For most of the business community, the events that have unfolded this year have proven to be incredibly challenging, but state and local governments, with their already limited resources, are stretched to an unprecedented level.
Considerable media attention has been focused on the states’ efforts to ease the financial burden that has been imposed on businesses that have been forced to curtail operations, lay off or furlough employees, or shut down entirely during the last several months.1 However, these relief measures will not be permanent.
According to Moody’s Analytics, state general fund revenues are projected to dip by an average of 20% in the coming months, leaving state policymakers scrambling to patch this massive budget hole.2 Thirty-three states are projecting budget shortfalls of more than 10%. Among three of the largest, California is predicting a 2020 budget deficit approaching $54 billion, New York $13 billion and Illinois $3.4 billion.3 Something must be done to turn the tide and increasing sales/use tax collections will play a large part in closing the forecasted state budget deficits.
For years, states have focused on expanding the net of goods and services subject to sales tax. The taxation of digital transactions has been at the top of list with all but two states adopting legislation or regulations to tax remote transactions in conformity with the 2018 Wayfair Supreme Court decision. The boom in remote sales post COVID-19 provides fertile ground for increased tax revenues.4
The Tax Man Cometh
With limited resources, states have become increasingly sophisticated in identifying possible audit targets. Some of the techniques that have become more prevalent include the use of data mining and artificial intelligence to concentrate their efforts. This includes:
- Collecting information on retailers that have large sales in a jurisdiction, but little or no corresponding sales tax remittances;
- Targeting specific industries that offer software as a service (SaaS) service offerings which bundle taxable hosted web-based support or bundled software with non-taxable services;5
- Relying on past audit activity which resulted in large audit assessments;6
- Monitoring fluctuations in sales tax reporting (e.g. increased exemptions, large decreases or increases in tax reported from prior periods); and
- Keying on the results from other audits which reveal under inclusion of tax on vendor payments or failure to collect tax on customer sales. Under the sales/use tax provisions in virtually all states, the vendor has an obligation to collect and remit tax from its customers, assuming the vendor meets the economic or physical nexus standards of the state requiring it to collect tax. However, if the vendor fails to collect tax, the customer is obligated to self-assess use tax on taxable purchases.
Planning to Increase the Bottom Line Through Sales Tax
While the states are almost certain to increase their collection efforts, companies are not defenseless. Below are some of the actions that can be taken to minimize risk of unanticipated audit activity.
Review Existing Sales Tax Compliance Processes:
For many organizations, sales tax and sales/use tax compliance is viewed as an administrative nuisance. The economic nexus rules resulting from the Wayfair decision have increased awareness among financial and tax executives of the need to conform with the sales tax collection requirements, but few are mindful of the true cost sales/use tax presents to their organization. That is because the true cost can range from 4-10% of sales if compliance efforts fail to properly collect the correct amount of tax on customer sales or are paid on purchases from vendors.
Since Wayfair was decided in 2018, 43 states have adopted conforming legislation, and companies have scrambled to comply. Despite best efforts, many have discovered significant obstacles or developments which may warrant visiting/revisiting compliance decisions including:
- Cost and complications of integrating a sales tax system with the company’s existing Enterprise Resource Planning (ERP) or primary accounting system
- Failure to map the taxability of a company’s goods/services to specific state and local tax guidelines
- Economic conditions may have reduced, or consolidated resources previously devoted to sales tax compliance
- Increased tax, interest or penalties imposed for late or incorrect returns be filed with the states
- Poor communications between tax compliance providers and company personnel (if some or a portion of the compliance process has been outsourced)
- Failure to develop processes to monitor sales tax or corresponding use tax charged by vendors on goods/services
What’s a Company to Do?
Sales Tax Compliance
- If you are among the companies reviewing their options, the first order of business is to truly assess your company’s exposure for prior years including those states where the company had a physical presence prior to Wayfair. In such instances, the company may be exposed to tax, interest and potential penalties for as long as the company had a presence (nexus) and taxable sales but was non-compliant. In such instances, it most often is advantageous to enter into voluntary disclosure arrangements (VDA) with the states to minimize the look back period in event of audit and to eliminate the risk of penalties and possibly interest. Each state has its own specific requirements, and for many states, the option of entering into a VDA is precluded if the applicant has already registered to collect tax in the state. As such, companies should not jump to initiate a sales tax process before assessing prior years exposure.
