Small Business Taxes & ManagementTM--Copyright 2014, A/N Group, Inc.
While many business owners give little thought to sales tax, doing so can prove particularly costly. In most states (there are a couple of exceptions) the customer pays the tax in addition to the price of the goods or services. If you're audited and have to pay additional taxes, the amount will come out of the business. If you had charged the customer the correct amount he would have paid it and it wouldn't have cost the business anything. That's different than income tax. There the tax is paid by the business (or partner, shareholder, etc.) whether on the return or following an audit.
There's another important difference. Sales tax is almost universally considered a "trust fund" tax, much like withholding taxes on wages. It was never your money to begin with; you're just collecting it for the state. You can't escape responsibility by doing business as a corporation, LLC, etc. The state will generally seek the money from shareholders, LLC members, etc. or other individuals it deems responsible. Add to that the liability is generally not discharged in bankruptcy.
Some states are even tougher. More than a few will press criminal charges in certain situations. That's usually reserved for those instances where the sales tax was collected, but not remitted.
You should also be aware that business failures are related to unremitted sales (or employment taxes) more frequently than you may think. There have been cases where the state has not been able to collect the tax and seizes the business assets. Few businesses survive such a situation.
Starting Out Right
Basics. If your business is simple--you operate only in one state and sell widgets only to schools--dealing with sales tax may be simple. Chances are you don't have to bill tax because there's an exemption for sales to governments. But things can get complicated quickly if you sell a range of products or provide both taxable and nontaxable services.
Keep in mind whether or not you're required to collect sales tax, in most cases you can't do so until you receive a certificate of authority or similar document.
The first step is to determine if the product or service is taxable. If you've got a hardware store, most likely everything is taxable. But there can be exceptions, like vegetable seeds. The issue is much more complicated if your business is a drug store. Candy is clearly taxable; cough syrup may not be. And don't assume anything. Just because the syrup is not taxable doesn't mean the cough drops right next to it aren't. It gets worse. Each state has their own rules. Just because one state considers an item clearly nontaxable, doesn't mean a bordering state will do the same.
If you provide both goods and services either separately, or together, that can add to the complexity. For example, in many states a construction contractor must bill a customer for sales tax on materials, but not on services. Real property is frequently dealt with differently than personal property (car, machinery). Repair work may be also get a different treatment than new.
Proper invoicing. Generating a proper, detailed invoice can be critical to avoiding problems should you ever be audited. It can also help your customer. Unless all the materials and/or services and both the service and materials are taxable or nontaxable, you'll need a breakdown. Provide the detail necessary for the situation. In one state construction services are nontaxable; materials such as lumber, nails, cement, etc. are; fill to grade the property isn't.
Shipping and handling may or may not be taxable. It should be detailed on the invoice. Same goes for setup charges.
The invoice should show the ship to as well as the billing address. It's not unusual for an in-state company to place and order with you to be shipped to the company's facility or drop shipped to a customer in another state. In that case you probably won't be responsible for tax in your home state but in the state where the item is delivered. Drop shipping for a customer may generate a taxable or nontaxable transaction. The taxing jurisdiction often depends on where title transfers.
Exemption certificates. Items for resale are generally exempt. So are goods and services incorporated into a product or used in the production process, machinery used in production, goods and services used in research and development, items for medical applications, provided to exempt organizations (schools, churches, nonprofit groups) etc. You're generally not expected to know if an item or service is exempt to the customer. Instead, he's supposed to provide you with a resale or exemption certificate. Generally, you can rely on the signed exemption certificate. That is, the customer buys an computer and claims it's used in research, but it ends up used in the accounting department. That's not your problem.
On the other hand, if it's clear that the product couldn't be used in an exempt function, you could be held responsible.
Get the exemption certificate before shipping. That's the requirement in most states, and you don't want to have to chase the customer. Retain the certificate for the three years from the due date or the date the return was filed, whichever is later. Some states require a longer retention.
If the state has a database allowing you to check if a buyer is registered, use it and document the use. You'll have trouble convincing the state it was an legitimate exempt sale if the buyer isn't in the database. Keep in mind that with the tax in the 6-7% range in many states, there's an incentive for customers to claim an exemption.
Use tax. This is the flip side to sales tax. If you purchase goods or services without paying tax and the item was not exempt, (e.g., you order office supplies from an out-of-state company and aren't charged the tax) you're supposed to pay the tax on your regular sales tax return. That's true for your customer too. Thus, if you sell to businesses, you may not be doing them a favor by not charging tax.
The word can be translated as "taxable connection". It applies to out-of-state (or nonlocal for those states with a sales taxes imposed by a county or city) sales. Another state can't just require you to collect sales tax without some sufficient connection. For example, Fred lives in Minnesota and orders a fishing rod from your business with its only location in Massachusetts. You don't have to charge Fred the tax. In fact, you can't unless you've signed up to collect the tax for Minnesota.
What constitutes a taxable connection? That could be a multi-part article. Clearly if you have an office in the state or have been authorized to do business in the state, you'll have to collect sales tax. Here's a list of the possible activities that create nexus.
There may be additional ones. Be aware that, as usual, the reasons vary by state. If it looks like any items on the list apply to your business in another state, check the rules or talk to your tax advisor.
You should also be aware that nexus for income taxes can be different than that for sales tax. You may be required to collect and remit sales tax, but not income tax.
Here are some other points that can help keep you out of trouble.
File on time. Late filed returns and missing returns can increase your audit chances.
Changes in filing. Changes in your filing pattern, such as a marked increase in exempt sales or a big drop in sales can trigger an audit.
Computers are everywhere. The states have access to many databases and have been mining information that can reveal audit potential.
Collect the tax. It's not unusual for some retailers, service providers, etc. to say "you don't have to pay sales tax if you give me cash". That's dumb. How do you know the customer doesn't work for the state, IRS, etc.?
Pay what you collect. You may get some sympathy from the auditors if you neglect to charge the tax because of a change in the law, an error on the part of an employee, etc., but you'll be in real trouble if you collect the tax and don't pay it over. That's where states look at criminal penalties.
Whistleblowers. A disgruntled customer, an ex-spouse or employee, etc. can trigger an audit.
Third party assistance. Just as their are payroll services to file employment taxes, there are companies that will take care of your filings and assist you in fulfilling your obligations. There are also software providers that will do the same thing. Your accountant may also be able to help.
Use a computer. Any good accounting program will help in charging and accounting for sales tax. That won't solve all your problems, but it'll make things easier.
This all sounds overwhelming, particularly for a new business. But once you start dealing with the issue you'll find that, for most businesses, dealing with sales tax becomes routine, with some exceptions.
For more information, go to our articles Taxpayer Wins Sales Tax Audit Case and Surviving a Sales Tax Audit.
Copyright 2014 by A/N Group, Inc. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is distributed with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional should be sought. Articles in this publication are not intended to be used, and cannot be used, for the purpose of avoiding accuracy-related penalties that may be imposed on a taxpayer. The information is not necessarily a complete summary of all materials on the subject. Copyright is not claimed on material from U.S. Government sources.--ISSN 1089-1536
--Last Update 06/27/14