In June 2018, the U.S. Supreme Court announced its ruling in South Dakota v. Wayfair, Inc. affirming that states have the right to collect sales taxes from remote sellers based elsewhere. Since the ruling, other states have enacted similar laws creating economic nexus for remote sellers. Economic nexus creates thresholds in both the dollar amount and number of transactions that remote sellers process; if the merchant exceeds either threshold, then it must collect sales taxes. According to the majority opinion, another reason for the decision was that taxing remote sellers was fairly simple in South Dakota, with one sales-tax rate for the entire state, not various rates for different localities.
Due to the particulars of the ruling, very small businesses such as mom-and-pop retail shops likely won’t reach the economic nexus threshold requiring them to submit sales taxes to states in which they don’t operate. Some of their competitors who haven’t been collecting sales tax, however, will now be compelled to, thus creating a better environment for these small businesses to thrive.
Large businesses such as Wayfair, Amazon, and Microsoft are better able to handle the increased compliance costs by spreading the work to comply with sales tax regulations among a large accounting team—and their presence is large enough that they can assume that they’ll exceed every state’s threshold.
Where the compliance costs will truly be felt are in those companies that are somewhere in between—they have a large enough online footprint for their sales to surpass the minimum reporting thresholds instituted by states, yet they aren’t quite big enough to have a sufficient number of accounting and finance professionals to spread the costs of compliance. Further complicating the matter is the other side of the sales tax equation, which is the use tax.
Before Wayfair, states expanded the definition of physical nexus to include items such as warehousing and other supporting functions to compel out-of-state companies to collect sales tax. Wayfair essentially means that physical nexus is no longer the sole requirement for states to be able to collect sales taxes from remote sellers, but that doesn’t mean physical nexus requirements have gone away. As such, if a small company is buying a warehouse or hiring an employee who’ll be working in another state, then it doesn’t need to meet the minimum thresholds for economic nexus to apply. It must pay sales taxes since the company fulfills the physical nexus requirement.
The Wayfair ruling leaves use taxes alone. While use taxes are paid and reported by the consumer, purchasers need to be diligent. With both economic and physical nexus issues in effect, purchasers need to review invoices to determine whether sales tax has already been reported and, if so, whether the correct amount was collected. In particular, purchasers will need to review invoices from out-of-state sellers to determine whether they charged sales tax, whether businesses need to report use tax, and whether specific items are exempt from sales taxes in their state or locality. They must document this process for their auditors, including those from governmental agencies.
In one of my consulting engagements, I helped a client that was going through a state use tax audit by reviewing and sorting supporting documentation and identifying items that were recorded either correctly or incorrectly. In my state, items used in manufacturing or shipping the client’s products were exempt. That said, some of its vendor invoices had items that were both tax-exempt and taxable. The vendor had a tax-exempt letter from the client and didn’t charge sales taxes on anything. My client was required to report and pay use tax on those items that weren’t exempt.
Going forward, it’s a good idea for small businesses to summarize the sales—both the number of transactions and the revenue—earned each year per state. In those states where the business performs at least 200 transactions or has revenue of more than $100,000, the company must review the reporting requirements. While not-for-profits generally are exempt from tax, they need to review their exposure on this issue since sales tax is paid by consumers but collected by sellers.
In Alabama, the rates are determined solely by local governments, but Alabama has established a single statewide rate for use by remote sellers. The issue is that this rate is higher than the lowest rate charged in parts of the state, which retailers argue might be unconstitutional. There are other issues with other states’ laws that will lead to challenges in court as well.
In Colorado, an in-state retailer that delivers taxable goods to a customer’s address outside its jurisdiction, but still within the state, must now collect sales tax at the rate effective for the customer’s address under the same economic nexus argument. This could be expanded to other states.
The challenge isn’t just determining whether sellers owe tax payments—it’s determining how much they owe. Some items on invoices are exempt from tax. Those items that are tax-exempt in one state may be taxable in another. Small businesses must learn the specific taxing rules for their products in each state. If you’re unsure, then it’s better to overreport rather than have the taxman demanding an audit.
This is a very complicated topic. For example, a remote seller has sales of $5 million divided equally in all 50 states ($100,000 of sales in each state). South Dakota’s sales tax rate is 4.5%, resulting in an annual collection responsibility of $4,500. If it takes seven years for South Dakota to realize noncompliance, then that would mean $31,500 of sales tax liability. Also, other states are likely to find out whether South Dakota enforces compliance. If the business is subject to collecting tax in 10 states (and, for the sake of argument, let’s also use a 4.5% rate), then we’re talking about $315,000 of tax, plus interest and penalties. In order to reduce the tax liability, the business might have to contact purchasers to determine whether they paid use tax on their purchases and, if so, whether they have a record for compliance auditors. This could prove tricky and possibly embarrassing to the business.
Since the Supreme Court’s decision in June 2018, several federal laws were proposed that would invalidate these state sales tax laws. They’re still stalled in Congress, but as businesses and consumers become more upset about paying these taxes, they could impress upon their representatives and senators the need to enact a version of one of these laws to remove or ease the burden of sales tax collection and reporting requirements.