Running a business requires dozens of decisions each week and requires owners attention to stay on top of day-to-day operations. With all of the work business owners have to attend to, it’s no surprise there are a handful of common sales tax errors that crop up.
Managing sales taxes may sound routine, but the process can be complicated and time consuming. Because the sales tax percentage differs by state, the profit recognized on sales in different states may differ. Here are 9 common errors related to sales taxes.
Use these tips to manage the process of paying and collecting taxes, and reduce the risk of error.
Sales tax defined
A sales tax is imposed by a government entity, typically a city, county, and with a few notable exceptions, states.
The tax is incurred on the sale of goods and services, and sellers are expected to collect sales taxes from the buyer and pass the tax dollars on to the government entity.
A seller reduces the dollar amount of each sale (gross sales) by the amount of sales tax charged to the buyer.
Common sales tax error #1: Not understanding state nexus
A business must collect sales taxes if the firm has a nexus in a particular city, county, or state. If you don’t understand nexus and how the term is used to assess sales tax, you may be making a common sales tax error and not collecting the appropriate state taxes required on company sales.
Nexus is a term that means a “sufficient physical presence.” It’s a legal term that determines whether or not a company must collect sales tax on sales made in a particular city, county, or state. A state nexus, for example, can refer to the people located in the state, or to property owned by the business in that state. The same rules apply to a city or county.
Where Nexus gets complicated, especially for online business, is when you’re responsible for collecting these taxes in every state, county and city you make a sale. In other words, an online company based in New York City isn’t just responsible for paying New York city and state taxes on products sold locally, but also all applicable taxes on a products sold in Boise, Idaho; Anchorage Alaska; and Lincoln, Nebraska.
Thankfully there are tools that plug into QuickBooks Online that help you automatically calculate the different sales tax rates you may encounter.
Online retail example
Camp USA sells mountain climbing gear to clients throughout the U.S. The firm is headquartered in Colorado, and operates warehouses in the following states:
- New York
- North Carolina.
The firm also sells merchandise online to customers in all 50 states.
Nexus laws may require Camp USA to collect sales taxes for online sales made in all 50 states.
If Camp USA also decided to expand their operation, and include international ecommerce in their mix, they would be responsible for Nexus in those regions.
Common sales tax error #2: Not deducting state sales taxes on your federal return – Self-employed
When a self-employed person does not include sales taxes paid as a business expense, the company profit will be inaccurate. The business owner, who may be none the wiser, will be responsible for paying more taxes than are owed. Obviously not a sales tax mistake you’d want to make.
If you’re self-employed you may pay federal income taxes using Schedule C of the Form 1040 tax return.
Schedule C allows the business owner to deduct sales taxes as an expense, and the expenses are subtracted from business income to determine net income (profit) for the year. The taxpayer posts the net income total to page one of Form 1040, along with other sources of income for the year.
Some other types of businesses, such as a single-member limited liability corporation (LLC), may file business income taxes using Schedule C.
Common sales tax error #3: No sales tax expense – C Corporations
If a C Corporation (C Corp) does not include sales tax paid as a business expense, the company profit will be incorrect. This sales tax mistake means the C Corp will pay more taxes than they owe.
C Corps file business income taxes using Form 1120, and these business entities do not take a separate deduction for sales taxes.
Instead, a C Corp adds sales tax paid to the cost of assets purchased for the business, and deducts sales taxes from the amount realized on an asset sale.
Assume, for example, that Camp USA purchases a piece of machinery for $50,000, and pays a 5% sales tax ($2,500) on the purchase.
When Camp USA calculates depreciation expense, the cost basis for the calculation should be $52,500. If sales tax is not included, the depreciation expense on the machinery will be too low. Forfeiting $2,500 in potential tax deductions.
Partnerships handle sales tax in the same way as a C Corp, because sales taxes paid are added to the cost of a purchased asset.
Common sales tax error #4: Not pricing profit margins by state
An owner needs to know the percentage sales tax charged in each state where the firm does business.
Some states have a combined state and local sales tax rates as high as 10%, while other states are in the 5% to 6% range.
When the same sales price is used nationwide, the profit margin for a product will differ by state, depending on the sales tax charged.
Fortunately, there are plenty of dynamic pricing tools available that allow you to maintain your profit margins in various geographies, and many other criteria.
Common sales tax error #5: Missing sales tax exemptions
If you collect sales tax on transactions that are exempt, you’re overcharging the customer and creating unnecessary work to submit sales taxes in error.
Some transactions are exempt from sales taxes, based on the type of product or service sold, or due to the purchaser’s background.
