The True Cost of Sales and Use Tax Non-Compliance
In a best-case scenario, the cost of Sales and Use Tax (SUT) non-compliance may add up to a few hundred dollars in fines. In a worst-case scenario? Penalties, fees, back taxes, and potentially even litigation damages can devastate a business.
Let’s look at all the potential non-compliance penalties businesses can face and talk about mitigation strategies your firm can use to help soften the blow.
A business is considered ‘non-compliant’ with sales and use tax regulations when they neglect to collect and remit tax in states where they have established nexus. Before 2018, nexus was relatively straightforward to manage, as physical presence was the primary factor businesses needed to consider when determining where they owe tax. However, when the passage of South Dakota v. Wayfair in 2018 introduced the concept of 'economic nexus,' remote sellers everywhere became suddenly liable for managing tax obligations in a lot more jurisdictions.
Not only did this decision open up a lot more tax triggers, but it also made nexus significantly more complex. With economic nexus at play, businesses need to be aware of how they’re tracking economic nexus triggers in every single state - as well as in some county and local jurisdictions. Each state can set its own rules and regulations for managing SUT, making navigating rules for remote sellers a very daunting task. As a result, many businesses have shrugged their shoulders, unsure of where to start.
What Happens When Businesses are Non-Compliant
States make a lot of money on sales and use tax and are deeply motivated to collect any unpaid tax – especially in the wake of the economic devastation caused by COVID. SUT is a massive state income driver, particularly since the passage of South Dakota v. Wayfair, as that ruling opened up a significant new revenue stream.
From a timing perspective, there’s currently a big push for states to start going after the money they're owed. Most states have a three-year audit period when conducting a sales and use tax audit. With the close of 1Q-2022, the three-year audit period under South Dakota v. Wayfair (June 21, 2021) is now applicable. As a result, states are gearing up for a big audit season, and they’ve got their crosshairs on businesses that have been non-compliant with remote seller tax laws.
Lots of sates have been sending out nexus questionnaires and audit requests to businesses that landed on their radar for tax non-compliance. As a result, any business concerned that they’ve met or exceeded thresholds needs to act fast to avoid hefty penalties.
Understanding the Value of Voluntary Disclosure Agreements
Many states have a safety net available to businesses in the form of a Voluntary Disclosure Agreement (VDA). Businesses and their accountants can use this tool to voluntarily come forward and ‘admit’ to their non-compliance.
It's a bit like debt consolidation in that, in many circumstances, states will settle on a lower penalty in exchange for the business proactively attempting to 'settle up' their unpaid tax. The issue is that as soon as the state has contacted a business, it is no longer eligible to submit a VDA. So, if any of your clients are knowingly non-compliant with remote sales tax, now is the time to get those VDAs submitted.
Potential Non-Compliance Costs
Businesses that fail to submit a VDA in time may face significant penalties. For example, let's say a company had $300,000 in sales in Arizona in 2021, a state with an economic nexus threshold of $100,000 – and the business neglected to collect or remit any of that tax. Arizona has a state sales tax of 5.6% and allows local governments to collect a local option sales tax of up to 5.3%, resulting in as high as a 10.9% cumulative tax rate. Right out of the gate, this business owes the state of Arizona a minimum of $17,400 in unpaid tax – possibly more, depending on which jurisdictions they sold into. And that's just the beginning.
Arizona is also tricky because the state changed its economic threshold three separate times. The original threshold, issued in 2019, was $200,000. In 2020, it was reduced to $150,000. In 2021, it was reduced again, down to $100,000. These thresholds trigger nexus for being surpassed in either the current or previous calendar year. That means each year between 2018 and 2021, more and more remote sellers triggered nexus in Arizona.
Additional penalties and fees also add up for a variety of other issues; failing to register with the state, late and nonpayment of SUT tax, and interest on nonpayment, to name a few.
Here’s what those penalties can look like:
- Failure to collect, remit, and file: 10-25% of the tax amount, with a max of 25%
- Interest on tax not collected and remitted: average of 7-9%, but some go as high as 18%
- Penalties for multi-year non-compliance: up to 40%
As you can see, it doesn’t take long to accumulate a hefty back tax bill, and it can get worse.
Long-term Non-Compliance Can Result in Lawsuits and Civil Penalties
If a business neglects to collect tax in states where they triggered nexus long-term, they may face civil penalties. Also, if a company collects tax but doesn’t remit it to the state, it’s an even bigger issue, as that’s considered civil fraud at a minimum and possibly criminal fraud.
Companies that are non-compliant for multiple years and that make no effort to remediate the issue or are non-responsive to efforts from the state to set things right can end up being served and sued. If this happens, penalties can be as much as three times the tax bill in damages, on top of your total back taxes.
There are also bottom-line considerations companies need to make. If accountants are doing their jobs effectively, unpaid SUT tax will show up as liability contingencies in financial reports and audits. These liabilities can reduce a company’s valuation and make it less attractive to potential investors.
The Best Path Forward
As you can see, SUT non-compliance is no joke. With all these possible not-so-attractive outcomes on the table, it’s in the best interest of every single business to understand their nexus obligations, submit VDAs where applicable as soon as possible to mitigate damages, and move forward with a solid compliance plan. For some, this may mean adjusting prices to make more room in their margins to remain profitable or making other changes to reduce overhead to absorb increased costs without negatively impacting their bottom line.No matter what a business’s situation is today, establishing and maintaining compliance is the only way to ensure long-term success. Your firm can help by offering SUT advisory services, performing proactive nexus studies, identifying key areas of risk, offering compliance scores, and assisting clients with taking all the necessary steps to meet sales tax obligations. This can include managing state registrations, filing VDAs, negotiating reduced penalties with the state on behalf of your client, and possibly even offering audit support if the client comes to you after the damage is already done.