How-to guide: Sales and use tax considerations in e-commerce (USA)

Introduction

This guide will assist in-house counsel, private practice lawyers, and tax and accounting departments with developing procedures to help businesses comply with sales and use tax regulations in e-commerce. Sales and use taxes are important sources of revenue for most states. The rise of e-commerce, and the ease with which sales transactions may be accomplished across state borders, have focused the attention of state revenue authorities on the collection of taxes from online buyers and sellers. This guide aims to assist businesses to address these challenges and comply with the enforcement regimes states have put in place.

This guide covers:

Overview of sales and use tax in e-commerce
Understanding nexus and how it impacts e-commerce business
Determining potential tax exposure
Compliance challenges with sales and use tax

This guide can be used in conjunction with the following How-to guide: Streamlined sales tax and Checklist: Drafting a business-to-business (B2B) contract with automatic renewals.

Step 1 – Overview of sales and use tax in e-commerce

1.1 What is e-commerce?

The simplest, yet most accurate, definition of e-commerce is ‘commercial transactions conducted over the internet’ – more often known as online shopping. The e-commerce process is different from a traditional brick-and-mortar store. In e-commerce, either the business’s website (or some neutral platform, like Amazon) are where the initial contact between the customer and the seller takes place. An e-commerce website acts like a digital store on the internet, and buyers and sellers can transact virtually. Once the order is placed, if the transaction is for goods, the seller delivers the items to the buyer and sends the customer a tracking number as proof of dispatch of the goods.

1.2 What are sales and use taxes?

1.2.1 Sales tax

Sales tax is a consumption tax on the sale of goods or services at the state and local level in the United States. Sales tax generally applies on the sale to the end user or consumer. A seller or marketer may have monthly, quarterly or annual responsibilities with regards to reporting their sales and paying the taxes to state agencies.

Sales tax is generally added to the sales price at the point of sale and charged to the purchaser. A business may be liable for sales taxes in a given jurisdiction if it has an economic presence there. That presence can be a brick-and-mortar location, an employee or an affiliate, depending on the laws in that jurisdiction.

While the burden of sales taxes is imposed on the consumer as purchaser, the seller usually collects the tax from the customer at the time of sale and then remits the collected tax to the appropriate state taxing jurisdiction. If the merchant fails to collect or remit sales taxes, the merchant will be liable for the unpaid taxes as well as for any potential interest and penalty that may be imposed by the taxing jurisdiction.

Conventional or retail sales taxes are charged only to the end user of a good or service. Where goods pass through several hands or stages, exemptions are available to purchasers who are not the end user. For example, a purchaser that will use the goods as raw materials in their product would be exempt from sales taxes. The seller is generally obligated to determine whether the sale is a taxable transaction. Practically speaking, the manufacturer registers with the various taxing jurisdictions where they get their raw materials in order to obtain ‘exemption certificates’ that they can provide to the sellers of the materials.

Different jurisdictions levy different rates of sales taxes. Sales taxes are typically levied at the state level. Forty-five US states and Washington DC collect sales tax. In addition to statewide sales tax, many counties and municipalities also impose their own sales taxes. Alaska, Delaware, Montana, New Hampshire and Oregon are the only states that currently do not charge sales tax. Be sure to search your state and local sales tax requirements and consult a professional for advice if you do not understand the obligations, in order to avoid penalties, interest and unpaid tax charges.

1.2.2 Use tax

Use tax is defined as a tax on the storage, use or consumption of a taxable item or service on which no sales tax has been paid. Use tax is a complementary or compensating tax to the sales tax and would not be due on transactions where sales tax was charged. Use tax was introduced to provide equality among in-state and out-of-state sellers by imposing a use tax upon the customer where the seller did not charge the sales tax. Use tax applies to purchases made outside the taxing jurisdiction but used within the state. Use tax also applies to items purchased exempt from sales tax which are subsequently used in a taxable manner. Accordingly, an e-commerce business needs to have the processes in place to determine whether its purchases would be subject to use tax.

Use taxes are typically the same rate as the jurisdiction’s sales tax. The responsibility for calculating and the burden of remitting the use tax usually, but not invariably, falls on the consumer or end user, not on the seller, as determined by business practices. In many states, the use tax is owed if the sales tax paid is less than the tax that would have been imposed by the purchaser’s home state. The use tax rate is the sales tax rate in the buyer’s state, less the sales tax paid to the other state.