Sales tax exemptions vary, based on the government entity that is imposing the tax. A state or local government may charge a lower sales tax rate, or exempt purchases from sales tax entirely. Here are some typical examples:
- Necessity goods: Goods, such as food, medicine, and clothing, are assessed at a lower sales tax rate, or exempt from sales tax entirely. The rationale for this tax policy is that consumers at every income level need these goods, and minimizing the sales tax makes it easier for individuals to afford these purchases.
- Other exemptions: Service transactions, such as fees charged by doctors, lawyers, accountants, and other service professionals, may be exempt from sales taxes. In addition, sales of real property and the sale of some intangible assets may be exempt from sales tax.
- Purchasers who are exempt: Sales tax exemptions are provided to specific groups of purchasers, such as government institutions, non-profit organizations, charitable groups, and religious institutions. These purchasers typically keep letters on file from the IRS and other taxing authorities. The letters state that the organization is exempt from sales tax, and the letters are provided when a purchase is made.
As you plan your spending for the year, carefully review your transactions to determine if any of these exemptions apply to your business.
Common sales tax error #6: Including sales taxes on goods purchased for resale
Certain purchases may be exempt from sales tax, if the goods are used to produce another item for sale, and this exemption can take several forms.
If a business includes sales tax as an expense by mistake, the total expenses for a particular product will be too high, and the profit will be understated.
Assume, for example, that a furniture manufacturer purchases maple wood to produce tables and chairs. Maple wood is a raw material, and many states exempt raw materials from sales tax. This tax policy is in place, because the sales tax will be assessed to a buyer when the furniture is sold to a customer.
The furniture manufacturer may have to report its raw material purchases to a state or city government, and document that the material was used in a product that was resold to customers.
A state will typically provide the business an exemption certificate, which verifies that the firm meets the state’s requirements for the sales tax exemption.
Common sales tax error #7: Miscommunication about sales tax with customers
This sales tax mistake is pretty easy to avoid.
When you don’t make it clear that sales taxes are being added to the cost to your customers, you risk losing sales and watching your repeat customers go away.
You need to clearly state in all of your marketing and sales materials if your retail price includes sales tax.
Online consumers, in particular, expect that the listed sales price includes sales tax, if sales tax must be collected. If you must charge sales tax and that amount is not included in the price of the good, explain that fact in your communications with clients.
Common sales tax error #8: Exposure to employee theft
Companies with a large number of transactions are exposed to a higher risk of employee theft, and that theft may include sales tax collections.
If your business collects sales tax, you should put these controls in place to reduce the risk of employee theft.
- Cash: This issue applies to retailers. Accept checks, all major credit cards, debit cards, and PayPal payments, in order to reduce the dollar amount of cash your workers must handle. Cash has the highest risk of theft, because a cash transaction does not create a strong paper trail.
- Point-of-sale (POS) system: Retailers should use a POS system to process sales transactions, because the software automatically increases cash (or a credit card payment) and increases revenue for each sale. Because the accounting records are updated in real time, the business owner can detect a fraudulent transaction faster.
- Reconciliations: The dollar amount of checks and cash received by a worker during a particular day should be reconciled to the POS system daily. If, for example, the POS system indicates that the employee received $1,200 in checks and $500 in cash, those amounts should agree to the checks and cash in that employee’s cash register.
The term shrinkage refers to a loss incurred due to theft. Despite your best efforts, an employee may steal merchandise, or cash received from a sale. If inventory theft occurs, it’s important that you immediately remove the stolen merchandise from your inventory records, and post the inventory cost to an expense account.
If, on the other hand, cash receipts are stolen after a sale, you need to remove the sale from your accounting records and post the amount to an expense account. Speak with a CPA to determine how to handle the sales tax amount that was stolen, because the tax reporting rules may differ by state. If, for example, $50 in state sales tax paid in cash is stolen, the state may want you to report the $50 as sales taxes collected, and also report a $50 loss due to theft.
Common sales tax error #9: Misusing sales tax collections
The most serious sales tax issue is the risk that company management uses sales tax collections to cover a cash shortage, and does not submit the funds to the state or local government in a timely manner.
At a minimum, this sales tax mistake will result in fines and penalties, and not submitting sales taxes is likely to create a legal problem for the business owner.
Find an expert
Dealing with sales taxes can be challenging, if you don’t do your homework and put effective systems in place. To address all of the issues related to sales taxes, consider hiring a CPA who specializes in sales taxes.
These experts can help you determine when sales taxes should be collected, and the transactions that may be exempt from tax. Maintain a set of written business procedures so that your firm will properly handle sales tax issues.
Use these tips to stay on top of the sales tax process, and manage your business efficiently.
To make life really easy, QuickBooks Online automatically calculates sales tax so you don’t have to. Spare the headache and let QuickBooks do the hard work for you.