Revisiting The Online Sales Tax

States are looking for revenue. Soon you may be providing it.

In 1998, Congress passed a moratorium on the collection of new taxes on e-commerce entities by state taxing districts. While the moratorium was specifically for new taxes on Internet Service Providers (ISPs), the debate has overflowed into a heated discussion about states’ rights to tax all goods and services sold online. The rationale for the moratorium was that this nascent industry needed a helping hand vs. an onerous burden in navigating the complexities of 7,000 state and local sales taxing districts. The moratorium was extended in 2001 and expires November 1, 2003. The hot question is whether the moratorium will be extended again and, if not, will online entities be subject to new state and local taxes.

The Background
The battle between a company’s right to sell beyond its state borders vs. the state’s right to collect sales and income taxes has been fought throughout the court system for years. Essentially, the courts have maintained that a company should not be taxed by a foreign state on sales to its residents if a company has no substantial presence or “nexus.” This is a violation of the commerce clause of the U.S. Constitution. However, the meaning of “nexus” has never been clearly defined, subjecting it to interpretation by individual state and federal courts. Generally speaking, if a company has legal status, premises, inventory or other assets in the state, it has nexus. Whereas if it merely has a salesperson who lives in the state and travels to other states within a sales territory, this generally does not constitute nexus, unless the salesperson maintains inventory in his home, repairs equipment, or performs other related services. Likewise, a computer which houses a website does not, in and of itself, constitute nexus. If a business has nexus in the state, it is responsible for the state legal and tax filings, including collecting sales tax on sales to the state’s residents and filing income tax returns.

As existing retailers developed their online retail operations, they incorporated new online companies as a separate subsidiary to minimize their nexus status.

While brick and mortar retailers have always collected sales tax (where required), catalog companies and other firms which ship across state lines collect sales tax in only those states where they have nexus. For example, if a welding distributor sells and ships an arc welder to any state where the distributor has a branch or fill plant, the distributor must collect sales tax. If the distributor ships the welder to a state in which they do not have nexus, no sales tax is required. In this case, it is the buyer’s responsibility to report and pay use tax on the purchase of the item. Note: Many states ask taxpayers to include use tax on income tax forms for items they bought from out-of-state retailers.

As online retailing gained steam in the late 1990s, the previously muddled issue of cross-border sales tax collection became even messier. While shipping a product to a physical address remained analogous to a catalog sale, downloading a piece of software for 100 PCs in multiple states proved too difficult to conceptualize the sales tax implications, much less implement and enforce. So with huge lobby support from the technology industry and against the warnings of the states and other tax paying retailers, Congress passed the Internet Tax Freedom Act.

The Battle
As existing retailers began to develop their own online retail operations, a.k.a. “Bricks ‘n Clicks,” they incorporated new online companies as a separate subsidiary so as to minimize their nexus status. Thus, Wal-Mart, Target and Toys ‘R’ Us began selling online without collecting sales tax in states where their “bricks” company had nexus status. In addition, many of these stores allowed customers to pick up and return their online purchases at their local store. Well, this was simply too much for the states to handle.

Shackled with billion dollar deficit budgets and the loss of several billion dollars in sales tax revenues due to online retailing, 37 states threatened major retailers for years of uncollected sales tax. The states claimed that these retailers were masking substance with form, i.e., that the retailers’ separate incorporation of their online companies was constructed solely to evade collecting sales tax, and therefore the retailer should be viewed as one entity, with nexus. In order to prevent the states from pursuing their fight and asking for prior year collections, a group of ten major retailers agreed in February to begin collecting sales tax on all online purchases where the companies have nexus.

What Does This Mean to Our Industry?
A lot has changed since 1998. The nascent online retail sector is now over $79 billion, and the technology “honeymoon” is over. States are racking up billions in deficits. The major retailers were accused of scheming to avoid charging and collecting tax. In addition, many surveys have shown that the effect on consumer demand after implementing sales tax collection has been minimal. Furthermore, 33 states have agreed to a streamlined sales tax collection system to be implemented in 2005. Certainly, the weight of the evidence currently points to the elimination of the moratorium.

33 states have agreed to a streamlined sales tax collection system to be implemented in 2005.

Even if the moratorium is lifted, however, there is no immediate impact. But one point is clear: States are looking for revenue and they will be auditing those companies not collecting sales tax that have a presence in their state. Online retailers in our industry would be wise to begin implementing a sales tax process within their “online check out” procedures for all states they have nexus in. If you have questions concerning nexus, see your attorney. Within these states, you must collect sales tax based on the location of the buyer.

In order to determine the correct amount of sales tax to charge, you will need to subscribe to a sales tax collection service.A list of service providers may be found at http://www.taxsites.com/software.html. These services will update your tax database (for 7,000 jurisdictions) and provide the forms for filing with the affected states.

It remains to be seen if sales tax charges will dampen demand for online purchases in the industrial sector. It looks as though we’re going to have a chance to find out.

Gases and Welding Distributors Association
Scott Ehrnschwender Meet the Author
Scott Ehrnschwender is GAWDA’s technology consultant and president of Efficiency Associates, Inc. in Terrace Park, Ohio.