short while new definitions often lack precision. Many states lack a clear definition of how sales tax applies to digital products or services. The scenario further complicates with cloud-based sales, such as software as a service, with states adopting a range of varied measures.
Adding to the complexity, while product taxability rules are generally established at the state level, local jurisdictions within states can also impose distinct regulations. This leads to scenarios where a product or service category could be taxable at the state level but not at the local level, and the other way around.
Practical Outcomes of Multi-State Sales
Every business that sells within the US faces numerous practical compliance challenges, given the varied rules and frequent changes. When establishing your US sales tax strategy, consider these key elements.
Destination vs. Origin-based Sales Tax Regulations
As a remote vendor, you generally follow destination-based tax guidelines, implying you're expected to apply the sales tax rules and rates based on the customer's location. But situations arise where you have a physical presence in a state, suggesting sales from within that state. For instance, consigned inventory in a state's warehouse shows physical presence. If you're in a state with origin-based tax rules and conduct transactions with a customer in that state, those rules apply.
Origin-Based Tax
Intrastate commerce follows origin-based sourcing rules. When a transaction occurs from within an origin-based state to a location within the same origin-based state, the sale is attributed to the origination point, and sales tax applies accordingly.
Destination-Based/Remote Seller Tax
Interstate commerce adheres to destination-based sourcing. If a seller ships goods from an external location to any state, the sale is attributed to the destination point, and sales tax is levied at that destination.
Determining Location for Tax Purposes
In the US, the corresponding tax rate is tied to a particular geographic location, with businesses commonly using the 5-digit US zip code for most scenarios. 'ZIP + 4' codes can be used for more precise sales tax rates. This requires providing additional address details such as street address, city, and state. The provided address should match with the United States Post Office address database. To determine the applicable tax rate more precisely, you could use specific latitude and longitude coordinates for rooftop-level accuracy.
Exemptions and Exclusions
Each state can implement tax exclusions on goods and services within their jurisdiction, making the item non-taxable for all customers. At this point, it's crucial to distinguish between tax-exempt purchases and non-taxable purchases. Tax exemptions apply to a transaction that would ordinarily be taxable, but due to factors like the customer's type or the specific use of the item or service purchased, they are exempt from paying the tax.
To claim a sales tax exemption, the customer provides a tax exemption certificate, which you must evaluate for completeness and validity (demonstrating due diligence in the process). Once a certificate is accepted, there is no need to validate every transaction by the certificate holder, as the certificate's validity can range from 1 year to several years. Nevertheless, it's crucial to implement a system for monitoring certificate validity.
Exemption certificates can be broadly categorized into:
1) Use-Based Exemptions
Resale exemption certificates are a common form of exemption certificate. To prevent double taxation, sales tax is typically exempted for goods and services purchased for resale since the tax is levied at the final sale point.
2) Entity-Based Exemptions
Entities other than resellers may also be exempt from sales tax. These entities include charities, religious and educational organizations, government/political bodies, trade associations, social welfare organizations, and veterans' groups.
Understanding Multi-Jurisdiction Exemption Certificates
Tax exemption certificates are usually state-specific unless the business has provided a multi-jurisdiction certificate that covers the relevant states. Although there isn't a nationwide exemption certificate in the US, the Multi-State Commission has introduced a standardized sales and use tax certificate that many states accept. Therefore, your systems must be capable of managing both single and multi-state certificates.
Tax Reporting
The process and level of detail required for reporting sales tax differ among states. Some key reporting considerations include:
1) Frequency of Returns Submission:
Typically, returns are due either monthly, quarterly, or annually. However, some states have different schedules, including semi-annual or occasional. Often, the higher the volume of sales, the more frequently you are required to file and pay. Some states even require pre-payments. Due dates differ, with the 20th of the month being the most common, while others may be on the 15th, 25th, 30th, or the last day of the month.
2) Reporting for Appropriate Tax Jurisdictions:
In states where sales tax isn't a flat rate, returns must detail relevant local tax jurisdictions. Tax reports must be broken down to demonstrate the distribution of the sales tax to the appropriate tax jurisdiction, including:
• State
• City
• County
• Metropolitan area taxes
Each portion of the collected sales tax must be attributed to the relevant tax jurisdiction.
3) Product Code Level Reporting:
When reporting sales tax, taxpayers typically organize their compliance process to file and remit the tax collected from customers. This often involves adopting a "bottom-up" sales tax return preparation approach, where they start with the collected sales tax and divide it by the applicable tax rate to determine the taxable sales to report.
Exempt sales can be included in taxable sales or calculated as the difference between gross sales and taxable sales. In states with reduced tax rates for specific products or service codes, these sales must be reported on separate line items in the return. Consequently, the level of detail needed to file and remit a return varies depending on the state and the nature of the business.
For the preparation and filing of the required tax returns, your internal sales tax reports typically require the following details:
• Geographic identifier – usually a state, county, city, zip code
• Gross sales amount
• Non-taxable or exempt sales amount, along with the corresponding reason (e.g., exempt for resale, exempt for manufacturing purposes, excluded from tax, etc.)
• Taxable sales amount
• Collected sales tax
• Specialty or reduced tax amounts
• Transaction-specific details for reconciliation or audit purposes (invoice number, invoice date, customer number, customer name, etc.)
Sales Tax Compliance Strategy
For both businesses selling into the US from other countries and US companies venturing into new states, strategic sales tax compliance planning plays a vital role in the overall strategy.
Here are a few critical components to consider when developing your compliance strategy:
1. Keeping Up with Legislation: Regulations around sales tax can vary greatly by state and are often subject to change. Your strategy should include a plan for staying up-to-date with these changes, whether that be through dedicated staff, consulting with a tax professional, or utilizing software that updates in real-time.
2. Sales Tax Collection: You'll need to consider how you'll accurately collect sales tax for all transactions. This is particularly important for online sales, which may be subject to different sales tax laws. Your strategy should include methods for determining the correct sales tax, as well as processes for collection.
3. Reporting and Operational Processes: Given the varying reporting requirements between states, your strategy should include a plan for integrating these into your existing operational processes. This includes keeping track of taxable sales amounts, collected sales tax, and other necessary details for filing returns. You should also consider the frequency of return submissions and plan your processes accordingly.
4. Compliance Technology: In the age of digitalization, various software and services can assist in maintaining sales tax compliance. Your strategy should address how to utilize such technology, how to integrate it with your current systems, and what benefits it might offer, such as improving accuracy and saving time.
5. Audit Preparation: Finally, your strategy should include a plan for audits. This can include maintaining accurate records, conducting self-audits, and understanding common audit triggers.
Remember, every business is unique. US sales tax compliance doesn't fit a 'one-size-fits-all' approach. Thus, it's crucial to customize your strategy, considering your company's individuality and business model. A well-planned and executed sales tax compliance strategy not only ensures legal compliance but can also mitigate potential penalties and interest resulting from non-compliance.
In conclusion, while the US sales tax system can be complex, with thorough planning and strategic considerations, it's more than possible to navigate. Always consider seeking professional advice to ensure that you're meeting all your sales tax obligations when operating in the US market.