When you run a brick and mortar business, collecting sales tax is pretty straightforward, but running a business online adds a layer of complexity to the process of charging state taxes.
Most states in the United States collect online sales tax on purchases made over the internet. However, that fact is about the only thing states have in common where sales tax is concerned.
The majority of states charge online sales tax on shipping, However, not every state requires you to pay both state and local sales taxes. To make matters more complicated, you may need to collect sales taxes according to state, county, city and district guidelines.
If the fear of paperwork and audits is preventing you from expanding your retail business online, this guide will help calm your fears by breaking down the basics of collecting sales tax online.
Understanding Your Sales Tax Nexus
A business has a sales tax Nexus when it has a significant physical presence in a given state. When you have a sales tax Nexus in a state, you must collect, report, and pay online sales tax in that state. It’s important to note that having a ‘significant’ physical presence can vary by state.
Determining Your Sales Tax Nexus
Although your physical business location ultimately determines where you are obligated to collect sales tax, you might have Nexus in other states as well. For example, if you have a second (or third) store, or a warehouse in a neighboring state, these situations can also qualify you for a sales tax Nexus, even having just a single employee in another state, may require you to collect tax within a particular jurisdiction.
Below are some of the most common considerations for determining when to charge and collect sales tax.
1. Drop Shipping
Believe it or not, whether or not you use drop shipping in your business matters for online sales tax. Drop shipping from any third-party fulfillment provider will qualify you for Nexus in that state. You might be wondering why. Many third-party fulfillment services store inventory in multiple states, to ensure the speedy delivery of merchant orders. If you use a drop shipping service, you will need a sales tax permit for every state in which your third-party fulfillment provider is storing your inventory.
2. Trade or Craft Shows
If you sell your products at trade shows or craft fairs, you’ll need to establish Nexus in every state in which you have a physical presence and do business, regardless of the length of business. Also, if you have business representatives traveling through various states selling your goods, their presence in those states is enough to establish Nexus.
3. Click-Through and Affiliate Referrals
As an online retailer, you also have to be aware that some states have click-through and affiliate Nexus requirements. If you make a minimum level of sales through click-through referrals on a website located in a state with click-through Nexus legislation and pay commission on those sales, you must make online sales tax payments in those states. If you have an affiliate in another state that advertises, facilitates or promotes sales of your products, you may have established Nexus under that state’s laws as well.
Determine Your Sales Tax Nexus Before Paying Online Taxes
Before you pay sales taxes to a state, you’ll want to identify all of the states where you have sales tax Nexus. As a good rule of thumb, you won’t have Nexus in states where you don’t have a physical presence or where your customers live and receive products. For example, if you’re located in California, and you have a warehouse and employees in Nevada, you have sales tax Nexus in both of these states and must register for a sales tax permit in each of them. However, if you ship your products to buyers in Colorado, but your company has no physical presence there, there is no need for a sales tax permit.
Because each state’s exact definition of sales tax Nexus differs slightly, make sure you confirm the states in which you must pay online sales tax and register for a sales tax permit in any state where your business meets the definition under that state’s laws.
What You Should Collect Sales Tax On
Collecting sales tax online is mandatory on all sales made in states in which you have a significant presence unless those items or the buyer are exempt from sales tax. You do not have to collect sales tax on purchases made in states in which you do not have a sales tax Nexus.
What Items Are Exempt From Sales Tax
Every state holds certain items exempt from sales tax. Also, certain types of sales are exempt from online sales tax, regardless of the items sold. While there are differences in exemptions from state to state, the following exemptions are fairly universal.
In general, food is not taxed, though food bought at a restaurant typically is subject to sales tax. Medicine and medical devices are also generally exempt from sales tax. In some states, these items are taxed, but at a lower rate than other items.
Also, raw materials that are to be used as ingredients or for the production of a product that is manufactured for future sales are typically tax exempt. These materials are often sold at wholesale prices with the presumption that tax will be collected on the final retail item. Some states also offer use-based exemptions designed to support specific industries within that state or to encourage environmental sustainability or other activities that serve the public.
What Buyers Are Exempt From Sales Tax?
