By Ned Lenhart, MBA CPA
When it comes to state sales tax, I’ve been told by many CPAs that they feel completely inadequate in responding authoritatively to client questions and would almost prefer if their clients did not even ask them about sales tax. In most tax engagement letters, sales tax is not mentioned at all or it is specifically excluded from the engagement. Despite every effort CPAs may take to avoid having to deal with sales tax, your clients still view you as their ‘tax expert’ and are expecting you to have conversational expertise about sales tax. Many CPAs freely admit to me that they “don’t know what they don’t know” about multistate sales tax. Even if your focus as a CPA is not tax, your client’s failure to understand and be in compliance with their sales tax obligations could lead to material understatements of liabilities on their balance sheet.
Commerce Sales Tax Risk
In the world of sales tax enforcement, states are laser- focused on identifying companies that remotely sell property into the taxing state but do not collect sales tax on the sales. For years, their attention was focused on Amazon.com, but Amazon is now registered and collecting sales tax in about 35 states so the states have shifted their attentions elsewhere. There are, however, thousands of other e-commerce businesses selling through their own websites or through the Fulfillment by Amazon (FBA) program. Some of these retailers are small but others are quite large. These companies are the focus of state auditors and investigators and some of these companies may be your clients. Once identified and contacted by a state, these companies may have few options for responding in a way that limits their liability. For unregistered businesses, there is no statute of limitations since no returns have been filed. States are permitted to assess back tax, interest, and penalties against businesses for as long as they have had nexus in their state. The concept of nexus is the focus of the remainder of this article.
What is Nexus?
For most CPAs, it is sufficient for you to know that nexus is the term used by the states that refers to the legal connection between a company (your client) and a taxing jurisdiction. Before a state can make any valid tax assessment for delinquent sales tax against a taxpayer, the state must first prove that the seller has nexus with the taxing state. To keep matters simple, the state and federal courts have pretty consistently held that nexus is established any time an out-of-state seller has a material physical presence in the taxing state. At this point I can’t over- stress that your concept of a ‘physical presence’ is not likely the same as the state’s concept of a ‘physical presence’. In this situation, the state’s interpretation prevails! Here is just a sampling of what most states consider to create a physical presence in their state:
- Having employees visit the state 2 or more times per-year,
- Owning any property or inventory located in the state for any period of time,
- Renting or leasing equipment or property in the state,
- Having employees live in the state,
- Performing any type of service in the state,
- Having independent sales agents in the state for more than 2 days per year,
- Delivering property into the state on company vehicles, or
- Having independent agents in the state performing service on the seller’s behalf.
For most remote sellers, the bulk of these activities exist only in their ‘home state’, which is the state where the company is domiciled. In these cases, the seller is only obligated to collect tax on sales of property shipped to customers located in their home state. Sales of property shipped to customers in other states are probably not taxed by the seller because they don’t have any of the physical presence attributes described above. In these situations, the purchaser is obligated to pay ‘use’ tax directly to the state. For individual purchasers, this never happens. As a result, state revenue officials claim they are losing $20 billion per-year in sales tax revenue as a result of the taxpayers’ failure to remit tax. The states need this revenue and are pursuing any and all efforts to recover as much of this lost revenue as possible. Their preferred method of recovering this tax is by auditing and assessing back tax against companies that have nexus in their state but have not collected the tax. In some cases, this may include some of your clients.
Economic Nexus Theories
The states are greatly frustrated by what they consider to be the ‘out-of-date’ nexus rules listed above and are beginning to take matters into their own hands. Given the advancements of electronic commerce and the virtual nature of retailing that makes up about 10% of the U.S. economy, many states legislatures have either adopted or are considering adopting their own nexus rules based on the seller’s “sales volume” in their state and not the seller’s physical presence in their state. These sales volume nexus rules are commonly referred to as ‘economic nexus’ rules. For example, the state of Alabama deems any business with $250,000 of annual sales to customers in their state to have nexus and requires them to register and collect tax. That is, if your client has $250,000 of sales to Alabama customers in any calendar year, it has nexus in the state and is obligated to collect tax even if it has never sent a single employee into the state and has none of the nexus factors noted above. Further, the state of Alabama has already filed a law suit against Newegg Technologies for its failure to register and collect tax under this rule and is aggressively pursuing other companies who are not in compliance with this law. A listing of other states that have some form of economic nexus is found at the end of this article.
The legality of these economic nexus rules is questionable under the current legal standards, but the states have been forced to take these dramatic steps to collect revenue. The Newegg Technology case is being litigated and all parties expect this case to eventually come before the U.S. Supreme Court. If the Supreme Court finds that these economic nexus theories are valid, then each state that has a similar rule in place at the time the Court makes this determination will immediately enforce its law retroactively to the point that it became law, and every state that does not have an economic nexus rule will quickly adopt one. That would be the end of the ‘physical presence’ nexus standard that has existed for almost 50 years. As such, if your clients meet or exceed the economic thresholds in these states and are not collecting and remitting tax, then they could be subject to tax, interest, and penalties for as far back as they had economic nexus in the state. Since most of these laws are only a couple of years old, the liability in any one state may not be that significant. However, if 20 or 30 or 40 states put these economic nexus rules on their books and your client exceeds the threshold in many of these states, the total risk to them could be catastrophic. If the states win on this issue in court, they will have no mercy on out-of-state sellers when it comes to enforcing the law.