Examples

Montana does not impose a sales tax, while North Dakota imposes a 3 per cent sales tax on the sale of new agricultural machinery. A farmer from North Dakota purchases a new combine from a dealer in Montana for $350,000 and pays no sales tax. The farmer must pay $10,500 (3 per cent of $350,000) in use tax to North Dakota.

South Dakota imposes a sales tax of 4.5 per cent, and a use tax at the same rate. A farmer in South Dakota buys a combine from a dealer in North Dakota for $350,000. The farmer pays the North Dakota sales tax and is also liable for the South Dakota use tax of $5,250 (1.5 per cent of $350,000).

Use taxes are, with some exceptions, not an issue for e-commerce sellers. The main focus of this guide is on sales tax, but it is still important to understand use taxes to avoid liability if the business is, in fact, required to pay use tax. Use taxes are usually paid by the consumer. In addition, since states have moved to ensure that sales tax is collected from online sales, the use tax liability has become less important in this context.

1.3 What is nexus for sales and use tax purposes?

1.3.1 Sales and use tax nexus definition

Currently, a business is required to comply with sales and use tax laws in only those states where they have the requisite connection or ‘nexus’.

Sales tax nexus is the connection between a seller and a state that requires the seller to register then collect and remit sales tax in the state. The connection can be established by having a physical presence (eg, through a warehouse or office) or relationship with a supplier, reaching a certain sales threshold, or selling into a state. It is critical to source the sale to the correct jurisdiction. The US Constitution limits the states’ powers to impose sales taxes on entities unless there is a definite link or substantial presence in the state.

Nexus for different taxes, while similar in concept, are different for the various types of taxes that may be imposed by a jurisdiction. Generally, thresholds for economic nexus are generally much lower for sales tax than the nexus for income taxation. Complying with nexus therefore depends on several factors, including the precise location of the business and customer base, sales volume, and the products sold. Meeting economic nexus status usually occurs after you have passed a specific transaction or revenue threshold.

The two principal constitutional limitations on a state to impose tax on an out-of-state corporation are provided by the due process clause and the commerce clause, which both similarly require some definite link or minimal connection to the state and the entity that is liable for collecting and paying taxes. The due process clause standard that has been developed through many court decisions is much lower than the commerce clause standard and merely requires that the state has given anything for which it can ask a return on. See, for example, Wisconsin v JC Penney Co, 311 US 435 (1940). This means that any state requiring a salesperson or marketer to pay taxes must be able to establish a link between that entity and the state (eg, residence, primary business location, etc).

Because the due process standard established by the courts is so low, the primary consideration in most subsequent sales and use tax nexus cases turns on whether the limitations of the commerce clause have been met.

1.3.2 Traditional nexus test in e-commerce

Historically, courts have established and upheld a bright line test that required states to demonstrate a physical presence in the state to satisfy the commerce clause limitation. In Quill Corp v North Dakota, 504 US 298 (1992), for example, the US Supreme Court reaffirmed prior rulings in holding that a state cannot require an out-of-state retailer to collect and remit use tax if it did not have a physical presence in, or substantial nexus with, the state. This substantial nexus standard derives from the commerce clause and requires some level of physical presence. Quill, a direct marketer of office and business supplies, had no contact with North Dakota other than through solicitation materials and shipment of goods into the state by US mail or common carrier.

As internet (ie, e-commerce) sales began to explode, states saw vast numbers of transactions going untaxed because of the bright line physical presence requirement and began to get creative to assert sales tax responsibilities on internet sellers. For example, in 2008, New York enacted legislation that imposed an obligation on out-of-state internet retailers to collect and remit state sales tax on tangible personal property or services sold through links on websites owned by state residents. For example, if an Amazon seller is based in New York, and sells to a New Jersey resident, the seller would be obligated to collect New York sales tax. The legislation (known as the ‘Amazon law’) appeared to target popular internet retailers who previously did not collect New York sales tax from their New York customers. See NY Tax Law section 1101(b)(8)(vi).

Subsequently, in a case involving Amazon, an appellate court found the statute constitutional on the face of it, and remanded the case for further fact-finding to determine whether the statute was unconstitutionally applied to Amazon.com under the commerce and due process clauses of the Constitution (see Amazon.com, LLC v New York State Dept of Tax and Fin, 81 AD 3d 183, 913 NYS2d 129 (1st Dep 2010)). Alongside litigation around the Amazon law, many other states began to enact similar legislation to enable collection of sales tax, with modifications that they believed could sustain legal challenges.

