Most businesses don’t set out to be non-compliant with sales tax, or anything for that matter. In fact, you probably have the best of intentions of meeting your sales tax obligations in the future.
But what about sales tax liability from prior months? Prior-period liability can be extremely costly as states and jurisdictions crack down on non-compliance. It’s generally better to be proactive in understanding and mitigating your sales tax risk rather than waiting for a jurisdiction to identify you for audit.
When do your sales tax obligations and liability start?
The first step in mitigating your prior-period sales tax liability is to assess your current obligations. First, you must determine where you have established nexus, or a connection to a taxing jurisdiction.
Tax jurisdictions have long used physical nexus to determine whether a company has a sales tax collection and remittance obligation. This can include your physical office or location in a jurisdiction; employees working out of their homes or a separate location outside of your home state; inventory or parts that are stored in a warehouse; sales reps visiting or conducting meetings in a jurisdiction or you exhibiting at tradeshows there; or even local contractors performing services on your behalf, among other activities.
In 2018, economic nexus was introduced and is defined by a threshold of sales or transactions in a jurisdiction where you don’t have a physical presence. It’s a real problem: Almost one in four attendees of the recent TaxConnex webinar on managing prior-period liabilities was not confident in the difference between economic and physical nexus.
Following the Supreme Court’s Wayfair decision in 2018, all 45 states that have a statewide sales tax now have economic nexus laws, as does the District of Columbia. Economic nexus can be determined by a dollar value of total sales or by volume of transactions.
Economic nexus thresholds vary – especially in the bigger states like California – but generally, if your sales into a jurisdiction are getting close to $100,000 a year, you should take a close look at whether you have nexus or not.
Download our Sales Tax Nexus guide to learn more!
What’s past is not necessarily past
Once you’ve determined whether you have sales tax nexus or not, you need to determine whether your specific revenue streams are subject to sales tax. When estimating your prior-period sales tax exposure, look at a couple of potential sources of taxability.
Your products/services: The sale of tangible property (TPP) is generally taxable unless specifically exempted. On the other hand, services are generally exempt unless specifically identified. There are numerous situations that are confusing. For example, the sale of electronically downloaded software or Software-as-a-Service. Many states will tax either or both of these types of software even though they don’t fit into what we would normally think of as a tangible item.
Your customer base: Can a customer give you a sales tax exemption certificate? This frees your business from having to collect and remit sales tax from that customer. From purchasers who are not-for-profits, school districts, manufacturers, public utilities and more, there are a host of scenarios across all the states that provide some refuge for companies to operate without paying sales tax on purchases.
How far back do you need to evaluate your sales activities, nexus footprint and taxable transactions? If you are not registered with a state and not collecting and filing sales tax returns, then you are not protected by a statute of limitations. As a result, a state could assess you from the time you first had taxable sales. This could go back a significant amount of time. It’s best for you to estimate what the total potential risk is as you look at options for how to mitigate that risk.
Mitigate prior-period tax exposure
One option to mitigate the prior period tax exposure is to register for sales tax purposes with a prior period effective/start date that aligns to when you first had nexus and taxable sales. By registering with a prior period effective/start date, you will need to file the applicable returns and remit the tax due. When filing these prior period returns, you will be assessed various penalties and interest as a result of non-compliance. Assuming you are voluntarily coming forth to file the prior period returns and remit the tax due, there’s a reasonable likelihood that the states will waive at least a portion of the penalty assessment.
Another option is to pursue a voluntary disclosure agreement (VDA). VDAs are generally reserved for non-registered taxpayers and taxpayers who haven’t been notified by the tax jurisdiction about non-compliance.
A VDA is a legal means for taxpayers to self-report back taxes owed for income, sales, property and other tax types. In exchange for voluntarily reporting the tax due, states generally grant a waiver of penalty and a limited lookback period (generally 3-4 years), potentially reducing the tax due significantly as compared to an audit.
A VDA is most beneficial in three situations:
- If you have previous non-compliance and exposure dating back more than 3-4 years.
- When you’ve collected sales tax but have yet to register and remit to the state.
- If you are looking to sell your business or otherwise seek outside capital and have previously not complied.
The last option only applies if you have no prior period tax exposure or an immaterial amount. In this situation, you may choose to register and comply prospectively. The faster you can start collecting the sales tax from your customers and passing in through to the taxing jurisdictions, the faster you can manage your risk.
Important: Regardless of the option you choose, if you have charged and collected sales tax then you need to report it.
Keep up in the future
Mitigation efforts largely backfire down the road if you don’t establish a process to stay compliant. Keeping up with changing nexus rules and understanding the taxability of products/services were the biggest concerns of attendees of the recent webinar, but it’s also key to maintaining your obligations in the future.
If you try to handle compliance in-house, your accounting platform may have some functionality to calculate sales tax via tax rate subscriptions and plug-ins. That still leaves you with the burden of filing and remittance – which sounds easy, but things like filing frequencies and your nexus footprint are likely to change over time. You also need a system to handle the many time-sensitive notices that tax jurisdictions love to send.
Yes, it’s a lot of work, but successful mitigation of sales tax liability is worth it.
For more, see our recent webinar on mitigation.
Sales tax isn’t getting any easier. Let TaxConnex manage the burden of keeping up with all the changes and challenges that come with staying compliant in this post-Wayfair world. Contact us to learn what it means when sales tax compliance is all on us.