For the last few months, we have been concentrated on Federal income tax issues. Given the time of year, we figured that's what might interest you. Now that we are a bit past April 15, though, we wanted to leave income taxes behind a moment and talk about other taxes, specifically sales and use taxes.
Most of us concentrate on the income tax side of things when we think of "taxes." After all, that's what we see come out of our paychecks. Then, there are those "love letters" we call tax returns that we send to the government every year.
Of course income taxes seem to be the big-ticket item to most of us, but not necessarily to state and local governments. With the exception of four states, sales taxes make up a significant part of our states' revenues, averaging 20.3% in 2002 according to the Tax Foundation. In the states that have a sales tax, but no individual income tax, sales & use taxes make up greater than 50% of state revenues, except for Wyoming (40.7%). The reason is simple, not everybody pays income taxes, but everyone has to eat and somewhere or sometime, you will have to pay sales tax on food and other purchases you make at your local store. And don't think that you save a fortune in sales tax if you buy everything on the Internet. In most states, you still owe tax, but instead of calling it a sales tax, the state calls it a "use tax." The problem for the states right now is there is no effective way to police the collection of use tax, or lack thereof, on Internet purchases.
Now that you know how important a source of revenue sales and use taxes are to state and local governments, let's define a few terms:
- Sales tax - The tax charged and collected on purchases of taxable items at the time of purchase.
- Use tax - The tax charged on purchases from an out of jurisdiction source and imported for use into another jurisdiction. Internet purchases are the perfect example. Suppose you purchase a book from Amazon.com for $10. Amazon will charge you for the book and shipping (possibly), but not necessarily for sales tax. If you bought the same book at Barnes & Noble down the street and your sales tax rate was 10%, you would pay sales tax of $1. Theoretically, you should, in many states, send $1 in use tax to the state where you received the book. Before you jump up and down and kick the screen, we said theoretically because many states have no mechanism to collect the tax and even if they did, most people still don't pay it.
- Nexus - A presence in a state sufficient to require a business to collect sales tax from customers. Generally, that means a company must have more than just sales into a state. Factors such as the presence of inventory (warehouse) or employees are typically two other major factors.
- Point of delivery - The place where the customer actually takes receipt of a product. For example, if you buy a mattress in Texas, but have it delivered to your house, where is the point of delivery and what tax should you pay? More than likely, if the mattress is shipped by common carrier or a store's own truck, the delivery point is your house, if that is where it is received. You would pay taxes based on the rate where you live. If you take your pickup truck to the store and get the mattress, then you pay tax based on the rate where the store is located. This can offer a substantial tax savings in some instances.
With these in mind, let's look at what businesses and individuals need to know.
Sales taxes for individuals are generally cut and dried. If you purchase something that is taxable, the seller collects the tax. What you should do, however, is be certain you know what state law says about taxable and nontaxable items as well as what constitutes a sale. Prescription drugs may be tax-exempt in one state, but taxable in another. Even within a state, one city may tax prescription drugs and another may not levy taxes on prescription drugs. What happens if you have an old television and sell it to Fred down the street for $10.00; are you required to collect tax? It is highly improbable you would be required to collect any tax on the sale since you are not in the business of television sales. The same is true if Fred was the seller; so don't let him collect sales tax from you.
If you are involved in charitable organizations that have carnivals, bake sales or any other fundraisers that revolve around a product, be sure you check the laws. In many cases, non-profit organizations don't have to collect sales taxes where they are the sponsors, but do if the sale is made by a for-profit entity and the charity's cut is a minor share. These rules will be different from state to state. If you will have to collect sales tax, you can factor that into the price of the product.
Businesses have the same considerations as individuals, plus a few more. The thing is, though, that businesses are much more likely to be visited by a sales tax auditor than an individual is. The revenue recovered per dollar spent from auditing an individual doesn't justify auditing the individual just for sales or use tax purposes. On the other hand, businesses, particularly retailers and those who purchase substantial amounts out of state can be lucrative indeed.
For example, one jurisdiction became very interested in services offered by CPAs and began auditing firms. In particular, the auditors really wanted to know if the firms sold off the shelf software, which is taxable in the state, rather than billing only for professional services, which are tax-exempt. The problem was even if the software sales were not present; there were many other items subject to use tax on which no tax was paid.
Businesses, particularly manufacturers, also have to precisely define their product and it's components. In many states, items bought for resale are free from tax to the purchaser with the idea that the tax is really due from the ultimate consumer. Sometimes, the purchaser is required to pay the tax to the seller and show it as a credit on a sales tax return and sometimes, if the purchaser has a tax-exemption number, the tax doesn't even have to be charged by the seller. A key distinction for manufacturers in many states will be whether the purchase is considered raw materials for the manufacturer's product. For example, suppose you are a baker and you make cookies. Naturally, the sugar that goes into the cookies is part of the final product. Now let's say you make a special kind of cookie and in order to get the sugar and your "secret ingredient" to bind and make that special flavor, you have to use vinegar as a catalyst, but when all is said and done, the vinegar is used up in the chemical reaction. Since the vinegar is not in the final product and was used like any other "supply" item, taxes must be paid on the vinegar.
We mentioned nexus a bit earlier. If you are selling into one or more states, you need to review what will cause you to have nexus for sales tax collection purposes within the states where you sell. If you are required to collect tax and you do not, you could wind up paying huge penalties in addition to paying the taxes owed and the interest thereon. This could literally put some companies out of business.
We have only scratched the surface of the sales tax jungle and believe us, it is a jungle. Luckily, there is a moratorium on new taxes to be levied on Internet sales while states seek to work out a cooperative agreement on the collection of Internet taxes. This still leaves a lot of room for businesses and individuals to make a costly mistake through ignorance of applicable laws. If your business is involved in multi-state operations, it may be to your advantage to undertake a sales tax study to determine your exposure. Businesses, as well as individuals, can also go to the state revenue departments' web sites to learn more about taxes in states where they have an interest.
If you are concerned about your potential exposure for sales taxes, give us a call and we can discuss the best alternatives to quantify any exposure be it personal or corporate.