3 Key Sales Tax Questions for Aspiring E-Commerce Businesses
Creating and building an e-commerce company means delving into many new frontiers â warehousing, fulfillment, shipping, and payment processing, to name just a few. Unfortunately, the dry, convoluted world of taxes is a must-do as well, even before you make a profit. Put simply, if your e-commerce business generates $3 million in revenue in its first two years, would you like to: a) pay six figures in back taxes and penalties, or b) keep as much of your hard-earned revenue as possible?
If you choose âb,â this tax playbook will help you navigate the United States' 9,998 sales tax jurisdictions and their eccentric, conflicting rules. By asking three questions about your business, you can identify some of the potential snares and prepare for that day when you are making money and need to share it with the government.
1. Where is Your Team Located?
Unlike brick-and-mortar retailers that need staff in physical stores, e-commerce startups can employ their staff virtually anywhere. However, a little-known fact is that virtual employees create nexus (a sufficient physical presence) wherever they live, regardless of where the rest of the business is located. This means that you must register to pay taxes in those states.
Some companies try to skirt this obligation by hiring team members as contractors. If your so-called âcontractorsâ have defined work schedules, use company resources, and have no other clients, the IRS and the government will define them as employees â and your ploy will backfire.
If your virtual employee creates nexus in a state, you will be accountable for the full gamut of taxes: income, sales, franchise, payroll, unemployment, and obscure local taxes. This may subject your company to bizarre rules.
For example, let's say your e-commerce company sells food gift baskets and you have a virtual employee in Illinois. The âLand of Lincolnâ imposes a 5 percent sales tax on candy, but not if that candy has flour in it. Yes, if you put chocolate-covered nuts in a gift basket, they will be taxed at 5 percent. If you put chocolate-covered pretzels in that same basket, they will not be taxed.
2. What Do You Plan to Sell Online?
When companies began selling goods and services online, state tax systems were blindsided. A 100-year-old tax system designed around tangible goods and services had to catch up with the world of intangibles. No one had a definition for electronics goods, let alone standards for how to tax them. Are you paying for a) the service to develop these intangible items, or b) for the function these items deliver â the ability to control the operations of computers and electronic devices? Different state legislatures went in different directions. Depending on what you sell online and how you sell it, your tax exposure can vary across state lines.
In New York, for instance, prewritten computer software is âtaxable as tangible personal property,â according to the state Department of Taxation and Finance. In comparison, custom software is not taxable because you are paying for the service of developing the software, âprovided it is designed and developed to the specifications of a particular purchaser.â Make sense? Probably not. Florida has a more straightforward approach: no sales tax on any digital goods.
Software has its snares, and so does paid content, a growing segment of e-commerce. For example, Colorado says that âmonthly newspapers and magazines delivered electronically are subject to sales tax,â while New York exempts electronic news services from paying sales tax. If you sell an innovative mobile app that displays premium news content, are you selling prewritten software or a news service? Should it matter whether news content is delivered electronically or printed on an old-fashioned newspaper?
The point is that in any state where you establish nexus, your product might be subject to different taxes. Even warranties and additional add-ons are taxed differently. If you try to track tax exposure manually, mistakes are inevitable.
3. Are You FBAware?
If you sell physical goods, the nature of your contract with a fulfillment agency determines whether you create nexus in a state or not. If you retain ownership of the goods while they are stored in a warehouse, you establish nexus in the tax jurisdiction where that warehouse is located. In contrast, if the fulfillment agency owns the goods, and you simply pay for shipping, the arrangement does not create nexus.
This distinction is crucial if you sell via Amazon. Some e-commerce companies use Amazon as a shopping front â their goods are never stored in Amazon warehouses. Companies that use Fulfillment by Amazon (FBA) do store their goods in Amazon warehouses and do create nexus in each location.
While using a wide network of warehouses can speed up delivery and lower shipping costs, reporting in 28 states will subject you to more tax requirements and create more opportunities to mess up. Keep in mind that Amazon has warehouses in two states that do not collect any sales taxes: Delaware and New Hampshire.
Plan on More Sales Taxes, Not Less
Unlike brick-and-mortar businesses that pay taxes on every sale, e-commerce businesses only pay sales tax in states where they have nexus. This duty-free era of e-commerce will come to a close when Congress passes a sales tax bill in the near future.
Therefore, do not factor tax-free sales into your business model, but don't worry about complex sales tax obligations either. With tax automation software, collecting sales tax in 10,000 jurisdictions is no harder than collecting in 10.
Regardless of how tax laws evolve, assume that every state is a special case, just like every child that 25-year-old might raise. Unless memorizing tax codes is your guilty pleasure, be prepared to ask the right questions and spot the snares that may otherwise make success bittersweet.