Sales tax calculation: Zip codes are a start but not enough

Single-rate states like Massachusetts calculate sales tax at one rate (6.25%) for every address in the state. If you don’t live in a single-rate state, the total sales tax rate could include as many as four different pieces that a small business needs to track.

The total sales tax rates for addresses in multi-level taxing states may be made up of tax rates for the state, county, city and district levels. In addition to this, what makes accurate calculation so tricky is that the applicable rates can vary widely by local jurisdiction and even by street address.

In this article, we’ll detail everything you need to know about local tax rates and sales tax information. We’ll cover why, when using a sales tax calculator, the zip code is not enough. We’ll also provide you with the relevant sales tax data you need to collect so you can pay business taxes accurately.

What is a sales tax?

A sales tax is a levy collected by retailers and remitted to state and local governments whenever a sale occurs. The United States Department of the Treasury states, “Ever since the beginning of our history, the states have maintained the right to impose taxes. The Federal Government has always recognized this right.”

The purpose of a state sales tax is to collect revenue to fund and maintain state governments. Currently, 45 states, along with Washington, D.C., carry some sort of statewide sales tax rate. Each state’s Department of Revenue is responsible for setting the rates. The five states that do not have a state sales tax are:

  • New Hampshire
  • Oregon
  • Montana
  • Alaska
  • Delaware

Additionally, at least 38 states collect an additional local sales tax at the county, city or district level. In some states, the combined local sales tax rates can even exceed the state rate.

The Tax Foundation provides a detailed breakdown of the average tax rate by state, factoring in both state and local taxes. The organization offers a look at the most current rates. Although local rate changes occur as often as monthly and are a bit more challenging to track, there has not been a single state rate change since July 2018.

Are sales tax and income tax the same?

As a business owner, you have probably heard of income tax. You may think that sales tax is the same as income tax, but this is not the case.

Income tax is the tax that you pay at the end of the year based on your total income. You pay income tax when you file tax returns. Your business will need to file tax returns at the federal level and potentially at the state level as well.

Income tax is noticeably different from sales tax. Sales tax represents a percentage of each retail transaction. As a business owner, you will need to collect sales tax from customers when you make a sale. Similarly, when you purchase goods for your company, you’ll need to pay sales tax to your vendors, unless you present an exemption certificate, such as a resale certificate, that exempts you from paying the tax.

Consider this basic example. You’re a small business that sells goods. You sell $100 worth of merchandise to a customer in Massachusetts where the sales tax is a flat rate of 6.25%. You’ll need to charge the customer a total of $106.25, as you’re responsible for paying the state of Massachusetts $6.25 on the transaction.

You’re obligated to remit this tax, whether you collect it from the customer or not. This is one of the reasons why it’s so important to understand sales tax. If you don’t know how sales tax works and how much you need to collect, you could end up costing yourself significant revenue.

For instance, say that the $100 product costs you $95 to make, and you don’t charge the sales tax to your customer. After paying the state of Massachusetts, you are left with $93.75. In this case, it cost you more to make the product than you earned.

Assuming you collect the correct amount of sales tax, you’ll be left with $100. This will go toward your revenues, which you’ll then need to pay corporate income tax on at the federal and likely the state level.

How addresses affect sales tax

As mentioned above, business owners are obligated to collect sales tax from customers and then pay the collected amount to state and local revenue departments. How do you, as a business owner, ensure the most accurate rates?

The more complete and accurate the address your customer provides to you is, the more precise the tax rate you can give them is. With more information, you’re less likely to get the rate wrong and under-collect tax.

Note that in many cases, you’re relying on the customer’s address instead of your address to figure out the rate. This is due to “sourcing rules.” A majority of states require that you charge tax based on the delivery address.

Some states do allow you to charge taxes based on the purchaser’s address. It’s imperative that you know the laws for your respective state — especially as you expand your business — so that you don’t end up under collecting and having to pay out of pocket.

So, how can a customer provide you with precise information? Let’s start with the United States Postal Service, which introduced Zone Improvement Plan (ZIP) Codes in 1963 to increase efficiency in mail delivery. The basic format of a ZIP code is five digits. In 1983, the Postal Service introduced an extended version, including four additional numbers to reference more specific locations.

The full 9-digit ZIP Code, commonly called a ZIP+4, provides more accuracy for mail delivery than the basic five-digit format. The same thing is true for sales tax calculation. The more complete the address, the more accurate the sales tax result will be.

There are nearly 11,000 local sales tax jurisdictions in the United States. Many states allow these local jurisdictions to impose their own unique local sales tax rates, in addition to the standard state rate. This is different from the single-rate states referred to above that apply the same rate everywhere.

