The demise of many of the larger traditional “bricks and mortar” retailers, coupled with the remarkable growth of mega online superstar Amazon, has encouraged many budding retail entrepreneurs to consider following an online sales format when establishing their business models. While the online model is still highly viable in many cases, it is not without its pitfalls. Perhaps the most treacherous of those lies in the area of sales and use tax.
Traditionally, based on longstanding precedents established by the U.S. Supreme Court, companies could not be required to collect sales tax with respect to their retail online sales to state residents unless they had some form of physical presence in the state at issue—thus establishing sufficient “nexus” with the state to allow the state to impose its sales tax collection obligations on the company. With the annual growth rate of online sales continuing to mount1 and many states facing financial woes, it should come as no surprise that certain states have come up with very innovative methods of attempting to circumvent this traditional physical presence requirement to capture some of their lost sales tax revenue.
The most recent development in this quest to corral out-of-state on-line retailers is the adoption of economic nexus standards by several states. In light of this development, Friedman LLP’s recent tax survey2 asked businesses with online sales if they are making changes to their sales tax collection process. The survey found that 40% of respondents are not making changes—leaving them exposed to potential sales tax assessments and penalties. 27% indicated that they are not considering making changes to their online sales tax collection process, while 13% are unsure of how to proceed.
What is Economic Nexus?
The application of economic nexus measures to sales tax represents a direct challenge to the U.S. Supreme Court’s holdings in the sales tax nexus area requiring physical presence. Economic nexus assumes that even if an out-of-state seller has no physical presence in a state, if that seller is reaping a significant amount of revenue from sales to in-state customers, then the out-of-state seller is establishing a sufficient enough connection to the taxing state to be subject to the state’s sales and use tax laws.
In 2015, the first state to apply economic nexus to sales tax was Alabama. Since Alabama’s confrontational stance, several other states have also adopted its position, including South Dakota, Tennessee and Massachusetts. All of these states are inviting litigation regarding their position as they would like to have the Supreme Court Justices re-examine the sales tax nexus area.
In addition to economic nexus rules, a common sales tax approach employed by a number of states to circumvent the physical presence requirement is “click-through” nexus.
New York was the first state to develop the concept of “click-through” nexus. In New York’s view, e-commerce companies that have contractual relationships with in-state residents with websites whereby potential customers can click-through from the residents’ websites to the companies’ websites to complete their purchases have established a “physical presence” in the state. The state’s statute provides for a minimum amount of revenue that must be reached with respect to sales to in-state residents before nexus is secured. Further, for the statute to come into play, the in-state website owners must be compensated for their efforts by the out-of-state online retailers. New York’s law provides that once the criteria set forth in the statute are met it is presumed that an out-of-state retailer has sales tax nexus with the state unless the company can successfully rebut the presumption.
Since New York’s employment of this procedure, at least 18 additional states have joined the party. While the New York law has been challenged in court, thus far the state has prevailed.
Use Tax Notice and Reporting Obligations
While state residents can often avoid sales tax when they purchase items from online out-of-state retailers, their obligation to pay use tax regarding such purchases is never in question. In reality, however, the vast majority of items that are bought online sans sales tax never see the light of the use tax day.
To counter that problem, Colorado enacted legislation that requires non-resident online retailers to report items sold to in-state residents if certain statutory criteria are met. The legislation mandates that companies give the state the information it needs to go after its residents with respect to their use tax obligations. Subsequent to the Circuit Court’s decision that the mandate did not run afoul of the U.S. Supreme Court’s rulings in the area, Louisiana, Vermont and Oklahoma have passed similar legislation.
It’s likely that the states will continue their fight to capture lost sales tax revenue. In that vein, they will use all opportunities available to them to eliminate the need for physical presence in the sales tax nexus area. With the myriad of sales tax nexus methodologies now followed by the various states, keeping track of a company’s reporting and collection responsibilities can be trying indeed. Businesses with online sales need to take caution that they are complying with the complex rules employed by each state to avoid potentially hefty sales tax assessments and penalties.
Check out our other tax reform insights in this series:
- Business leaders favor sweeping tax reform proposals, with some hesitancy towards international proposals
- A majority of businesses would offer the same or more health benefits if ACA repealed
- Companies using independent contractors may be at risk for taxes and penalties
1 According to industry information, as of 2014 online retail sales in the United States surpassed the $300 billion mark. Further, a study by the U.S. Commerce Department found that e-commerce accounted for over 60% of total retail sales growth in 2015, the sixth straight year for which online sales have demonstrated a greater than 15% increase.
2 Friedman LLP conducted the web-based survey in early 2017 among companies across the United States, with a focus on the New York, New Jersey, Pennsylvania, and Connecticut areas. The survey compiles responses from 483 senior leaders of companies across industries including technology/computer services, manufacturing/distribution/wholesale, healthcare, retail, real estate, financial services, architecture/engineering, marketing and advertising, nonprofits, law, and more. The size of the companies surveyed ranged from below $10 million in annual revenue to over $500 million. The respondents include business owners, company presidents, chief executive officers, partners, directors, chief financial officers, controllers, and managing directors. All insights in this series are based upon the specific responses of the business leaders who participated in our survey.