The internet has spawned a burgeoning sector of the retail industry that has consumers spending billions, states losing billions in sales tax revenue and brick-and-mortar retailers crying foul. At issue is the tax treatment of internet sales. A huge percentage of web-based sales occur without the vendor collecting state sales tax. This situation derives from a Supreme Court ruling in 1992, which pretty much gave internet merchants a pass on collecting sales tax under certain circumstances.
This disparity between those who must collect taxes and those who don’t, is leading to a confrontation which may soon be settled with new legislation or potentially a new case before the Supreme Court. With state budgets under severe pressure, the collection of sales taxes on internet purchases is becoming a serious priority for most of them. Now that every revenue dollar counts, the states are looking to recover all those lost dollars of sales tax revenue. As a result, many states are evaluating tax regulation changes to bolster their ability to collect sales tax on web based sales.
For businesses that are contemplating an online retail strategy, it is critically important to understand the current rules for internet sales taxes as well as the sales tax approach of the state in which the business resides. Before selling on the internet be sure to do your due diligence on this issue and fully understand the rules. It is also important to know that, whatever rules are in place today, everything could change if the states and brick-and-mortar retailers prevail in challenging the status quo.
The Basic Internet Sales Tax Rule
On online business can sell products on line to a buyer anywhere, and if the buyer is located in a state other than the one where the business has a physical presence, the business generally does not have to collect a sales tax. As an example, if the business is in Massachusetts and the buyer resides in California, usually no sales tax would be collected. However, should the Massachusetts based business open up an outlet or distribution center in California, a sales tax would have to be charged to the California buyer because the out of state business would have a physical presence in the state of the buyer. This concept of “physical presence” can be a pretty grey area sometimes, so it is important to get advice from a tax professional familiar with this subject before you start selling online. The penalties for getting it wrong can be quite substantial.
So What Happens to the Tax?
There is a serious misunderstanding around the concept of “non-taxable” internet sales. It really isn’t about whether or not something is taxable, it’s about who is going to report and remit it to the state.
Retailers selling goods over the internet to out of state customers may not be obligated to collect the sales tax, but that does not mean there is no sales tax due. If a product or service is subject to sales tax in the jurisdiction in which the purchaser lives or does business, the purchaser actually owes the sales tax. The difference is that the responsibility of remitting it is transferred from the seller to the buyer. The tax is then known as a “use” tax instead of a sales tax and the purchaser is supposed to report the tax and remit it to their state. As you can imagine, this confusion causes a major loss of revenue to the states.
For the use tax, consumers are asked to itemize purchases they made online and pay the applicable sales tax that would have been paid through a brick and mortar retailer. Often this is done on an individual’s annual state income tax return or, for businesses, on their sales tax returns. Up to this point, the states have not been very effective in enforcing collection of user taxes, but the current need for additional revenue is propelling states to take a much more aggressive stance and they are stepping up their efforts to collect this tax, especially on large purchases.
How Does this Affect Small Businesses?
For a small business to have to comply with the sales tax reporting and remittance statutes in 50 states would be an overwhelming and costly paperwork burden. And since most small businesses have a web presence these days, pretty much everyone would be caught up in this paperwork nightmare. So this is an area to keep a watchful eye on, as it is a safe bet that Congress and the state legislatures will be looking at this issue again and that the states will be pressing to change the law so that they can more effectively collect their sales tax revenues. To that end, some states are stretching the definition of “physical presence” to include affiliates and independent sales representatives. New York successfully re-wrote its sales tax regulations to do just that. And there are groups comprised of states and brick-and-mortar advocacy groups that are mounting efforts to have the Supreme Court decision overturned as well.
It could take years before any of these efforts realize any kind of success and there’s a chance that the efforts will fail altogether. For now, the best defense is to know what the current rules in your state are and follow them closely to avoid problems and potential financial liability for uncollected sales tax. As more states, focus on collecting these web-based sales tax revenues, you will need to adapt your business model and sales accounting to conform to any new regulations.