Sales and Use Tax Defined and Explained; a Guide for CPAs
Business owners are required to manage an overwhelming amount of regulatory compliance. Categories include everything from permitting to human resources, and that’s just the beginning.
Once a business starts to purchase equipment and sell goods, things get more complicated. At this point, both state sales and use tax come into the picture.
Both rank high on the list of the most confusing and time-consuming compliance components to manage, so many business owners turn to a CPA for help keeping it all straight. That means you need to both understand and be able to explain sales and use tax and how each one works to your clients.
Knowing the difference can be confusing, but this quick guide will explain both tax types in a way that will help you easily relay information to your clients. Let’s start with a basic definition.
An Introduction to Sales and Use Tax
Sales tax and use tax are both taxes on the sale of goods and services, but they have very different applications. These taxes are mutually exclusive, meaning at no time would both taxes be charged on the same sale.
Sales tax is the responsibility of the seller. When an item is sold, the customer is charged sales tax, which is a percentage of the sale price. Sales tax is usually calculated based on the gross sale receipt.
Business owners are responsible for accurately calculating tax on every applicable transaction, collecting sales tax monies, correctly reporting sales tax in nexus states on a pre-defined filing schedule, and remitting payment when taxes are filed. In case you're unfamiliar with the term nexus, it's a minimum connection to a state that requires businesses to report and remit sales tax to a state.
Use tax is the responsibility of the buyer. It’s required to be reported and paid by individuals and organizations who purchase over a certain dollar amount in goods without paying sales tax on those goods. In Virginia, use tax kicks in after $100 of purchases of taxable items that haven’t been taxed. In Missouri, the threshold is $2,000.
What types of transactions are not subject to sales tax?
- Purchases from an online seller located in another state (this is less common now that economic nexus allows states to collect sales tax on online sales)
- Purchases from an online seller who is not established as a business
- Purchases from an in-person seller who is not established as a business
- Phone or mail purchases from an out-of-state seller who ships a product to you
Now that you have a general idea of what sales and use tax are, let’s talk about some key similarities.
Sales and Use Tax Similarities
- Both apply to goods and services:
Sales and use tax are charged on purchases of all non-exempt goods and services. While some categories are typically taxed (ex; clothing) and others typically aren’t (ex; medication), what qualifies as non-exempt can vary from state to state. Details on what qualifies can usually be found on your state tax authority website.
- Both are impacted by taxes from multiple tax jurisdictions:
Part of the reason sales tax is difficult to manage is rates change by zip code. To accurately calculate sales tax, you have to add your state, city, county, and special taxes together. To further complicate things, some cities have special taxes - like a restaurant or cigarette tax. These are typically a flat rate added to applicable good or service transactions.
- Both are overseen by state tax authorities:
The department that handles tax regulation usually has a title related to financial management. In US states, tax authority divisions go by a variety of names; Department of Revenue, Comptroller, Department of Finance, Treasury, Board of Equalization, and Office of Tax and Revenue to name a few. Generally, this division is responsible for reporting the state’s own compliance via an annual review and for managing and processing business sales and use tax returns.
- Erroneous reporting on either can result in an audit:
Each state has an audit division, usually within their tax authority division, that’s dedicated to investigating tax compliance when business returns raise red flags. While sales tax frequently triggers audits, use tax is less likely to do so unless there’s a systemic issue within an organization - but both can be considered when determining unpaid taxes owed.
- Both can be affected by legislation:
After the South Dakota v. Wayfair Supreme Court case, the concept of economic nexus resulted in all kinds of new legislation making its way through state judicial systems across the country. As a result of that ruling, The Supreme Court deemed economic nexus constitutional but left it to states to decide where to set their economic threshold and how and when to enforce new legislation. In addition to state-wide legislation, local elections can sometimes result in the addition or repeal of special taxes that pertain to a specific city, town, or zip code. These taxes are often used to fund special projects like infrastructure or road repairs. Use tax isn’t often a focus because it isn’t as big of a moneymaker for states and it’s harder to enforce, but it is still governed at a state level.
Now that you've got the basics down, it's important to understand how these taxes affect your clients on a daily basis. Regardless of what kind of business they own, to legally collect sales, your clients must be registered in every state where they have sales tax nexus.
Brick-and-Mortar Business Owners
Business owners with a shop located in one of the 45 states that collect sales tax must report and pay sales tax to their home state (where the sale was made). The same holds true for businesses who sell online to customers in their brick-and-mortar home state.
If your client sells online to a customer in another state, they only pay sales tax to that state if they exceed their economic nexus threshold. This applies if they sell exclusively online and if they have a brick-and-mortar location in addition to inter-state online sales.
Use Tax Considerations
If your client rents items to customers, there’s a chance they're mishandling use tax. When an item is purchased to be rented, sales tax is charged on the rental. That means, if your client paid sales tax when they purchased the item, they likely shouldn’t have. Items that are intended to be rented out can be purchased tax-free by obtaining a license that allows you to buy items "for resale".
Audits Are Increasing Post Wayfair
States are passing new economic nexus legislation left and right in an attempt to increase revenues and make up for budget shortfalls. Also, in response to the explosion of online sales in recent years, many states are now going after businesses that are out of compliance. It’s essential for you to stay up to date on this issue and to keep your clients informed and compliant.
Helping Your Clients Stay Complaint
To help clients with compliance, you first need to understand what all their responsibilities are.
To be compliant, your clients must:
- Registering for a seller’s license in any state where they have to file taxes as soon as they have nexus
- Collecting sales tax at the correct rate for any state where they have nexus
- Setting tax money aside to remit with state tax returns
- Filing on time with all nexus states to avoid late penalties
- Knowing, understanding, and keeping up with nexus and sales tax legislation
- Anticipating when economic nexus thresholds will be met and being prepared to be register and file in states with new nexus to avoid penalties
Considering the increasingly complex landscape of tax legislation, a knowledgeable, up-to-date tax advisor is becoming a necessity for many business owners - which is good news for you! To earn their business, you need to make sure you're well-informed when it comes to sales and use tax applications and are ready to explain how you can help with burdensome compliance issues.