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How to calculate sales tax and avoid audits

As a small business owner, one of the toughest things to learn is how to calculate sales tax correctly, a common error that can trigger an audit. With the explosion of e-commerce, calculating sales tax has become even more critical. It’s especially challenging for online retailers, as they often don’t understand what’s taxable, which sales tax rate they should use, and which government agency receives the sales tax that they collect.

In this article, we’ll break this tricky subject down into three areas:

Sales tax for brick-and-mortar businesses
Sales tax for online businesses
Sales tax exemptions

Before covering these three subjects, we’ll start by defining sales tax and outlining how to collect it. We’ll then divulge some of the things that cause a sales tax audit and some of the things you can do to avoid it.

What is sales tax?

Sales tax is a retail point-of-purchase charge that is paid by the customer, then passed on to the state or local taxing authority by the seller. Imagine buying a pack of gum from a convenience store. When you buy the gum, the sales tax is lumped into your total. The convenience store must now take the tax collected and pay it to the taxing authority.

In the United States, there is no federal-level sales tax. Instead, it’s set at the local or state level, and the amount of tax varies from state to state. For instance, sales tax on a pack of gum would be different in Louisiana than in Florida or Georgia. Currently, there are only five states in the United States that do not levy state-level sales tax:

Alaska
Delaware
Montana
New Hampshire
Oregon

Tax fact: There are currently nine U.S. states with no income tax for residents, including Alaska and New Hampshire, which also have no state sales tax.

What is sales tax comprised of?

The tax itself is imposed primarily by state governments. However, county and local governments can supplement the state’s tax amount with their own local tax. For example, let’s take a look at Intuit’s U.S. headquarters, located in Mountain View, California. Mountain View is part of Santa Clara County. As of writing this, the city’s total sales tax is 9.00%, which is broken down as follows:

California’s State Tax of 6.25%
Santa Clara County’s Cumulative Taxes of 2.75%

This means that a customer buying a product valued at $100 in Mountain View will pay $9 in tax for a total price of $109.

What is sales tax comprised of?

Businesses assess the tax on purchases, collect it, and then pass it on to the appropriate agency within the required timeframe. Timeframes, or “filing frequencies,” can vary, but they typically occur either monthly or quarterly. In many states, businesses must have a permit to collect sales tax. The Small Business Administration (SBA) offers a breakdown of sales tax permit requirements by state. You can also check with your state’s department of revenue.

Sales tax for brick-and-mortar businesses

Generally speaking, any retail sale may be subject to sales tax. This means that if you own a small business that sells clothing, any time you sell an article of clothing to a retail customer, that customer is responsible for paying the necessary sales tax amount on the retail price. As the business owner, you’re responsible for keeping track of the tax you collect so that you can report it to your local and state governments.

There are, of course, exceptions to this rule. Notably, sales tax is only applicable at the final point-of-sale from a business to a consumer. So sales tax can only be levied against the final retail sale of an item, not against a wholesale transaction.

For example, if you’re a clothing manufacturer who sells shirts to a local retail store, the retail store is not required to pay sales tax when they purchase the shirts from you. But when the retail store turns around and sells that clothing to a customer, the retail store must collect sales tax and pay it to the appropriate agency.

As a brick-and-mortar business, it’s also important to note where you’re responsible for paying sales tax. A state cannot demand that a company register to collect sales tax unless the business has a physical presence in that state. Having a physical presence in a state is known as a “nexus,” which is defined as:

An office, store, or other facility located in the state
A business where the business owner or their employees take orders, perform services, or otherwise do business within the state’s borders

If you have any physical presence in the state, an argument can be made that you have established a nexus and thus are subject to the state’s sales tax laws.

Sales tax for online businesses

Online transactions are trickier when it comes to sales tax collection for small businesses, especially in this past year. There are three main reasons this area is so challenging.

Wherever you have established nexus (the connection between a seller and a state), you must collect sales tax on sales made to residents in that state.
For example, let’s say that you operate an online store and have office space in New York. Because of the physical store location, any sales you make to anyone within New York State are subject to New York’s state sales tax rate.
Many states that charge sales tax also have a complementary “use” tax law. In these states, you have to pay use tax on any purchases made online or through a catalog where sales tax was not charged. The use tax rate is often the same as the sales tax rate, but the requirement to report use tax is on the purchaser, not the seller.
In June 2018, the U.S. Supreme Court upheld a South Dakota law which reversed the long-standing physical presence requirement for nexus. Now, sellers with an economic presence in states where they sell online have nexus and are required to collect sales tax and pay it to the state. Many of the states’ new laws mirror the law upheld in Wayfair and impose this collection requirement when sellers have $100,000 in sales or 200 transactions into a state.

Sales tax exemptions

There are exemptions to sales tax laws. Here are the most common exemptions where sales tax won’t apply.

Items necessary for daily life

Some states recognize there are certain products that people must purchase to survive. Therefore, things like food, clothing, and prescription medicines are often exempt from state sales tax. Some states may not completely exempt these items but may instead assess a lower tax rate.

Selling to tax-exempt buyers

According to U.S. law, states cannot charge sales tax on any sales made to the federal government or its agencies. In most states, this is also true for sales made to the state and its agencies, or to cities, counties, or local jurisdictions. Non-profit, religious, and educational organizations are also exempt from sales tax in a lot of states.

Items used for public good

Some states exempt items that it believes encourages activities that contribute to the public good, such as industrial development or pollution control.

For example, in many states where farming is the primary industry, the sale of products or equipment used to produce food for human or animal consumption are sales tax-exempt. This may also be the case with the sale of manufacturing equipment. Raw materials purchased by a business in order to manufacture or make something else that will be sold may also be exempt.

