Small Business Sales Tax Basics: Sourcing and Nexus
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:
|California **||New Mexico||Texas|
** California is unique because it is a modified origin state. The state, county and city taxes are based on the origin (the ship-from address), but district taxes are based on the destination (the ship-to address).
Under the Constitution of the United States and several precedents set by Supreme Court cases over the years, transactions that occur between locations in two different states are sourced to the destination location.
Example: When a widget is sold by a Rhode Island business to a customer located in Iowa, the Rhode Island business would calculate and collect sales tax based on the location of the customer in Iowa, BUT only if the Rhode Island business had an obligation to collect sales tax in Iowa. This obligation to collect revolves around a second concept called nexus, which is addressed a little later on in this article.
Sourcing Services: How is it Different?
What if your client’s business sells services? Good question. Products and services may be sourced differently, depending on the nature of the transaction. For example, a landscaping company that has a business address or storefront location may actually source their services using their customers’ home address, otherwise known as the job location for a landscaper. In most states – and for most, but not all services – the sourcing location used for tax rate calculations will be the ship-to location. Again, this is the location at which the services, such as lawn mowing or snow plowing, are performed. This is generally true regardless of whether the state itself is an origin-based or a destination-based state.
Of course, some states have special rules regarding the sourcing of service-based transactions, such as New Mexico and Texas.
Example: Texas is generally an origin-based state for both products and services, except for a few enumerated services, where the tax is calculated at destination. This enumerated list is very small and only includes three to four services, such as nonresidential real property repair and separated contracts for new construction, or residential repair and remodeling.
Sourcing can sound pretty scary. Automating the calculation of sales tax with QuickBooks® Online takes away some of the guesswork. QuickBooks Online understands the details of your client’s sales transactions and calculates sales tax using the appropriate sourcing rules, which are based on what they are selling, who they are selling to and the location in which they are doing business.
Let’s move on to the other half of what your clients have to consider, which is nexus – the when.
“Nexus” is when the business has activity or presence within a state that triggers a seller’s obligation to collect and remit sales tax. Historically, the most common type of nexus was physical presence. In other words, it’s the location of your business within a state via a store, sales people and more.
This past June, however, the Supreme Court’s ruling in South Dakota v. Wayfair changed the sales tax landscape as it relates to businesses that sell online and remotely, including small businesses. The Court ruled in favor of a South Dakota law that requires any out-of-state seller that delivers more than $100,000 of goods or services, or has 200 or more transactions in South Dakota, on an annual basis across any platform, to collect sales tax on sales located in the state. What changed the landscape is that this ruling overturned the longstanding physical presence rule set out in Quill Corp. v. North Dakota in 1991 and set the foundation for all other states to enact similar remote seller laws, which those states have been doing very quickly. To date, more than 20 states have either recently enacted economic nexus laws for remote sellers or will be enacting laws over the next year. Check out this link for a handy list outlining economic nexus rules state by state.
What’s the big deal? History. In the past, most remote sellers did not need to be concerned with whether they were required to collect sales tax on a transaction in situations where their product was shipped into another state in which they had no physical presence. The new economic nexus rules in a variety of states have changed this. Looking forward, small businesses that meet the economic nexus requirements under state law will need to collect sales tax from customers in states in which they have no physical presence. Note that many states are enacting economic nexus laws for remote sellers that parallel the language of the South Dakota law litigated in South Dakota v. Wayfair. While many small businesses may not meet the $100,000 in sales threshold, they may more easily have 200 or more transactions into a state and, therefore, be required to follow the new rules.
Economic nexus requirements can cause a high level of difficulty and complexity for small business owners who do not use an automated solution for calculating sales tax rates in locations outside of where their business is located. Without an automated solution, a remote online seller that meets economic nexus thresholds in multiple states will have to track the current sales tax rates for all of the states, and potentially hundreds of locals within all those states in which they do business. That means that every time a sale is made, the seller will need to determine the purchaser’s city and state of residence (based on mailing address), and use that information to calculate the sales tax due on each sale. Additionally, once the sales tax is collected, total sales will need to be reported to the appropriate state and local jurisdictions, and the amount of sales tax that has been collected must be remitted to each state individually. Reporting and sales tax payments may be due as frequently as once per month.
If a business wants to avoid the hassle of figuring out sales tax and all of the nuances we have described, solutions such as QuickBooks Online can automatically calculate sales tax for your clients, saving them time. This time can instead be spent running the business.
Automated sales tax calculation and filing solutions, such as those inside QuickBooks Online, can help manage the nuances of sales tax laws, reduce the risk of error and minimize the likelihood of a sales tax audit. QuickBooks Online not only provides automated calculations, but also provides tax categories, which can be assigned to individual products and services so businesses can be sure sales tax is accurately calculated to the line item – when it should be and how it should be. Whether a business sells coffee beans or t-shirts, or provides traveling barbering services, QuickBooks Online has it covered.