Understanding sales tax
Conventional sales taxes, also called retail sales taxes, are paid by the end-user of the good or service in question. When you buy an axe at the hardware store to use to chop your firewood, you are the end-user, and you are therefore on the hook to pay sales tax. Meanwhile, those involved in manufacturing a product aren’t liable to pay sales on the materials purchased to build the product they created. So the company that bought the wood to make the axe handle didn’t have to pay sales tax on that wood, nor did the foundry that crafted the axe head have to pay tax on the iron ingots it used to create it. These manufacturers did pay sales tax on the machinery used to fabricate the axe, as they are the end-user of that equipment, which is a key component of their business.
Those who aren’t liable for sales tax on products used in the manufacture of goods — such as the foundry and the handle-maker — must provide documentation to prove they are not the end-user, but a reseller and/or manufacturer instead. This means they buy a product in order to resell it, whether in its original form or after transforming it in some way. The foundry is purchasing the ingots as raw material for further manufacture — that is, to transform them into axe heads. That means the foundry will have a tax-exemption certificate that will validate it is not required to pay sales tax on the ingots it buys.
History of sales tax
Sales tax in the U.S. dates back to the 1930s, when it was instituted as a temporary measure to make up for a drop in other taxes in the wake of the Great Depression. Each state adopted its own rules for administrating sales tax, including its own sales tax rate, exemptions, and regulations about which businesses would have to collect it. Those companies that had a physical presence in a given state, such as a brick-and-mortar store or an employee — known as having physical nexus — were required to collect and remit sales tax.
Local and state governments quickly became dependent on sales tax revenue, and soon enough this temporary tax became permanent. For decades, the general rules created in the 1930s held, with businesses that had a physical presence in a jurisdiction being the only ones responsible for sales tax collection. Along with a brick-and-mortar location, other things that can give a business a physical presence nexus in a given jurisdiction are an employee, an affiliate, a warehouse, or other property. The rules of what gives a business nexus vary from jurisdiction to jurisdiction. With the explosion in e-commerce in the 2000s, however, states began to complain that they were missing out on sales tax revenue that should rightfully be theirs. This was because e-tailers based in one state could easily sell to customers in another where the company lacked nexus and was not responsible for sales tax collection.
To take our example of the axe, an e-commerce retailer based in Wyoming and with no nexus in any other state might sell an axe to a customer in New York, and ship it via the USPS. The Wyoming company would not have to collect sales tax on the sale since it doesn’t have nexus in New York. Technically, the buyer of the axe is supposed to pay the amount equivalent to sales tax to the state as use tax, but this rule is almost impossible to enforce, and the axe buyer is unlikely to follow through on it. This means that New York has missed out on the sales tax that should have been levied on the axe. With this happening over and over, states began to see much-needed revenues declining with the rise of online shopping.
To fix this growing problem, the U.S. Supreme Court ruled in 2018, in a case called South Dakota v. Wayfair, that companies can create nexus in a state by financial means — called economic nexus. As with physical presence-based nexus, each state could now create its own rules regarding the economic threshold for nexus. Typical rules are $100,000 in gross sales and/or 200 transactions in the state, but rules vary quite a bit from state to state. Here are some examples of these rules as they stand today:
- Connecticut’s threshold is $100,000 and 200 transactions over a 12-month period ending September 30. Its registration requirement is October 1 of the year in which the threshold is crossed on September 30.
- Texas’ threshold is $500,000 in gross sales in the prior 12-month period. And the registration requirement is the first day of the fourth month after the seller exceeded the threshold.
- Lastly, Washington D.C.’s threshold is $100,000 in gross sales or 200 transactions in the previous or current calendar year. And the registration requirement is the next transaction (not specified by District).
It’s an understatement to say that Wayfair was a big deal: This decision completely transformed states’ abilities to collect sales tax on a vast number of sales, helping them collect revenue they badly needed. In the meantime, it suddenly created the potential for complicated sales tax obligations for many companies that until 2018 had been blissfully ignoring the topic.
Different types of sales tax
- Retail sales tax: The most common type of sales tax is retail tax, in which shoppers pay a percentage of the sale price to the retailer, who then passes that amount on to the government via regular tax filings. State, county, and local governments may all impose sales taxes on a given sale. For example, a shopper who buys the axe at a hardware store may have to pay a 4% sales tax, a 2% county tax, and a 1% city tax, for a total of 7% sales tax on the axe. Some items are exempt from tax, depending on the rules of a given jurisdiction. Examples of items that are commonly exempt include food, medicine, and clothing of a low dollar amount.
- Use tax: A use tax is a percentage tax on the sales price of taxable goods, products and services and is typically applicable when no sales tax was charged at the time of purchase by the seller. Use tax is a complementary tax to a sales tax, meaning if sales tax was charged on a purchase then use tax does not apply, and vice versa. A common example is if a purchaser buys something online and the seller, because they don’t have nexus in the jurisdiction the purchaser is buying from, does not charge and collect sales tax. At that point, a use tax obligation is imposed on the purchaser to self-assess use tax and remit use tax to their jurisdiction.
- Excise tax: Excise taxes are special sales taxes imposed on specific items and are typically used to fund large capital infrastructure projects. One example is taxes known as “sin taxes” that are levied on items such as cigarettes, liquor, and firearms. Gasoline and airline tickets are also frequently subject to excise taxes.
- Value-added tax: While the U.S. continues to use conventional sales tax, most developed countries have moved to a value-added tax (VAT) model, which has the producer at each stage of the manufacturing process pay its share of the tax on the item. In a VAT system, the axe-handle maker would pay VAT; likewise, the foundry would pay VAT. The end-user then pays VAT on the end purchase of the axe itself. However, unlike the end consumer, the foundry and handle maker are entitled to VAT deductions on the costs of their inputs to the manufacturing process. So even though the vast majority of VAT is still borne by the end consumer, VAT creates more constant revenue streams for jurisdictions since it is paid at multiple points throughout the manufacturing process.
Common terms related to sales tax
- Bundled transaction: A bundled transaction is the retail sale of two or more distinct and identifiable products and/or services sold for a single non-itemized price. Typically, jurisdictions take the position that if at least one of the products and/or services in the bundled transaction is taxable, the entire sales price is subject to tax. Some jurisdictions may take a 50% approach, where taxability is determined based on the more valuable item in the bundle. If that item would be subject to tax on its own, then the bundle is taxable.
- Exemption: A sales tax exemption is a specific statutory exception that permits a purchaser to make a purchase that would otherwise be subject to tax, tax-free.
- Home-rule jurisdiction: In the sales tax context, a home-rule jurisdiction is a city, county, or municipality with a self-administered local taxing authority that manages taxability, collection, and compliance independent from the state department of revenue.
- True object test: The true object test is a method used by a jurisdiction's taxing authorities to determine whether an invoiced item is taxable. This is typically used when there are some ancillary items included in the sales price of a good or service. For example, if a SaaS product is sold with a few free hours of integration services, the jurisdiction would identify the primary product the customer is purchasing. In this case, the true object of the sale is the SaaS product, not the integration services, and SaaS taxability rules would apply to the transaction.
- Voluntary disclosure agreement (VDA): A voluntary disclosure agreement is a contract between a seller and a jurisdiction's taxing authority regarding the seller's past tax obligations. A VDA is entered into when the seller comes forward prior to being contacted by a jurisdiction, and agrees to pay past tax obligations in exchange for a reduction in penalties and capped lookback period.