Fulfillment by Amazon (FBA)
Amazon.com sells property that it owns and property that is owned by third-party retailers. E-commerce sellers that want to leverage the virtual reach of Amazon.com website and the fulfilment capabilities of Amazon’s distribution facility network can participate in what is called the fulfillment by Amazon (FBA) program. Most typically, FBA participants arrange for inventory to be shipped to one or more of Amazon’s distribution facilities as instructed by Amazon. Amazon also has the ability to move property between distribution centers as it sees fit to meet the anticipated fulfillment needs of the seller. FBA participants must meet strict obligations for maintaining the accuracy of the products listed for sale on the Amazon website. Amazon charges a fee for these services that can range from 6 percent to 20 percent depending on the type of property sold on the Amazon.com site.
In talking with many FBA sellers, the topic of nexus naturally arises. Without exception, these sellers say that they only have nexus in their home state because that is the only state where they have any physical presence. But is that really true? The primary feature of using the FBA program is to have Amazon pick and ship the seller’s property which is stored in the Amazon warehouse. In order for the entire FBA program to work, sellers must have inventory (property) stored in the states where Amazon has distribution centers. There are currently 24 states where Amazon has distribution centers. That means that the FBA seller (your client) may have property located in one or more of the states where Amazon has its distribution center. As noted above, sellers that own inventory in a state have a physical presence for sale tax and income tax in that state. As such, to the surprise of these FBA sellers, they have nexus in these states and, accordingly, a sales tax collection and remittance obligation in each state where they have inventory located in an Amazon distribution center.
The Amazon.com seller’s portal has detailed information about the movement of property into and between Amazon distribution facilities so the sellers have visibility to the location of property and the dates that the property was in the state. The states also have access to this information by working with Amazon to get a list of companies that have property located in one of the Amazon warehouses. California and Washington have already been contacting companies about their participation in the FBA program. Companies are scrambling to understand what future and historical sales tax obligations they have connected with the FBA program.
Not only do FBA sellers have a future obligation to collect and remit sale tax in the states where the seller has inventory, the FBA sellers also have a historical liability for all the tax that should have been collected but was not collected for as long as they have had property located in these distribution facilities. As noted above, state revenue officials believe they are losing $20 billion a year in uncollected sales tax. The goal of these revenue officials is to collect as much of this lost revenue as possible. If these FBA sellers are identified by the state sales tax auditors, the state where the property is located is within its authority to assess the FBA seller sales tax on all the back sales made to customers in their state, regardless from where the sale originated. Further, states will also assess late payment and failure to file penalties and interest in addition to the tax. To make matters even more significant, foreign states can legally and fully enforce these tax assessments against companies domiciled in other states. These assessments can be enforced against the business assets and the assets of the owners and officers.
If you think you can reorganize your business to avoid these historical liabilities, please think again! Almost every state has rules related to ‘successor liability.’ That is, the successor to any business asset previously owned by a company with a large sales tax liability becomes liable for the tax due by the predecessor company. This is true if the business is sold or is just reorganized. If assets of the company that has a tax problem are transferred or sold to another entity, the new entity or new owner inherits some or even all of the sales tax problems of the old company. In short, once a sales tax problem exits, it’s almost impossible for it to go away.
State sales tax represents about 45 percent of total state revenue. With pressure to lower individual and corporate income tax rates, states are forced to place more reliance on sales tax as the major driver of state revenue. States are increasing sales tax rates, expanding the base to include more services, removing exemptions, and increasing enforcement efforts against noncompliant companies. Many state revenue departments have offices outside of their home state so that auditors are closer to the businesses they audit. The ability of non-resident companies to avoid detection and audit by state revenue officials is becoming more challenging and once these companies are caught in the state audit dragnet, it may be too late to take any measures to reduce the tax liabilities. As CPAs, your clients expect you to have some level of knowledge about sales tax. You don’t need to be an expert, but your clients do expect you to know an expert or know where to get assistance. Using the rules outlined above about physical nexus and economic nexus and the FBA program, you should be able to have some elementary conversation with your clients about these issues. If you have any questions or believe your clients may have deeper issues to evaluate, please contact me at email@example.com for a free 30 minute discussion about your client’s situation.
Economic Nexus states:
The following states have either adopted legislation or regulations imposing some sort of economic nexus theory or are considering such a change as of this time. Each state rule is different and must be evaluated individually. Such an analysis is beyond the scope of this article.
Alabama, Arkansas, Georgia, Kansas, North Dakota, Pennsylvania, Rhode Island, South Dakota, Tennessee, Vermont, and Wyoming.
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