What You Need to Know About Online Sales Tax
Right now, I bet the vast majority of your customers don’t pay state or county tax on the products they buy from your online store. In fact, the general feeling is that tax-free shopping is a major reason e-commerce flourished over the past decade.
That is all changing. If you manage an online store, you better start preparing to charge your customers sales tax.
The Wall Street Journal recently reported that more and more state governments are looking to tax online sales as a revenue source of low-hanging fruit ripe for plucking.
This issue is important and will transform how your online store operates. In the coming weeks, months and years, more states will require online business to charge state and country taxes to local customers.
What was once the problem of large corporations with extensive and far-flung networks of administrative offices, sales forces and warehouses is now the problem of small businesses as well.
The first question that comes to your mind is probably, “How do I know if I should collect sales tax from my online shoppers?”
An Illinois based software company is obligated to collect local state sales tax if it sells and delivers a product online to a customer located in Illinois. If the business and customer are located in the same county, then any applicable county taxes must be collected as well.
An Illinois based software company is exempt from charging sales tax to an online customer located in Wisconsin. This exemption includes both state and county taxes in Wisconsin and state and county taxes in Illinois.
Why is there a difference between these two cases?
In the mid 1960s, the Illinois Department of Revenue sued a Missouri-based mail-order merchant named National Bellas Hess because the merchant was selling goods to Illinois residents, but neither the residents nor the merchants were remitting taxes to Illinois.
When the case appeared before the Supreme Court of the United States (SCOTUS) the court prohibited Illinois from forcing the merchant to collect sales tax from Illinois customers.
The court worried that those taxes “could entangle…interstate business in a virtual welter of complicated obligations to local jurisdictions.” Simply put, the process of collecting taxes across state lines was too complicated. Therefore, the court ruled that merchants would only be obligated to collect and remit local sales taxes if they had a physical presence in the state (e.g., office space, warehouses, etc.).
The “physical presence” creates what is known as a tax nexus, and that is where things start getting complicated.
In 1992, the North Dakotan Tax Commissioner sued Quill for the same reason the Illinois DOR sued National Bella Hess in 1967. People were shopping across state lines and the government was not getting its share.
Both of these Supreme Court decisions prevented government from capitalizing on the burgeoning e-commerce economy.
Unfortunately for digital shoppers, state governments are searching high and low for revenue. They want to place the onus of tax collection on online merchants, which means that state governments need to broaden the criteria that create a tax nexus.
For example, last year, California broadened their definition of “physical presence” to include business partners like affiliates. This meant that a business establishes a tax nexus if certain of its business partners are located in the same place as its customers.
States like Pennsylvania are going further and are now considering broadening the definition of “physical presence” to include businesses who conduct sales of over $1 million in that state, even if the business does not have a local office, warehouse or affiliate partnership.
Origin vs Destination
The dissenting opinion in the 1967 SCOTUS case stated that collecting and remitting sales tax is not much of a burden.
While that is true for a company that only sells in one state, the situation is more complicated for online retailers who sell to customers in all 50 states. They will need to comply with literally thousands of unique tax codes all of over the country.
What complicates the issue even further is that some states apply an origin based tax rate and other states apply a destination based tax rate.
Origin means that a company must charge customers sales tax based on the tax rate of the state where the product was made.
Destination means that a company must charge customers sales tax based on the tax rate of the state where the product is delivered.
This means that an e-store must be able to calculate dozens (actually thousands if we factor in local municipalities) of tax rates to display to visiting customers.
What to do
The administration of online sales tax is a pressing issue.
Companies that have their hands full developing great products will need to hire an accounting department to make sure they are fully compliant.
Alternatively, they will need to enlist Sales Tax Management Systems if they want to avoid paying fines and penalties on back taxes.
How is your business preparing for this challenge?
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Richard Stubbings says:
A nice article, but completely missing the international aspect of Ecommerce. What about online retailers outside the USA. Like UK retailers. What will happen to us?
Derek Bacharach says:
I recently made a purchase online that charged me sales tax even though they're not in the state that I live in. Why would they do that?
Elizabeth Ball says:
When I'm in the US, say New York, and buy a shirt from a store, I get charged tax which, irritatingly, is added on at the end, changing the final figure (I don't understand why they don't just list a price with sales tax already included). In the UK, I buy items and are charged VAT. There's sales tax in European countries too. In Australia and New Zealand, it's called GST. You can claim the sales tax back at the airport, but only if you've spent a certain amount at the same store, have the paperwork, yada yada.
Unlike the US, these countries charge national - not state & county - sales taxes. GST was introduced in Australia in 2000 to financially support our 5 states & 2 territories which are now effectively bankrupt without it. Many Aussies want our state governments to be abolished in favour of a two-tier federal and super-local council governments. Much less waste and govt duplication. Much less paperwork. But I don't see that ever happening in the US.
Craig Vodnik says:
Richard, EU residents are, of course, outside the jurisdiction of US tax laws, and are therefore not subject to US state sales tax. However, As Elizabeth noted, EU residents are subject to EU tax laws, manifested in the form of Value Added Taxes (VAT).
VAT rates in online digital sales are currently calculated based on where the seller is located. Which means that any buyer who visits the online shopping cart of a business based in the UK is subject to a 20% UK VAT rate.
If that same buyer visited the shopping cart of a business based in Luxembourg, the VAT rate would be 15%.
This has created a situation whereby companies set up dummy headquarters in those EU countries where VAT rates are low. The EU is therefore considering revising the VAT laws to function more similarly to US state sales tax, with VAT rate is determined based on the buyer's location, not the vendors.
This will end a certain advantage for businesses located in countries with a lower VAT rate, but ultimately complicate things as businesses will need to comply with 27 separate VAT rates and display the correct one for each online visitor.
Finally, VAT rates are typically incorporated into the final price you see in a EU shopping cart. It is rare for companies to display the VAT as an additional component of the price.