Sales Tax: An Important Early Consideration for Startup Companies
Of the many tax obligations that a startup has to deal with, sales tax can have the most impact on day-to-day operations.
This area of taxation is changing rapidly. Entrepreneurs should have a basic understanding of the issues and their obligations.
- What are sales and use taxes? Sales and use taxes are determined by state law. Most states impose a sales tax on the purchase of tangible personal property and some services. Tangible personal property includes most goods purchased and many business-to-business transactions. The burden of sales tax collection and remittance is on the seller.
Use tax is imposed on items that are used, but for which no sales tax was paid. Use tax relies on self-reporting and payments by the consumer instead of the seller.
- Who is affected by sales tax? Potentially any startup that intends to sell products or services could be affected. Forty-five out of 50 states and the District of Columbia have enacted statewide sales and use tax. The obligation for the seller to collect sales tax at the time of sale is determined by a business’ presence (the legal term is “nexus”) in a state.
Software companies, both those offering a product license and those providing their software as part of a service (SaaS), should pay particular attention to the rules and definitions adopted by each state.
The rapid growth in solicitation and sales online has caused several states to enact statutes that impose sales tax collection requirements on sellers even if they don’t have a business presence, as previously defined, in the state.
- Straightforward or complex? It’s a state by state issue, and the rules can be different in every state. (Googling sales tax + nexus generates >1MM hits.)
- Early Priority or it can wait? Entrepreneurs need to understand the potential implication of sales and use tax early on. These are considerations that can affect the business model, physical distribution plans, direct and Internet sales, and reporting and accounting, just to name a few. Sales and use taxes may impact your startup before federal and state income taxes do.
- How do I figure it out? Become informed enough to ask questions, then hire an expert for advice. Every state has a website where you can find information.
Research the requirements of the state where you are located and the states where you plan to sell. Gain a high-level understanding of the topline issues and terms, especially the concept of “nexus.” Then invest in a couple of hours with a legal or accounting professional who is experienced in dealing with entrepreneurs and sales and use tax implications. Have this discussion before you set up your website, engage your first sales partner, or begin selling to your first customer.
States attempt to expand the concept of “nexus” to make more firms and transactions subject to sales tax.
The dictionary defines nexus as connection. In terms of sales and use taxes, the term refers to the determination of whether a company has relationships in a state that would require that company to collect and pay sales tax on sales in that state.
The 45 states that assess sales tax receive about 25 percent of their total revenue from such taxes.
Sales tax revenue continues to slip away. And a significant contributing factor is Internet sales. (One SBA report estimates that more than $10B in sales tax was lost in 2012.)
States that tax Internet sales through sales and use tax statutes can require the seller to collect and remit the tax when the seller has a sufficient connection (nexus) with that state. Faced with declining revenue, states are attempting to expand the definition of nexus and increase the number of companies required to collect and remit state sales tax.
Prior to the explosion of Internet sales, nexus was fairly straightforward. A physical presence (e.g., storefront, warehouse, office), including employees working from home or even contractors, if they were soliciting business, created nexus.
Recently, however, many states have adopted “click-through” nexus laws that directly impact remote, out of state sellers. These laws could impact technology start-ups even if they do not meet the older physical presence test. For example, if your business maintains a website where customers can place orders, and you leverage affiliates that drive traffic and orders to your website, you may have created nexus for the state to which the order is shipped.
Most of the new click-through nexus laws have a greater impact on startups planning to sell product from their websites and software startups with businesses based on license or subscription (SaaS) business models. Such firms should contact an expert to help them navigate state sales tax requirements from day one.
However, for startups that have made mistakes by not collecting or paying state sales tax as they should, it’s never too late to come clean.
If a company finds itself in circumstances where they should have registered in a particular state and were obligated to collect and remit sales tax in that state, it’s usually better to approach the state than for them to approach you.
In fact, most states have voluntary disclosure programs under which the taxpayer will usually pay less penalty and interest by alerting the state. With most state voluntary disclosure programs, it’s usually best to have an experienced advisor reach out to the state anonymously on the company’s behalf and broker terms of an agreement. Occasionally states will announce tax amnesty programs that may offer even greater benefits.
During due diligence, sophisticated investors will consider the potential for unrecorded liabilities related to uncollected/remitted sales tax. The last thing an entrepreneur wants is to have an audit exposure or any hidden or unfunded liabilities when due diligence starts. Whether you are aware of the rules or not, If your company has sold in a state and not collected or paid sales or use tax, those obligations aren’t going to go away.
Keep an eye out for potentially more changes in this area, specifically additional states adopting click-through nexus laws, movement of the Marketplace Fairness Act in Congress, and the Streamlined Sales Tax Project.
It’s in the best interest of the business to talk to a sales and use tax expert and prepare to deal with these considerations up front, to register in a state if the company has nexus, and to collect and pay sales tax if and when it is owed.
Note: This is not tax advice, and is offered only as a commentary on non-specific circumstances or investments. We are not tax advisors. This discussion is based on current IRS publications. We recommend that entrepreneurs and startup companies always consult their tax advisor and attorneys on the specifics of their situations, any tax-related matters, or to learn more about the subject discussed in this article.