Sales tax essentials for small businesses
Big sales tax challenges, limited sales tax resources
When you’re a small business dealing with sales tax collection, you may be facing a steep learning curve. Sales tax compliance can be confusing — and the more you grow, the more complicated it can become.
But it’s important to take sales tax compliance seriously. Failing to follow the rules can result in fines, penalty or audit, and those are big burdens for small businesses to take on.
Chances are, you don’t have the manpower or budget to devote someone full time to sales tax like big companies do. So you’ve got to get it right with the resources you have. Here at Avalara, we can help. We’ve got the sales tax expertise — and it’s our mission to help small businesses conquer the complexities of sales tax compliance. This white paper walks you through the essentials of sales tax compliance to get you started on the right track.
Understanding where your business has triggered sales tax nexus
Nexus is a relationship that your business has with a state that obligates you to collect sales taxes in that state, and it's the most important thing you need to know in order to get sales tax right. Figuring out where you have nexus is the first step you need to take toward sales tax compliance.
The foundation of sales tax nexus law in the United States is a 1992 Supreme Court ruling, Quill Corp v. North Dakota, that businesses are only required to collect sales tax for a state if they have a physical presence there. However, in recent years, states have come up with many different ways to incur nexus, and that list is growing as states seek new sources of tax revenue.
If your business has a physical presence in a state, you will be required to collect and remit sales taxes there. "Presence" can mean branches, stores, warehouses, drop-shipping facilities or any real estate or property that belongs to your company. This can also apply if you are using a distribution service such as Fulfillment by Amazon (FBA) that stores your goods in warehouses for you. The presence of your products can trigger nexus in the state in which they are stored, even if you didn't put them there yourself.
Nexus can also be created if you employ sales people in different states or if your employees or contractors conduct any work at a customer's out-of-state location or deliver products in another state. This aspect of nexus has never been more relevant than during the COVID-19 pandemic as millions of people were forced to work remotely to avoid close contact with fellow employees.
Regularly attending trade shows, conferences or other out-of-state events can create a nexus obligation. This is especially true is you are making sales, signing contracts or otherwise doing business at the event. The increased use of streaming technology to host virtual events has introduced a way to participate while avoiding the nexus risk associated with travel.
Shipping and delivery
As long as you ship goods to customers by a common carrier such as USPS, UPS, or FedEx, you are unlikely to trigger a sales tax obligation through delivery.
However, the use of drop shipping — in which you order an item on behalf of a customer from a supplier, who then ships it directly to the customer — can create some nexus complexities. In some states, the use of a drop shipper in the same state as the customer by an out-of-state retailer can create nexus for the seller.
Online affiliate nexus
Several states have expanded the definition of nexus with "click-through" or affiliate nexus laws. In this case, a business in another state sends customers to your business through links on a website, which can create nexus in the originating state. While these laws are also often referred to as "Amazon laws," they can also affect small businesses.
If you are a small business using click-through marketing or affiliate programs to drive sales, you need to know:
- Which states have laws that can create nexus for you through referrals of affiliates.
- The minimum sales thresholds for the click-through nexus states.
- Where your referrals are coming from, so you can see if any click-through nexus laws might apply to those transactions.
Even if you cease doing business or having a presence in a state, your nexus may not end immediately. You may still be considered to have nexus for a period that can last through the end of the calendar year or even longer. Make sure you check with the state for the deregistration rules.
Some states are trying to push the boundaries of the Quill standard by classifying remote sales as nexus-creating. South Dakota, for example, is only the latest of several states that have created a tax obligation for remote sales. South Dakota's 2016 law requires sellers to register and collect their sales tax if they have either more than $100,000 in sales at least 200 sales of tangible personal property or services delivered or transferred electronically to South Dakota customers. The law will not be enforced until litigation surrounding the law is resolved, but small businesses should be aware of this and similar laws in other states.
Determining accurate sales tax rates based on street address
Once you determine that you need to collect sales tax, you need to figure out the right rate. Particularly if you are an online seller making sales to customers in many different places, there are many variables that can go into calculating the correct sales tax rate.
It's crucial to have a clear understanding of how your product is categorized for sales tax purposes, because different categories of goods and services can be taxed at different rates or be exempt from sales tax altogether. And that can be different in each tax jurisdiction.
Information on sales tax rates for your products is available via tax rate tables and state revenue department websites. But beware of plugging in a rate and forgetting it, because rates change all the time.
As services become a greater part of the economy, more states are applying sales taxes to services as well as product sales. Some common types of services that are taxed include services to tangible personal property, services to real property, business services, personal services, professional services and amusement/recreation. However, taxation of services is unique to each state.
State and local sales taxes
The sales tax rate that you charge your customers is a combination of a statewide rate plus any local rates. In most states, if you have nexus in the state, you will also have nexus in any localities there. And in most of these states, you can collect local and state taxes together at one combined rate.
Home rule states
However, there are a handful of states that let local jurisdictions not only levy sales taxes, but independently regulate and administrate those sales taxes as well. These are known as "home rule" states. The states that allow total home rule are Alabama, Arizona, Colorado and Louisiana. Not all localities in home rule states take this option, but when they do, they can create sales tax rules and processes that are completely separate from the state's. In Alaska, there is no statewide sales tax, but local jurisdictions can independently levy and collect sales tax according to their own nexus rules.