Another state, Colorado, enacted a two-part statute, effective from 2010, that takes a different and unique two-step approach to raise revenue on e-commerce sales:

the statute uses an affiliate nexus standard that confers nexus on out-of-state sellers and requires them to collect Colorado use tax. For example, Apple may sell from California to a Colorado customer and be required to pay use tax in Colorado. Utilising the federal definitions, a ‘controlled group’ (as defined in Internal Revenue Code (IRC) section 1563(a)) must collect and remit tax if the group has a ‘component member’ (as defined in IRC section 1563(b)) that is a retailer with a physical presence in Colorado); and
the Colorado statute imposes a requirement on out-of-state retailers (previously not required to collect Colorado sales tax) with annual gross sales in Colorado of $100,000 or more, to give their Colorado customers notice with each purchase that Colorado sales or use tax is due on all purchases that are not exempt from sales tax. This notice may be made on the internet website of the retailer or on an invoice provided to the customer.

Many other states enacted legislation similar to New York’s ‘Amazon law’, including Arkansas, California, Connecticut, Illinois, North Carolina, Rhode Island and Vermont. Also, Pennsylvania announced in a 2011 Bulletin that its sales and use tax law already allows the state to assert click-through nexus. Other states, like Colorado, continued enacting legislation that tried using alternative approaches to imposing tax on e-commerce sales.

It follows that states are not uniform in their enactment of these nexus provisions, and in order to determine its sales tax obligations, a seller should identify the states in which they have nexus, including traditional physical presence or nexus under the more recently introduced types of nexus (eg, affiliate nexus or click-through).

1.3.3 Current developments in sales and use tax nexus

In 2018, the Supreme Court transformed the e-commerce world when it overturned the long established, bright line, physical presence nexus rule for sales and use tax collection. Instead, the Court stated that it would allow states to require remote sellers to collect and remit sales tax on sales delivered to locations within their state, regardless of whether the seller has a physical presence in the state. The decision changed the sales tax compliance obligations for businesses with revenue from multiple states. In overturning Quill, the court stated that:

‘[m]odern e-commerce does not align analytically with a test that relies on the sort of physical presence defined in Quill. And the Court should not maintain a rule that ignores substantial virtual connections to the State.’ See South Dakota v Wayfair, 585 US, 138 S Ct 2080; 201 L Ed 2d 403.

Since the Wayfair decision made it possible for states to enforce the new ‘economic nexus’ standard, e-commerce business has drastically accelerated, and consumer behavior has shifted in favor of online sales. State governments have created new laws, and businesses have had to adapt to new rules and regulations. Since the Wayfair decision, most states have adopted new rules defining nexus and the imposition of a sales and use tax obligation.

The new online shopping habits established during the covid-19 pandemic has had repercussions for state and local governments as online sales grew exponentially. When online shopping was first introduced, there was uncertainty from regulatory agencies around revenues and spending on relief measures. As a result, many states are seeing double-digit growth in sales tax revenues. Much of this growth is attributed to the upturn in consumer spending, primarily due to e-commerce sales tax revenues being collected in 45 states via an economic nexus law that bases a sales tax obligation on a remote seller’s sales volume in the state.

Finally, e-commerce sellers must be aware of marketplace facilitator laws, which require the platform owner of any online marketplace to charge sales tax on transactions on their sales platform (think eBay as the platform owner).

As a result of these trends and widespread adoption of the economic nexus test in state laws, a perfect storm of complexity and liability has been created for businesses selling remotely. Businesses have to adapt to new rules and regulations and lack of uniformity creates cumbersome compliance obligations. With the expansion of online sales and e-commerce presence in the past two years, the likelihood of businesses having already triggered new sales tax obligations to multiple jurisdictions is very high. It is expected that businesses will only continue to increase their tax obligations as they multiply online sales and adopt new sales channels.

Step 2 – Understanding nexus and how it impacts e-commerce business

2.1 Economic nexus and e-commerce

Since the Wayfair decision, several states have enacted ‘economic nexus’ legislation. This means that sales taxes only apply when internet sales reach a certain threshold or economic value. In fact, every state that collects a sales tax now has economic nexus rules for sales tax purposes, with Missouri enacting such legislation (effective since 1 January 2023). In practice, economic nexus rules require sellers to collect sales tax in states where the seller’s sales exceed the state’s monetary or transactional threshold (or both).

