One of the toughest things for a small business owner to learn is how to calculate sales tax correctly. Miscalculating sales tax is 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.
Using this guide, we’ll walk you through the intricacies of sales tax. We’ll start by defining sales tax, including how to collect it and how to pay it. Then we’ll dive into how to avoid sales tax audits.
- What is sales tax?
- Are businesses required to charge sales tax?
- What products and services require sales tax?
- What products and services are exempt from sales tax?
- How to calculate state sales tax
- How to pay state sales tax
- How to avoid a sales tax audit
Sales tax is a retail point-of-purchase charge that is paid by the customer. Sales tax is 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, IRS-levied sales tax. Instead, it’s set at the local or state level, and the sales tax rate 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:
- New Hampshire
Businesses are responsible for charging, reporting, and paying sales tax on goods and services sold within the state(s) where the business has a physical presence. Because sales tax rates and regulations are set at a state level, it’s important to know your state’s specific general use and sales tax rates.
In many states, businesses must have a permit to collect sales tax. The Small Business Administration offers a breakdown of sales tax permit requirements by state. You can also check with your state’s department of revenue to evaluate your taxation obligations.
Sales tax for brick-and-mortar businesses
Almost all retail sales 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 total cost. 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.
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, you must collect sales tax on sales made to residents in that state.
- 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 that reversed the long-standing physical presence requirement for nexus. Now, sellers with an economic presence in states where they sell online have nexus. This also means that they are required to collect sales tax and pay it to the state.
If you’re an online business, collecting sales tax can be equally confusing and overwhelming. Here are a few terms and rules you should know about:
- Origin-based sales tax: Sales tax collected by the seller based on where the seller is located. Origin-based sales tax is imposed in 12 states: Arizona, California, Illinois, Mississippi, Missouri, New Mexico, Ohio, Pennsylvania, Tennessee, Texas, Utah, and Virginia.
- Destination-based sales tax: Sales tax collected by the seller based on where the buyer is located.
- Tax rules for remote sellers: Remote sellers are defined as sellers that do not have a physical presence. Remote sellers are subject to specific guidelines and thresholds that vary by state. Check with your state’s department of revenue to locate your sales tax rules.
Each state features its own unique set of products and services that are considered taxable. Generally speaking, retail, sales of tangible items, and prepared foods are subject to sales tax. To determine what’s taxable in your state, take a look at The Federation of Tax Administrators’ list of state revenue departments. Find your state’s hub page, and locate the sales tax rates, inclusions, and exemptions.
There are exemptions to sales tax laws. Here are the most common exemptions where sales tax won’t apply.
To pay your local sales tax, you will need to prepare and file a sales tax return. The vast majority of states offer electronic filing so you can avoid the trouble of manual reporting. Some states require businesses to report and pay sales tax each month, whereas others operate quarterly or yearly.
With smart accounting software like QuickBooks, you can set up automatic sales tax payments to ensure timeliness and avoid late penalties.
Sales and use tax audits can be overwhelming for small business owners, requiring them to invest a lot of time and money. Each different 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:
- Sales volume
- Complexity of its tax returns
Events can also 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.
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 local 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. Nonprofit, religious, and educational organizations are also exempt from sales tax in many states.
Items used for public good
Some states exempt items they believe encourage 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 total price 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 to manufacture or make something else that will be sold may also be exempt.
If your state, county, and city impose a sales tax, you must add each of these rates together to get the total rate. Let’s say your business operates in Boston, Massachusetts. You’ll need to factor in the sale tax rates for Suffolk County, the City of Boston, and Massachusetts. With each of these figures, you can use a sales tax calculator to do the math for you, right down to the last decimal.
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. In addition, filing before your deadline could net you a bonus. Some states offer a reduction in tax for companies that file early.
Get legal help
Attorneys who specialize in tax law can review your records and identify areas that increase your risk of fines because of 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 calculations ensures you collect and pay the proper and total amount of sales tax. This also reduces your chances of an audit or the risk of penalties and interest after an audit is performed.
Knowing how to calculate sales tax is critical for any small business owner. Whether you’re in Colorado, Indiana, Michigan, or New Jersey, it is absolutely essential to understand your tax obligations. 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.
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