States are not allowed to charge online sales tax on any sales to government agencies. This includes federal, state, municipal, and county governments and their agencies, as well as other local governmental jurisdictions, such as school boards. Sales made to nonprofits are also exempt from sales tax.
Just as you aren’t required to charge sales tax on wholesale raw materials, you also shouldn’t tax buyers who are purchasing items from you to pass on to their customers. For example, if you ferment wine and sell it liquor stores that in turn sell your product to their customers for profit, you should ask that liquor store for their reseller’s permit or resale certificate.
How to Register for a Sales Tax Permit
The easiest way to register for a sales tax permit is to complete an application online via the state’s Department of Revenue. Prepare by gathering all of the necessary information about your business, including your federal employer tax ID number. Once you have this information, visit your State’s Department of Revenue website and proceed with the process of submitting an application.
In most states, collecting sales tax online without a permit is illegal. If you do so, it can be considered defrauding the state. To prevent running into any issues with the law, check with the states in which you have Nexus to confirm how often you need to renew your sales tax permit. Different states have varying renewal requirements, so it’s best to play it safe.
How to Collect Sales Tax
You might think the actual collecting of sales tax would be the simplest part of the whole operation. You find out what the online sales tax rate is, add it to your purchases, then collect it, right? Unfortunately, it’s not that straightforward. Different states may charge different amounts if you’re selling an item within the state or selling to a buyer in another state. Some states also require you to collect sales tax at the point of origin, namely your business location.
Other states, however, require sales tax collection at the destination, or the location of your buyer. Typically, most states rely on a destination-based tax system when taxing items sold out of state, but you must check the regulations of all states involved with the transaction to determine where the tax liability lies. California, Arizona, and New Mexico are exceptions to this rule; they don’t require sellers to collect tax at the rate of the destination address.
For many businesses, the easiest way to calculate and collect online sales tax at the time of purchase is to use shopping cart software services or apps designed to do just that. Many of these services allow you to input the states and local areas in which you must pay tax, then handle the calculations and add them to your customers’ purchases automatically. If you’re selling on a third-party platform, that platform probably has built-in services to calculate tax and pass it on to your customers.
How and When to Report Your Sales Tax Collections
Sales tax is a pass-through tax. That means you collect the money on behalf of the state, then deliver it to the state when you file your tax returns. Your state may require you to report and pay online sales tax on a monthly or quarterly basis. This may be based on the volume of your sales and the corresponding amount of tax collected. If your state only requires annual reporting, typically your sales tax is due in January.
While many states require sales tax to be filed by the 20th of every month, the reporting date can vary significantly. Quarterly reporting dates can also vary wildly, so make sure to set calendar reminders.
You’ll also want to check with your state’s Department of Revenue or Taxation to get the required sales tax form and the instructions for using it. You must use your state’s form to report your sales, breaking them down into taxable sales and exempt sales. You must also report the amount of tax owed to the state.
Paying on time is important; if you don’t, you’re likely to be assessed penalties and fines. Some states run regular sales tax audits, so it’s unlikely that any errors will pass by unnoticed. Also, most states require you to file your return even if you didn’t have any sales in a given month, quarter or year. Failure to file, even with no sales can also subject your business to fines or penalties.
To track your online sales tax liabilities in a timely and accurate fashion, you need to keep excellent and up-to-date records of all sales in all states. Make sure to maintain all tax returns, reports and records, spreadsheets and sales data for as long as each state requires, in the case of an audit.
How to File Your Sales Tax Return
In general, when you register for a sales tax permit, you can expect to receive instructions for filing your sales tax returns with each state where you have a sales tax Nexus. Remember, even if you have no sales tax liability for a given reporting period, it is very likely that you will be required to file a return.
Most states allow online sales tax filing, and some states offer no other options. Some states have extremely complex requirements, mandating that you report sales tax separately for every single district in which you have had sales. Some states, such as Washington, can have hundreds of districts involved in these regulations. If you’re unsure of how to file taxes based on your Nexus, it is best to consult with a professional or visit Irs.gov for more detail.
The Bottom Line
While collecting sales tax online can be complicated, it’s worth familiarizing yourself with the basics if you want to expand your business or products online. Before you make the transition from bricks to clicks, use these guidelines and review each state’s requirements thoroughly to ensure that you’re not breaking any tax laws.