For example, most states have taken the legislative position that a business has economic nexus if:

it has annual retail sales of goods or services into the state that surpass a certain dollar threshold (eg, $100,000); or
it makes a specified volume or number of sales transactions throughout the tax period (eg, 200 or more) with residents located in the state.

Some states may also combine a dollar threshold with a transaction threshold as their nexus standard. E-commerce business owners must know the tax rules for each state where they do business to determine if they are liable for taxes based on these economic nexus rules.

2.2 State-specific nexus standards

While there is some uniformity in the two thresholds that states are using in determining their nexus standard, the dollar amount and the transactional level thresholds vary from state to state. This presents a clear challenge to companies trying to ensure that they are compliant with the differing rules that apply across the various states in which they may have customers.

Online resources can provide basic information for each of the 50 states, which will facilitate further research into any sales or use tax implications within the state. State departments generally have helplines that take calls to answer taxpayer inquiries in case additional assistance is needed.

2.3 Local taxing jurisdictions

Sales taxes may be imposed by counties, cities, or special assessing districts (ie, municipalities or counties that impose a tax dedicated to a particular purpose). One source estimates that there may be more than 12,000 state and local tax jurisdictions across the 50 states, with regulations that may change quickly and with little or no notice.

Only five states do not charge a statewide sales tax – New Hampshire, Alaska, Oregon, Delaware, and Montana. Of those that do, the highest tax rate is 7 per cent, which is charged by Indiana, Tennessee, New Jersey, Mississippi, and Rhode Island. Local sales taxes are imposed in addition to state sales taxes. The two cities with the highest sales taxes are Monroe and Sterlington, Louisiana, both of which have combined state/local/parish (county) sales tax rates of 13.5 per cent.

Minnesota has a unique approach to sales tax on clothing. Most clothing items intended for everyday wear are exempt from sales tax. This includes a wide range of apparel like shirts, pants, dresses, skirts, sweaters, jackets, coats, hats, gloves, undergarments, socks, and shoes (including boots). Baby clothes are also exempt. This has resulted in the Mall of America, in Bloomington and Minnesota, to become one of the most visited tourist destinations in the world.

Step 3 – Determining potential tax exposure

3.1 Are your sales subject to sales tax?

Not all sales will be subject to sales tax. States typically alter tax rules according to their revenue needs. Determining if your sales are even taxable would be the first step in determining the potential tax exposure that the business may be facing. Sellers are responsible for knowing what is taxable in the states in which they have nexus, and where relevant, collecting sales tax from a customer, unless an exemption applies. A transaction may be exempt because the customer making the purchase is exempt, the particular transaction type is exempt, or because the property or service being traded is exempt.

Some common non-taxable and sales tax exemptions are described below.

3.1.1 Non-taxable transactions

Sales for services are almost universally non-taxable transactions. Some transactions, though, include both products and services. In these instances, many states utilize the ‘true object test’ to help determine taxability of mixed transactions (ie, those involving the taxable sale of tangible personal property and non-taxable services). If the main purpose of the transaction (the true object) is the sale of taxable property or equipment, the entire transaction is subject to sales tax. If the true object of the transaction is the provision for non-taxable services, the entire transaction is not taxable. Consider, for example, a mechanic who changes the oil in a customer’s automobile. The portion of the total price attributed to the mechanic’s work would not be taxed, but the price of the oil and filter (which is usually stated separately on any invoice) would be taxed.

3.1.2 Wholesale exemptions

Sales of products are taxable when they are made to the end user. Transactions from wholesalers to retailers, though, are not taxable. This helps to avoid multiple layers of taxation (potentially from different jurisdictions) on the same products. Examples include businesses that sell fresh food to restaurants or car parts to a manufacturer. Each state has slightly different requirements for claiming the reseller exemption and a list of wholesale-exempt products. State departments may or may not require registration or documentation indicating a tax-exempt status, so verifying this during the due diligence process of establishing tax obligations is essential.

3.1.3 Sales tax exemptions

Sales tax exemption eliminates the need for the retailer to collect sales tax on certain transactions or sales to certain customers, such as sales of raw materials to manufacturers. A customer-level exemption is based on the type of entity and whether it qualifies for an exemption. The purchaser must register in the jurisdiction where the transaction occurs, file the appropriate paperwork to obtain exemption status, and provide a completed exemption certificate to the seller.

