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How to Pay Taxes on Internet Sales

State officials are cracking down on small businesses that don’t comply with tax law relating to online sales. Here’s how you can keep tax auditors from knocking on your door.

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Charging sales tax on Internet purchases can be a messy, nebulous issue.

Case in point: You can buy the latest Stieg Larsson novel on Amazon.com without paying any tax. But order the same book from Barnes & Noble's website, and you'll still pay the 9.5 percent tax you would have paid at a store location in San Francisco, because any company with brick-and-mortar operations in California must collect sales tax online.  

"It's a real mess," says Scott Peterson, of the tangled web of rules relating to the sales tax on Internet purchases.

Peterson is the executive director of the Streamlined Sales Tax Governing Board, a Nashville, Tennessee-based group that's lobbying for more uniform tax laws across state lines. "If things don't change," he added, "there is going to be this tremendous continuation of lack of collections, and lack of a level playing field," in the retail marketplace.  

Things are changing. States in deep fiscal trouble are hungry for a bigger piece of the sales tax pie. This month, Gov. Pat Quinn, Democrat of Illinois, signed a law that requires online retailers working with affiliates in his state to collect sales tax on purchases by residents. Lawmakers in California, Hawaii, New Mexico, Minnesota and Vermont have introduced similar legislation.

So, what does all this mean for small-business owners who sell online? We talked to tax experts to find out how you can get compliant—and keep tax auditors from hitting you with hefty fees.

How to Pay Taxes on Internet Sales: Find Out Where You Stand

A state can compel companies to collect taxes only if they have a physical presence in the state, or a 'nexus,' as the Supreme Court ruled in Quill Corporation v. North Dakota in 1992. Without a nexus, online retailers and mail-order companies can sell products without collecting the tax.

Your first step is to figure out whether or not you have a nexus in a state where you ship goods bought online, says Diane Yetter, a sales tax consultant and founder of the Sales Tax Institute, a Chicago-based think tank. The criteria aren't consistent across states, but a nexus is usually defined as one or more of the following: a physical presence in the state, employees working in the state, or independent contractors soliciting business in the state.

If you do have a nexus—in which case you are responsible for charging the state sales tax—you need to determine if your customer is taxable or exempt. Some states exempt schools, non-profits and state agencies, among others. You can find out by accessing tax-rate tables and other information available on many state treasury websites, says Yetter. 

If all this sounds overwhelming, Peterson recommends using corporate tax solutions that automate the process, such as software by Vertex and other firms. Yetter suggests working with a tax professional, though she cautions against using local accountants if you're operational in several states.

"A lot of small companies work with fairly small bookkeeping firms that don't understand the multi-state issues," she says. "We've had a lot of small businesses get audited, call us and say, 'We've talked to our accountant and they never told us any of this.'"  

Dig Deeper: Do I Need to Collect a Sales Tax?

How to Pay Taxes on Internet Sales: What to Do if You're Not Compliant

You are responsible for every dollar you don't collect sales tax on, says Yeller, and you're probably going to lose at least 15 to 20 cents more per dollar in interest and penalties. "The cost of avoidance is huge," she adds. "It would put many small firms out of business."

So, how can you cushion the blow? Find out if your state has an "amnesty program" that waives or reduces penalties and interest on delinquent state and local sales taxes. They are offered for very limited periods of time, usually 30 to 90 days, during which business owners can come forward voluntarily.

"You always want to be aware if you have an amnesty," says Yetter, adding that most states have post-amnesty penalties. If you didn't report under amnesty in Illinois, for instance, and you're caught, you'll have to pony up double the tax dollars and double the penalties. And these days, you're more likely to get caught, since states facing budget crises are using new legal tools to force Internet retailers to do what every other retailer must do.

Dig Deeper: Tax Collecting for Online Sales

How to Pay Taxes on Internet Sales: You're Getting Audited. Now What?

If you are audited, don't twiddle your thumbs and wait for an assessment, says Yetter, since cash-strapped states are telling auditors to be less flexible and forthcoming during audits.

"The policy now is, 'Do the audit, don't tell the taxpayer anything until you do the assessment, and make them fight,'" she says. "So, you have to take the initiative and go to the auditor and ask them questions."

If you disagree with an auditor's assessment, you can submit a written request to the state for an appeal. Most states have an informal appeal process, says Yetter, during which you don't have to appear in court, you can represent yourself, and you typically don't need legal counsel.

Always do a cost-benefit analysis, says Peterson. "If it's going to cost you $150,000 to appeal a tax or penalty of $8,000, then it's not worth fighting. Sometimes the principle of things cost you much more than kicking the ground and righting a check."

If you do agree with the assessment, stay on top of the timeline, says Yetter, recalling a potential client who was audited and blew her 30 days notice, after which the penalties were automatically assessed. Some states will issue document requests with a 30-day deadline, "or you're prohibited from presenting those documents as evidence in an appeal," she added. 

Dig Deeper: Is an Internet Sales Tax Coming Soon?

Last updated: Mar 31, 2011




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