When most entities are formed, they usually register for the various tax registrations (withholding, sales, income, and unemployment) only in their home state. Over time, as the business expands, they have sales to customers in other states. Usually, there is no formal review of whether or not registration for additional taxes is necessary until there is a resident employee in a new state.
Companies should be reviewing their sales tax filing requirements in other states regularly, even long before they hire their first out-of-state employee. We find that companies may not think this is necessary because of two misunderstandings that occur with regard to filing requirements.
Myth 1 – My company does not file income tax returns; therefore, sales tax returns are not required.
The nexus standard (minimum connection to a state that allows the state to tax an out-of-state entity) for sales tax is different from the standard for income tax. For income tax, there is a federal law, Public Law 86-272, that limits a state from imposing an income tax on an out-of-state entity if its sole activity within a state is solicitation for sales of property, when the orders are accepted and shipped from outside the state. This federal protection does not apply to sales and use taxes. A sales representative, whether an employee or independent contractor, soliciting sales in a state on your behalf could cause a state to require sales and use tax collection on your sales into the state. It does not make any difference whether the employee is based in that state or is based in another state and periodically solicits in the state.
Myth 2 – All my sales are via the Internet; federal protection from sales tax applies.
We routinely hear that there is federal protection for Internet-related activities, which is often interpreted to mean that purchases made via the Internet are not subject to sales tax. There is federal protection related to the Internet, but it is usually limited to the transfer of digital products or Internet services. The maintenance of a website that provides online ordering of a tangible good which is physically transferred to the customer does not have any federal nexus protection.
Steps to Help Determine Sales Tax Filing Requirements
Since many companies technically have activity in various states, we’re often asked how or when they should register. We recommend a few initial steps be taken to determine any collection responsibility:
1. Determine the various activities performed in each state. Many accounting firms have created their own nexus questionnaire template. The AICPA has also developed some checklists that can be used to document the current level of activity by state.
2. After you have identified states in which you may have nexus, you need to determine whether the product or service being sold is subject to sales tax in the destination states. Many companies mistakenly assume that if a product is exempt in their home state, it will be exempt in the other states. This is a risky assumption. We have worked with many companies that supply machines to manufacturers; they assume that manufacturing equipment is exempt in all states. However, there are a handful of states where it is fully taxable, taxed at a lower rate, or exempt only at a state level and not at a local level. Similar issues arise for companies that sell to governmental agencies. A few states (e.g., California and Washington) impose sales tax on most governmental agencies in their state.
3. If you determine that the product or service is generally taxable, then you need to determine whether your customer can provide an exemption certificate. A best practice is always to request exemption certificates from your new customers even if you are not registered in that state. It is always easier to secure certificates at the time of the sale rather than years later.
4. If you are selling to end users and no exemption certificates can be provided, you need to determine the sales volume for prior years. You should review sales-by-state reports for the last three to four years (based on the state’s statute of limitations).
Depending on the level of sales, various actions may be taken, including pursuit of a voluntary disclosure, prospective registration, or continued monitoring of the activity and sales volume in the state(s). The company may base its decision on the facts and circumstances, its risk tolerance, and other factors (e.g., competitor’s tax collection policies, pending merger or sale transaction of the company, changes to product/service mix, and the applicable state’s department of revenue aggressiveness).
It is best practice to perform this task regularly because business activities change frequently or dramatically. We often see this analysis performed when there is a change in financial leadership and the company wants to understand its current reporting and potential exposure. If the company is considering a sale, this review is important as this potential exposure is often uncovered in the due diligence process. This can either reduce the purchase price or create a higher holdback/escrow. While companies can document their activities, it is beneficial to use state and local tax consultants to help evaluate the data and recommend an action plan. Wipfli has experience with the voluntary disclosure process, state discovery unit policies, and evaluation of risk and exposure in merger and acquisition scenarios. We can help manage the process so your customer’s tax obligation does not become yours.