Frequency of sale

For the most part, states offer tax exemptions on sales that are defined as occasional, casual, or isolated. A primary example of this is your neighborhood’s annual garage sale. If the sale is not made in the ordinary course of business, it may not be subject to sales tax.

But if a person is in the business of making regular, taxable retail sales, (i.e., sales that resemble a regular company or sole proprietorship) then the state may deny the exemption to him or her. The ordinary course of business typically stands for anything that is “usual” or “necessary.”

Exclusions based on the relationship between the buyer and seller

If you sell your products to another company who then resells the products to a consumer, you are not responsible for assessing a sales tax on the original sale. However, if you are a business that sells products or services that another company will use themselves and not resell, then those sales are typically subject to sales tax.

Take, for instance, a company who manufacturers industrial light fixtures. If they sell lights to a home improvement store for the purpose of selling to consumers, the manufacturer does not have to collect sales tax from the home improvement store. However, if that home improvement store instead purchases the light fixtures to hang in their stores, then the manufacturer would be required to collect sales tax because the home improvement store becomes the final consumer.

Sales and use tax audits?

Sales and use tax audits can be overwhelming for small business owners, requiring them to invest a lot of time and money. Each state has different requirements for what may trigger a sales and use tax audit. For instance, states may choose companies based on certain factors, like the company’s:

Size
Sales volume
Complexity of its tax returns

There could also be events that trigger an audit. For instance, opening or closing brick-and-mortar stores tends to trigger an audit. Although there are some things that you cannot control, there are steps you can take to reduce the likelihood of a random sales tax audit.

Register your company

One of the best ways to avoid a sales tax audit is by registering in any state where you have a nexus. Make sure that you register appropriately. States tend to have different requirements depending on the industry you’re a part of and what you’re selling. Make sure you register with local municipalities as well.

File taxes on time

Another way to reduce the likelihood of a sales and use tax audit is by filing your taxes on time. Some states may also require you to make monthly or quarterly tax payments based on estimated revenue. Additionally, filing before your deadline could net you a bonus. Some states offer a reduction in tax for companies who file early.

Get legal help

Attorneys who specialize in tax law can review your records and identify areas that increase your risk of fines due to sales tax errors. Work with an experienced tax law firm to maintain accurate records and to prepare for a possible audit.

Invest in accounting software

If you want to reduce the risk of fines after a sales tax audit, you should consider using accounting software with a built-in sales tax calculator. QuickBooks will automatically calculate sales tax for you while also tracking other relevant financial information. Automating your sales tax calculations ensures you collect and pay the proper amount, thereby reducing your chances of an audit or the risk of penalties and interest after an audit is performed.

Calculating sales tax and avoiding audits

Knowing how to calculate sales tax is critical for any small business owner. Unfortunately, understanding the intricacies of sales tax law is not easy. Use the information above as a guide, and consult an accountant with sales tax experience or a tax attorney for more detailed requirements regarding your state and city sales tax laws. Doing so could help you avoid an annoying sales tax audit, allowing you to focus on the day-to-day operations of your business.

South Dakota v. Wayfair, Inc. and the new rules governing sales tax

On June 21, 2018, the Supreme Court decision in South Dakota v. Wayfair, Inc., overturned the long-standing case of Quill Corp. v. North Dakota (1992). Quill held that states could not enforce the obligation to collect sales tax against businesses that do not have a sufficient physical presence or connection to that state. This connection is also known as nexus.

Under the Quill ruling, an online business in Colorado, for example, did not need to collect state sales tax on sales to South Dakota residents if the business did not have a physical presence in or a connection to South Dakota.

The Supreme Court’s Wayfair decision means that states are no longer barred from imposing a sales tax obligation on online businesses that sell to their residents. Essentially, the state of South Dakota can now require a Colorado-based online business to collect state internet sales taxes on sales to South Dakota residents.

Following the ruling, each state will have to pass legislation to require online sales tax collection, and states may choose the minimum thresholds that apply before the tax must be collected.

The law in South Dakota, which led to the Wayfair lawsuit, requires any business with more than $100,000 in sales annually into South Dakota to collect state sales tax.

The same South Dakota law also applies when companies have more than 200 transactions in a year in the state.

Companies with sales below these 2 thresholds are not obligated to collect and remit the South Dakota sales tax without further nexus.

In making its decision, the Supreme Court specifically took into account the potential cost and complexity of managing this sales tax process. The ruling very explicitly noted that the Court granted South Dakota its petition because there were inherent protections of small businesses within their law. Based on this, it’s presumed the Court would not support a state law that makes compliance overly complex.

What are the next steps by the states?

This is the biggest question that our researchers are tracking. Currently, in addition to South Dakota, a number of other states either have already enacted economic nexus laws or have court cases or legislation pending, all which were waiting on the outcome of the Wayfair case. Below is a current compilation of those laws.

Alabama

Alaska

Arizona

Arkansas

California

Colorado

Connecticut

Delaware

District of Columbia

Florida

Georgia

Hawaii

Idaho

Illinois

Indiana

Iowa

Kansas

Kentucky

Louisiana

Maine

Maryland

Massachusetts

Michigan

Minnesota

Mississippi

Missouri

Montana

Nebraska

Nevada

New Hampshire

New Jersey

New Mexico

New York

North Carolina

North Dakota

Ohio

Oklahoma

Oregon

Pennsylvania

Rhode Island

South Carolina

South Dakota

Tennessee

Texas

Utah

Vermont

Virginia

Washington

West Virginia

Wisconsin

Wyoming

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