Most states require consumers to pay sales tax on the purchase of goods and many services. As your small business clients are aware, however, it may be hard to determine what rate of sales tax to collect in a given situation, especially when they deal with customers both inside and outside of their state and/or local taxing jurisdiction. A brief explanation of sales tax sourcing and nexus – the where and when of sales tax – can help you guide your clients through this situation.
Let’s first take a look at sourcing – the where.
“Sourcing” is the location at which your clients calculate sales tax. It is also called the place of the taxable event. The real importance of sourcing comes into play in states that apply county, city and/or district tax rates (in contrast to a single rate state such as Massachusetts, where the sales tax rate is the same 6.25 percent at every location in the state). Sales tax obligations at the local levels, in addition to the state level tax, add another layer of complexity when determining the proper sales tax rate for a particular transaction.
At a high level, there are two main types of sourcing, referred to as “destination-based” and “origin-based” sourcing. Destination-based sourcing means that a business charges sales tax at the place where the item is going, or the “ship-to” location. Origin-based sourcing means that a business charges sales tax at the place where the item comes from, or the “ship-from” location. Most states follow destination-based sourcing rules, but there are handful of states that follow origin-based sourcing. Those are listed in the sections below.
Let’s take a deeper look.
Destination-based sourcing is the most common method of sourcing intrastate transactions, and represents transactions that occur within a state – i.e., a transaction from Boston, Mass., to Salem, Mass. Again, with this method, taxable sales are sourced based on the location at which your client’s customer receives their product or service. This is referred to as the “ship-to” location.
Example: When your client sells a widget (a product), where does the final customer receive it? If they ship the widget to their customer’s home, the customer’s home address is where the customer receives the widget, and serves as the location of the transaction. Alternatively, if the customer picks the widget up at your client’s store, the address of your client’s store is where the customer receives their product, and that is the location of the transaction for sales tax calculation purposes.
If a state follows destination-based sourcing, it means that sales tax is collected based on the location of the purchaser. This has no effect on sales tax calculations in single-rate states because the tax rate is the same regardless of where a purchaser is located within the state.
Example 1: In Massachusetts, a single-rate state, the sales tax rate in Salem (6.25 percent) will be the same as the sales tax rate in Boston, or anywhere else in the state.
Example 2: In California, the sales tax rate in San Francisco (8.5 percent) is different than the sales tax rate in San Diego (7.75 percent), due to different county, city and district rates that apply.
For states that are not single-rate, you can see that the sales tax can become very difficult to calculate, as there are many local districts, cities and counties that have varying sales tax rates.
The thing to take away from these examples is to remember that just because the state rate is one set rate, local level jurisdiction(s) may be allowed to impose and require their own sales and use tax rates, too.
Origin-based sourcing, the less popular rule in the U.S., means that tax is charged at the “ship-from” location for intrastate transactions. In other words, sales tax should be collected based on where the seller is located.
Example: A business is located and ships from an address in Phoenix, Ariz. For any transaction, that business would charge all customers located in Arizona the sales tax rate of the Phoenix business address, no matter where the customer lives or where the item is shipping to. In other words, the rate charged would still be the rate in Phoenix, even if products were shipped to a customer in Sedona, Ariz.
The following is a list of origin-based states: