Most states require consumers to pay sales tax on the goods and services they purchase. However, as a new small business owner, you may be at a loss when determining how much sales tax to charge in a given situation, especially whether or not your customer is inside or outside of your state or jurisdiction. Sales tax sourcing deals with just that situation.
Sales tax sourcing is the term for determining which tax rates should be applied based on jurisdiction, which is especially important for online and catalog retailers who regularly sell to customers in other locations. This starts with determining whether your business is located in a state with origin- or destination-based tax laws.
States with origin-based laws tax customers based on the location of the business as opposed to that of the consumer. For example, if the company is located in a state with a 5% sales tax rate, all customers are taxed at a rate of 5% no matter where in the country they are located. Currently, the following states use origin-based taxes:
- New Mexico
(* California is unique because it uses what it calls a “modified origin system.” Under California law, state, county, and city taxes are origin-based. District transaction taxes (i.e. supplementary local taxes) are destination-based.)
In destination-based states, businesses charge sales tax based on the location to which goods are being sent. More common than the origin-based tax system, destination-based taxes also pose a greater challenge for business owners, as they are responsible for charging their customers the correct rate, which can vary based on the customer’s address. Further, businesses may need to break down sales by taxing authority on their tax returns.
With destination-based taxes, businesses are responsible for tracking and reconciling different state and local tax rates. If the destination’s state tax rate is 5% but the business is shipping to a customer in a city with a local tax rate of 2%, the business must charge a total sales tax of 7%. If customers are picking up goods at your facility, then your business address is typically considered the delivery location. Online and catalog retailers may be required to reconcile county and district tax rates as well.
Sales Tax by Business Type
It’s important to note that states have different requirements for in-state and remote sellers. Generally, remote sellers are obligated to charge sales tax based on the location of the buyer. Additionally, a business in a destination-based state will not have to collect that state’s sales tax for goods shipped to another part of the country.
Further, the goods and services your business offers could affect its requirements with regard to sales tax. While laws vary by state, resellers tend to be exempt from paying sales tax on wholesale purchases. Instead, the final buyer will be responsible for these charges.
Additionally, raw material retailers enjoy sales tax-exempt status, as do those selling to nonprofits. Finally, service providers like doctors, dentists and lawyers are exempt from charging sales tax. It’s important to stay abreast of your state’s specific guidelines to avoid IRS penalties and fees.
As more states adopt a destination-based sales tax, many brick-and-mortar establishments feel that they’re being unfairly penalized. Not only is determining tax rates more complex and expensive in destination-based states, but it can also put businesses at a disadvantage to remote retailers. Hence, remote businesses can provide products and services for a lower rate than in-state brick-and-mortar companies. If you find that your current business is losing money based on its current location, you might consider opening a new location in a different market.
The truth is that numerous factors and events can affect your business’ tax requirements including opening a new location, keeping products on consignment and even cross-selling goods through an affiliated location. As a result, it’s important to stay up to date on all your state and municipal tax guidelines. Otherwise, you might find yourself having to play catch-up if tax amounts aren’t correctly reported the first time.
For more information on collecting sales tax online, read our guide on how sales tax works on the internet.
If you want to avoid the hassle of figuring out sales tax on your own, solutions like QuickBooks can automatically calculate sales tax for you, so you can save valuable time that you can instead spend on running your business.