Example 1: In Maryland, a single-rate state, the sales tax rate in Annapolis (6%) will be the same as the sales tax rate in Baltimore (6%) or anywhere else in the state.

Example 2: In California, a multi-rate state, the sales tax rate in San Francisco (8.5%) is different from the sales tax rate in San Diego (7.75%) due to different county, city and district rates that apply.

For states with local-level sales tax, you can start to see that the total sales tax rate may become very difficult to track and calculate. And, it gets worse.

The missing pieces

Using the traditional five-digit ZIP Code will not always calculate sales tax at the most accurate rate. For example, the following two addresses in St. Louis, Mo., have the same five-digit ZIP Code:

  • 827 Washington Ave., Saint Louis, MO 63101
  • 521 Olive St., Saint Louis, MO 63101

If you calculate sales tax based on just the five-digit zip code of 63101, you will get the same rate of 9.6790% for both addresses. This total rate is made up of the state (4.225%) and the city of St. Louis (5.454%) rates. This is the correct sales tax by zip code, but for one of the addresses, additional pieces are missing.

With the same example, if we get more complete information about both of the addresses (i.e., ZIP+4), things change:

  • 827 Washington Ave., Saint Louis, MO 63101-1201
  • 521 Olive St., Saint Louis, MO 63101-1809

The ZIP+4 for each address is different. When we run the addresses through the Missouri online sales tax rate lookup tool, we find the accurate total sales tax rates at each address, the ones the state will expect you to collect on your sales in these locations:

827 Washington Ave., Saint Louis, MO 63101-1201

  • 4.2250% Missouri State Rate
  • 5.4540% City of St. Louis Rate
  • 1.0000% St. Louis Convention Center Hotel 3 CID
  • 1.0000% St. Louis Convention Center Hotel TDD
  • 11.6790% Total Rate

521 Olive St., Saint Louis, MO 63101-1809

  • 4.2250% Missouri State Rate
  • 5.4540% City of St. Louis Rate
  • 9.6790%Total Rate

What you see in these results is that the total applicable sales tax rate at each address is actually different because there are Community Improvement (CID) and Transportation Development (TDD) Districts that apply to one of the addresses but not to the other.

The complete picture

Imagine if your small business was located on Washington Ave. in St. Louis, and you were only calculating sales tax by zip code. Large sales volumes could lead to a substantial monetary difference between taxes owed and tax collected that your business will still be obligated to pay.

This simple example, like many thousands across the U.S., illustrates how multiple sales tax rates can affect the same ZIP Code. The reason: five-digit ZIP Codes often cross taxing areas such as counties, cities, and districts. If your sales tax calculator is based solely on zip code, you may find that you under-collect taxes, hurting your bottom line.

Under-collecting could not only leave your business paying out of pocket for the tax, but could also leave you paying penalties and interest for incorrect filings. It is crucial, therefore, to use the full ZIP+4 to calculate sales tax rates for your business and generate the most accurate figures.

Similarly, you may want to consult a trusted tax professional for further guidance on how to collect taxes in your area. As your business grows and you cross into different states where local tax also applies, you’ll want to make sure you remain compliant with all local tax laws.

Other factors that influence tax rates

In addition to accurate address information, there are some other things to consider when collecting sales tax.

These factors include the pre- and post-Wayfair nexus, the location of your business, customer, or job site, the products and services you sell, the timing of your transaction, and whether your customer may be entitled to a sales tax exemption.

For instance, your state may have a use tax rate. A use tax rate means that the taxes apply not where the buyer purchased the good, but where they used it. To help better understand this concept, look at eight different ways the sales tax life cycle of a lemon is impacted.

Using QuickBooks to calculate your sales tax

If you want to see how the information above affects your business, take a look at the new online sales tax calculator powered by QuickBooks Sales Tax. QuickBooks Sales Tax can help you avoid the hassle of figuring out sales tax and all of the rules that exist in each state, including the multiple factors that could change a sales tax calculation.

By using reliable, automated software, you won’t have to calculate sales tax by hand or through an Excel accounting spreadsheet. Because local sales tax rates are updated in real-time, you can rest assured that your business always collects the correct sales tax, no matter where you are.

Quickbooks Sales Tax automatically takes into consideration the vital information from your business. The software also tracks — and automatically updates — all of the rules and rates as they change by state.

You’ll find the right rate for every transaction, from calculation through filing. This reduces your business’s risk of error and minimizes the likelihood of a sales tax notice or audit, leaving you with more money in your pocket to grow your business.

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