On September 1, 2012, the state of California started to collect sales tax from Amazon after a years-long argument over whether the Internet company should pay such a tax. In just the first four months of collection that tax amounted to $96.4 million. A good deal? Maybe, but you could argue that this apparent win for California was not so good, as the state agreed not to pursue Amazon for back taxes, penalties and interest that it may have been owed—a potentially huge sum given the number of years Amazon has been in business.
California is pursuing other out-of-state Internet business companies for sales tax on business performed in the state. It is not alone. Many states are realizing that out-of-state Internet companies with in-state sales are a huge potential source of income to themselves if they can somehow establish that the companies have a business presence, or nexus, in them.
The Internet businesses potentially affected include not only those selling tangible goods, like Amazon, but others that sell or license products such as software and social gaming—products that did not exist when states first established their sales tax rules. Not surprisingly, states are rushing through legislation to pursue these new forms of revenue. Unfortunately, this means that sales tax rules will vary from state to state, making compliance a nightmare.
The rules for determining nexus in each state can be complex and subtle and can involve relationships that you wouldn’t think would affect tax status but in fact do. Take a California-based Internet company that sells to New York-based consumers. If it advertises in New York via a fixed-fee advertising agreement with a New York-based company, it probably has not created nexus in New York under that state’s nexus rules. However, if the fee is found to be commission based, even in the remotest way, the company probably has created nexus, as the arrangement amounts to a reward-based referral. What seems like a minor variation in the terms of an advertising agreement can have very large tax liability consequences.
The size of the deal is irrelevant for determining nexus. Once you have nexus, you pay sales tax on all your sales to consumers in the state, not just those sales generated from the agreement. So the price of bad tax planning can be high.
Some sales tax rules remain straightforward. For example, if your company employs someone resident in another state—someone who assists in any way with the company’s sales process or sales cycle—you have nexus in that state. But with new sales-tax rulemaking afoot across the land, you will need to consider many other factors to determine your liability.
Internet businesses have choices. Good tax planning will pay off, but it’s not cheap. Some businesses pay third-party organizations to help them comply with ever-changing state tax rules. Unfortunately, many businesses choose to ignore the rules altogether and hope they don’t get caught. That’s not a smart choice, because when they are caught, the back taxes, penalties and interest will be considerable.
Not everyone can get the past eradicated like Amazon did.