- Review the methodology of assessing tax on both sales and purchases. Most sales tax systems are configured to charge tax based on a customer billing address whereas the correct rate is based on where the goods/services are delivered or depending on the state, where the title transfers. This distinction can have profound implications. Consider a company that is headquartered in Chicago where the sales tax rate is over 10%, but the goods or services are delivered outside the city where the rate can be as low as 4-6%. It is critical that companies review the methodology for sales tax determinations. Equally important is that considerable opportunities exist to reduce the sales tax imposed by vendors on purchases of both goods and services. For some, reviewing the volume of purchases each month to access the correct taxability determination is cost prohibitive either due to lack of resources or technology. However, significant software solutions are available to aid in the process without costly implementation efforts that can help streamline the review process.
- Take full advantage of all possible exemptions. All states provide specific exemptions from tax including manufacturing, resale, pollution control and special purpose exemptions applicable to specific industries and/or goods/services. Each state has explicit guidelines and with careful planning and review of a company’s activities, it is possible that often overlooked exemptions can be secured.
- Retaining required records is critical. Often a company is exposed to additional sales/use tax liabilities because it fails to retain adequate books and records. Sales tax audits typically extend three to four years back, some as far as seven or more years, and require detailed support of customer invoices, accounts payable and capital expenditures to avoid tax being imposed on the seller. With the proliferation of both system conversions and corporate restructurings it is not uncommon for such details to be archived in outdated systems that can no longer be accessed. Companies should pay careful attention to its record retention policies and safeguard necessary data required in event of audit. This also includes securing and retaining customer resale and exemption certificates. In the event of audit, many states only permit a limited period of time (60-90 days) to secure these certificates from customers. Failure to produce these exemption certificates will result in tax being imposed on the seller.
- Review major customer and purchase agreements. It is quite possible that companies are at risk of paying incremental tax because otherwise nontaxable services (such as maintenance, customer support, warranty and even shipping and delivery charges) are bundled with other taxable services. Failure to separate the nontaxable goods/services can result in the entire invoice falling subject to tax. Again, each state has specific requirements on taxable vs. nontaxable goods/services. A review of major contracts, particularly those digital services offerings can help an organization to dramatically reduce both its sales tax liability and/or exposure in event of audit. Among those contractual agreements to review in a COVID-19 home office work environment include video conference contracts, data security software agreements and both enterprise wide hardware and software purchases.
Currently 45 states and the District of Columbia impose a state sales tax, and 38 of those states, plus Alaska, permit the imposition of local tax. Within those jurisdictions, no one state or locality follows the same rules regarding taxable vs. nontaxable activities. It is incumbent on the taxpayer to interpret the myriad of different requirements, and this is a virtually impossible task without knowledgeable and easily accessible resources. To aid in the process, Duff & Phelps' Sales and Use Tax specialists encourage taxpayers to carefully explore their options and seek independent outside advisors that help apply your organization’s specific facts and circumstances to the complex nuisances with the sales/use tax system. Doing so can not only minimize risk upon audit, but also give rise to overpayments in prior years and yield tax savings for current and future periods.
2.See Dan White et al., “Stress-testing states: COVID-19,” Moody’s Analytics (2020), https://www.economy.com/economicview/analysis/379097/StressTesting-States-COVID19
3.https://www.politico.com/states/california/story/2020/05/07/california-faces-54b-budget-deficit-1282926; https://www.thecentersquare.com/new_york/with-13-billion-state-budget-deficit-looming-and-doubt-about-federal-aid-new-york-lawmakers/article_988908f4-9947-11ea-addc-33e3daac2daa.html; https://www.illinoispolicy.org/reports/budget-solutions-2020-a-5-year-plan-to-balance-illinois-budget-pay-off-debt-and-cut-taxes/
4.During first quarter 2020 online sales increased 14.8% over first quarter sales during 2019, this was before the advent of the COVID-19 crisis. https://www.census.gov/retail/mrts/www/data/pdf/ec_current.pdf. During the last couple of months online retailers are witnessing increased online sales that are doubling or tripling prior periods. https://www.forbes.com/sites/kaleighmoore/2020/04/17/retailers-selling-non-essentials-see-double--triple-digit-increases-in-online-sales-during-covid-19-crisis/#442c91436431
5.Over 30 states impose sales use tax on the sale of digital goods. These guidelines vary by state and even those that do not tax digital services have guidelines which impose tax on the sale of certain forms of software or services that often are associated with otherwise taxable transactions, such as maintenance and warranty contracts.
6.History has proven that many companies fail to take preventative measures to close control weaknesses that previously led to unanticipated tax adjustments. See example study conducted by the sales tax software provider Avalara at https://www.avalara.com/us/en/learn/guides/triggers-sales-tax-audit.html.