Home rule can be tricky for online sellers, as each locality can potentially define nexus differently as well as also require a separate registration, filing and payment process.
Take Colorado, for example, the most complex home rule state, with 70 cities that administer their own sales tax. Say you are an online retailer based in Denver (a home rule city). You would have nexus in Colorado as well as in Denver, so if you sell to a customer in Denver, you would need to collect Denver sales tax as well as state sales tax. Although the sales tax would be collected all at once from the customer, you would report and remit the two different sales taxes separately —the city tax to Denver and the state tax to the state. However, if you are based in Denver and have a customer in Boulder, but no nexus in Boulder, you would only need to collect state sales tax on that transaction since the tax is based on the location of the customer.
Origin vs. destination sourcing
Understanding "sourcing" is important to getting sales tax rates right. Origin-sourced sales are taxed where the seller is located, while destination-sourced sales are taxed at the location where the buyer takes possession of the item sold. As a seller, it is important to know whether you are located in an origin-sourced state or a destination-sourced state.
Generally, if you are located in an origin-based state and make sales to customers within that state, you would charge sales tax based on your location, including any local and state taxes.
Meanwhile, in destination-based states, if you are making sales within that state, you will charge state and local taxes based on the location of the customer. However, the rules work differently if you are based in one state and are selling into another state where you have nexus. In this case, sales will generally be destination-based.
ZIP codes vs. geolocation
It's common for businesses to use ZIP codes to determine sales tax rates, but this may not always give you the right results. Tax jurisdiction and ZIP code boundaries do not necessarily align, so one ZIP code can include more than one city or taxing jurisdiction and multiple sales tax rates. In Colorado, for example, the ZIP code 80111 includes at least five different sales tax rates. The key to getting the right rate is geolocation, pinpointing the location of the transaction using data such as latitude and longitude coordinates.
Annual sales tax holidays
Some states offer specific periods of time during which exempt items such as school supplies, clothing or footwear are exempt from sales tax for a specific period of time. These are known as tax holidays. In order to avoid overcharging customers, you need to keep current on the tax holidays that apply to your products in the states where you have nexus.
Managing sales tax exemption certificates
Sometimes, transactions that would normally be subject to sales tax are exempted. This could be because your buyer is a reseller rather than an end consumer, or because your customer is exempt from paying sales tax, such as a government entity.
When you make an exempt sale and do not collect sales tax, you need an exemption certificate to prove that no sales tax was due. Exemption certificates should be collected anytime a new tax-exempt customer is buying from you for the first time, or when a certificate you have on file for an existing customer is invalid or is about to expire. Exemption certificate requirements vary from state to state.
Getting registered to collect sales tax
Before you can legally collect sales tax on behalf of a state, you need to register with that state. If you start collecting sales tax without being registered, you could face criminal penalties, so it's an important step.
The good news is that states want to give taxpayers incentive to register, so they make it relatively easy to do so. All states offer online registration, and it's free in the majority of states. Others charge fees ranging from around $5 to $100.
If you do business in several states, you may want to think about Streamlined Sales Tax (SST) registration. In the 24 states that participate, you can use one registration form to automatically register in all SST states. This can save you time and money, but if you are only doing business in a few SST states, it may not make sense.
Filing & remitting sales tax returns
Once you are registered with a state and any local tax jurisdictions, you'll be required to file sales tax returns and remit sales tax to the state. You'll be assigned a filing frequency ranging from biweekly to annually, depending on the amount of sales tax that you collect.
All states offer electronic filing and payment, and some require it. Others offer the option to file and pay manually with a paper return. In most states, you must file sales tax returns even if you didn't collect any tax for the reporting period. This is called zero-tax filing.
It's important to file and pay on time in order to avoid penalties, fines and increasing your chance of being audited. Many states offer incentives to taxpayers who file and pay early or on time by offering discounts on the amount of tax that must be paid. These can range from 0.5% to 5% with various maximum amounts.
Deregistering a business
If you cease having sales tax obligation in a state — for example, you're shutting down your business or you've stopped nexus-creating activities there — you'll need to deregister so that the state no longer expects you to file and pay sales tax. Keep in mind, however, that you may not immediately be free of sales tax obligations instantly when you deregister. For example, some states may consider you to have nexus for six months or longer after you request to cancel your registration. Make sure you know the requirements in your state in order to plan properly.
Accurate record keeping
It's crucial to keep good records of your sales tax operations for filing your sales tax returns and in case of any questions from the tax authorities. Your records should clearly show where and when your transactions take place and how much tax you collected on those sales — and you should be able to find those records easily when you need them.
Leverage sales tax technology to do the heavy lifting
Even when you know what you need to do, sales tax compliance can be overwhelming for small businesses. Making sure you're using the latest rates, keeping updated on constant changes that can affect your compliance and meeting filing due dates are only the beginning.
Sales tax automation can be a huge boon to small businesses, decreasing the amount of time you spend on sales taxes while ensuring greater accuracy. If you want to simplify filing and payment, Avalara Returns for Small Business offers a time-saving solution. Special pricing for small businesses keep both solutions affordable.
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