9 Signs Your Clients Have Sales Tax Compliance Risk
With over 10,000 jurisdictions that levy sales and use taxes in the United States -- 14,500 if you include special-purpose tax districts -- big and small retail clients alike may not be aware of their tax obligations, especially if they sell goods online.
To help you guide your clients, here’s an overview of nine areas most likely to pose sales tax compliance risk:
1. Brand New Compliance Requirements – Each year, entirely new sales tax requirements or exemptions are enacted, and a sheer lack of awareness due to the newness of tax policies can lead to sales tax compliance risk. These can relate to changes in tax rates, taxation amounts, product taxation, tax boundaries, exemptions or the application of amended or newly enacted (and controversial) sales tax laws.
It’s important to assist clients with keeping track of the new compliance regulations going live each quarter, as well as significant court cases and federal sales tax bills that can have sales tax implications. For example, there are currently four pieces of federal sales tax legislation being considered that would have significant impacts on sales tax policies across the country.
2. A Merger or Acquisition – Any time your clients’ businesses grow, there can be a slew of potential changes due to restructuring, relocation of operations, or other changes. Even before the merger or acquisition is complete, the due diligence process may reveal nexus, and potential sales tax exposure, in unregistered states.
It’s almost certain a merger or acquisition will lead to significant changes to their tax profile. Your clients will need help re-evaluating their new nexus, exemptions, product taxability, and taxation processes or software.
3. Online Sales – Selling and shipping goods across state or country lines raises the risk of running afoul of local sales tax regulations. State and local taxes are varied and detailed, and must be properly applied to the transport of goods or online sales.
A business’ online store must be prepared to apply the proper tax rate (including the proper combined state and local rate) for online transactions involving taxable products. This can be significant especially for micro and small businesses as they are the most likely to have inadequate software or underdeveloped sales tax collection processes.
In addition, companies must comply with a state’s origin sourcing practices in states where these apply. Although most states determine sales tax based on the destination of an online sale, nine states, instead, use a "point of origin" rule.
4. Exemption Certificate Management – Businesses need to focus on their exemption certificate policies, for instance, determining when exemption certificates are collected at the time of sale or during their new customer onboarding process. Because a sales tax audit will commonly include a review of a company’s exemption certificates – especially if exempt sales are often reported on returns - it is advisable to ensure that someone in your clients’ businesses evaluates exemption certificates for accuracy, completeness and length of time a certificate has been on file as some states require that exemption certificates be renewed periodically.
The time is well spent! An audit could easily turn many “exempt sales” into taxable sales and additional tax liability if the exemption certificate is incomplete or missing altogether.
5. Keep up With Use Tax – When assisting clients with use tax compliance there are two issues; a client’s requirement to collect vendor’s use tax on sales to out-of-state customers and their requirement to self-assess use tax on their own purchasers or where they convert inventory or other business goods to personal use. For instance, an out-of-state client may have nexus in a state due to having inventory stored in a state but no in-state retail location.
In some states the out-of-state seller collects use tax (not sales tax) on sales to customers in that state. A business that withdraws goods from inventory for its use or as a promotional give-away is required to self-assess use tax on the inventory.
This could easily occur by simply taking office supplies on which no sales tax was paid for employee use, or by using inventory in displays or as product samples. As with exemption certificates, if no record is kept of that the business has self-assessed and paid use tax on these items, an auditor will likely assume no tax has been paid.
Businesses should be warned because states are now increasing audit activity in an attempt to increase revenue by collecting consumer use tax.
6. Business Dealings – Your clients could create nexus for themselves, unknowingly, through their business dealings, and be at risk for back taxes or penalties if they do the following:
- Participate in tradeshows.
- Use manufacturer or independent sales reps to solicit sales.
- Work with out-of-state freelancers.
- Conduct online marketing or advertising in a different state.
- Use a data center or an inventory warehouse, even if it’s a third party’s.
- Work with out-of-state business marketing affiliates or resellers who are compensated for referring sales to the out-of-state business.
Many states have passed sales tax laws requiring businesses with marketing affiliate relationships in the state to collect taxes. These laws are often referred to Amazon laws and are modeled after New York’s Amazon law – the first such law in the country.
Your clients should also be aware that any changes to sales territory, distribution strategy, new warehouse usage or new marketing strategies can create new nexus for their business. Sometimes the internal corporate tax or accounting professionals may be the last to know about some of these business changes with potential nexus impact. It’s important that the corporate professionals charged with sales tax responsibilities also be kept up to date on business and strategy changes.
7. Regular purchases of technology – Whether it’s buying hardware, software, or technology services, they all can be a sign of compliance risk. Technology vendors often provide services and products through a remote connection via the internet.
In addition, clients should review software contracts, licenses and methods of delivery to determine taxability and confirm that taxes were appropriately paid. For instance, software downloaded from the internet and Software-as-a-Service (SaaS) programs, are taxable in some states, but not in others.
The taxation of software and related products, including SaaS, is one of the hottest topics for state tax administrators as they struggle to apply outdated laws to newer technologies. Clients that purchase or sell software and other technology related products need to stay up to date on developments in this area.
8. Supply Chain and Vendors – It can be challenging for manufacturers and distributors to manage their transactional tax compliance, so clients could be unclear as to whom in the supply chain is responsible for paying taxes and how that person should be properly documenting it all. It’s a good idea to have open discussions with all members of the supply chain to ensure compliance. The sales tax rules relating to drop ship transactions are some of the most complicated ones to understand.
Because drop ship transactions always involve at least two transactions - one of which is a sale for resale – these complex rules can impact which party is responsible for the tax collection and whether the reseller’s exemption certificate is acceptable. For this reason, drop shipments can be a sign of compliance risk for your clients.
The use of drop shipping adds an additional layer of complexity to their sales tax obligations, thereby increasing the risk of errors. Ensure your client has a process in place to ensure tax is paid by one of the three parties for every applicable sale: your client, the drop shipper or the customer. And if your client is the reseller in the drop ship transaction, make sure they understand the exemption certificate rules in their customers’ states.
9. Previous Audits – If your clients have previously been through an audit, it is likely they haven’t addressed all the previous issues, or that they do not have the proper compliance checks in place. Begin by assessing the previous compliance issues that triggered the audit: does this signify a weakness in oversight, process or something else? Encourage your client to take sales tax compliance seriously, as negligence penalties can be 10% to 30% of the tax due.
Industries with Greater Compliance Risks
Generally speaking, the nature of certain businesses exposes them to more compliance risk than average. Manufacturing, large retailers, e-commerce sellers, digital goods and services (software, music and marketing consulting), and medical or healthcare businesses all have a greater chance of violating sales tax laws.
If you have clients in these industries, offer to help them carefully assess their possible compliance risks.
Sylvia Dion, CPA is the Founder and Managing Partner of PrietoDion Consulting Partners, a State & Local Tax (SALT) Consulting firm providing comprehensive tax services to U.S. and International businesses.