Internet Sales Taxes Could Change Your Business

This article is a reprint of Wise Bread's contribution to OPEN Forum from American Express -- where small business owners can get advice from experts and share tips with each other.

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With federal and state budgets in deep trouble, lawmakers are looking for ways to increase the money coming into their tills. Sales taxes are about a third of total state tax collections, second only to personal income taxes as the largest source of state revenue. But the Internet Tax Nondiscrimination Act (P.L. 108-435) means states don't collect taxes on any out-of-state online transactions.

If you have a business in California, your website shopping cart is only required to collect taxes from people who use a California address. Or, seen from the other side of the process, if you live in California and buy from an online retailer in Vermont, you don't have to pay sales tax on your purchase.

Technically, customers in other states who buy from you are supposed to pay use taxes (and you're supposed to pay them when you buy out of state), but trying to enforce that is complicated and virtually impossible, pun intended. The reason is something called "nexus," or physical presence, a concept that originated with the very first use taxes 80 years ago during the Depression.

New York State decided to apply the idea to the Internet with what has become known as the Amazon Law. New York claimed that commissions Amazon paid to Empire State affiliates meant it had nexus in the state, and thus was required to collect sales tax. The state legislature passed a law supporting the claim. Amazon challenged in court and lost, but it is appealing on the basis that the affiliate relationships were simply is a means of advertising.

When North Carolina and Rhode Island passed laws similar to New York's Amazon law, Overstock.com (and Amazon) canceled affiliate programs in those states, putting some online retailers out of business. Fortunately, California, Hawaii, Colorado, and Virginia have defeated proposals to tax Internet sales. But other states, including Oklahoma, are going ahead with Internet tax measures based on nexus.

States such as Nevada, Florida, and Washington rely on sales taxes in lieu of a state income tax, so they have a keen interest in the issue and are working to broaden the definition of nexus.

Still, the lack of sales-tax and use-tax enforcement is attractive to online shoppers, proven by the 20% annual increase in online sales. With that kind of growth it's no surprise that there's a push for new tax legislation through the Main Street Fairness Act. The Act calls for an online sales tax to ensure online stores have the same tax regulations as retailers.

How this all plays out, we can only hope, will be based on business realities, not just legislative avarice.

With something like 7,500 unique tax jurisdictions in the United States, keeping track of changing tax rates will be a job that only a central service or software provider will be able to handle. But the problem is more complicated than that. Some states, for example, don't tax software and other digital products while others do, but they have lower tax rates for prescription drugs, clothing, and food.

Unless special Internet sales exemptions are provided, a seller would have to register in every state where it sells its products or services. For that matter, as it stands, sellers would have to register their businesses in every county, borough, parish, city, or town where they have customers. They’ll have to keep tax records for each jurisdiction too, of course, and make them available in the event of an audit...from any one of 7,500 regimes.

But Internet transactions aren’t the only ones under scrutiny. Catalog sales and interactive-TV sales raise nexus issues too. Even postcards inside magazines that a purchaser mails in to order a product raise nexus issues because the cards have codes that track sales back to the magazine.

In any event, unless a solution is found, your business could find itself in the unfortunate position of selling competitive products that cost your customers as much 8.25% more than other online retailers, simply because you have to collect state tax and they don't. Your choice, of course, is to reduce your price, but that means narrower margins.

One approach to solving this problem was the Streamlined Sales Tax Project (SSTP), created by the National Governor’s Association and the National Conference of State Legislatures in the fall of 1999 to simplify sales tax collection. The leaders of those two organizations were concerned that the 1930s sales-tax approach is just not relevant to 21st century e-commerce. So far, 44 states and the District of Columbia have adopted the approach which encourages "remote sellers" selling over the Internet and by mail order to collect tax on sales to customers living in the streamlined states. It levels the playing field so that local "brick-and-mortar" stores and remote sellers operate under the same rules.

But, according to Scott Peterson, executive director of the Streamlined Sales Tax Governing Board, "people have lost their enthusiasm and patience for the Streamlined Sales Tax project." Why? George Isaacson, representing the Direct Marketing Association as senior partner at Brann & Isaacson, said at a recent conference (mp3) that it was, at least in part, because SSTP had backed away from simplicity.

With states losing billions of dollars in revenue, it's a safe bet they’ll use whatever legal authority they have to chip away at the nexus issue. The unanswered question is whether the federal government will step in to defuse the issue, or at least make it equally painful for everyone.