Some other common exemptions across states are for clothing, prescription drugs, and sales to government entities. However, some states have special or lowered sales tax rates for certain products or services, such as groceries, restaurant meals and jewelry. In addition, some states will also exempt certain property for a specified period, such as when a state provides a ‘tax holiday;’ for school supplies just prior to the state of the new school year.

3.2 Determine where you have nexus

The next step in evaluating potential sales tax exposure is finding out where the company is doing business – its economic nexus. This is done by generating reports that show sales volume by state and local jurisdictions by:

dollar value; and/or
volume or number of sales transactions.

Once the company has determined where it is doing business, and to what extent, it must match those sales with the nexus standards in the states (and, possibly, the local jurisdiction) where business is transacted by the company. Generally, local taxing jurisdictions tend to follow state nexus standards. Another important consideration when evaluating nexus standards, is that some states’ sales through affiliates or third parties may result in an obligation collect and remit tax.

3.3 Obtain a permit to collect sales tax where appropriate

If, based on an analysis of nexus standards and sales volume, it appears that the entity may have an obligation to collect sales taxes, it should register in those jurisdictions. Most states require businesses to register for a sales tax permit which will then authorize e-commerce sellers to collect sales taxes on purchases within that jurisdiction. You can register with the various states by registering with the state tax authority website or filing a form. Note that many states and/or jurisdictions provide for online registration and registering at the state level will also register the taxpayer for local tax filings. Each state may have differing requirements as to the type of information and supporting documents required for registration. Deadlines for filing taxes and registering for a sales tax permit differ by state, so it is crucial to be aware of this across the states you are conducting business.

If exposure is identified in many states, the taxpayer may consider utilizing the Streamlined Sales Tax Registration System (SSTRS), which streamlines registration for 20+ states. Certain businesses qualify for free sales tax calculation and reporting services from a certified service provider. Other businesses could consider using software such as ADP, QuickBooks, or any other similar software to complete regulatory filings on the business’ behalf.

3.4 Assess, collect, and remit sales tax

Going forward, the business should begin assessing, collecting and remitting sales tax. The sales tax is separately stated and based on a percentage of the retail price. No allowance is made for the costs of collecting or remitting the tax. The frequency for remitting the tax collected varies but is commonly done on a quarterly or monthly basis. Usually, the website or platform that is being used to conduct sales transactions will have an option to charge the end user tax automatically. There are several ways to keep track of the sales and subsequent tax, including accounting software, spreadsheets, reports generated through sales platforms, and bank account transactions. Accountants and bookkeepers also often offer a service to maintain the records on behalf of a business.

If the analysis demonstrates that there is potentially tax due from prior tax years, the business should consider entering into a tax amnesty program in those states, if such a program is allowed. This may provide relief from the imposition of penalties and interest on the past due taxes. The amount of the penalties, if imposed, will vary from state-to-state.

3.5 Ongoing maintenance and monitoring

3.5.1 Accounting for taxable and non-taxable transactions

Going forward, the business should ensure that they are appropriately categorizing transactions as taxable or non-taxable. This may require additional training of employees who are responsible for handling the accounting and finance portion of the business.

3.5.2 Tax law developments

Because tax law changes frequently, the business should develop a process for ensuring that tracking any critical legal or regulatory developments is incorporated into their sales tax processes. Monitoring state and federal registers for rules and laws on a regular basis, as well as monitoring the news pages of relevant regulatory authorities (such as the state and federal revenue departments) will be critical.

3.5.3 Self-audit for compliance

The business should conduct periodic self-checks (or internal audits) on compliance processes. This should follow the general process that an external state audit would follow to best ensure that systems are performing as expected. Regulatory audits will vary from state to state, depending on the priorities of the agency and their available resources. Generally, if an agency has enough information to determine that a mistake was made and to establish how to fix that mistake, the agency will automatically process an amendment, and will notify a business in writing. The audit would then be over. If there is not enough information to accurately process any amendments, the auditor would ask for relevant information pertaining to their subject matter of interest. Sometimes the auditor will ask for proof that all applicable laws and regulations are being complied with. For that reason, understanding the business’ obligations and the required proof for each of those obligations is critical.

Step 4 – Compliance challenges with sales and use tax

4.1 Registering to do business

In some instances, a sales tax liability analysis may demonstrate that the business is on the cusp of incurring a tax liability in a state. The business may therefore pre-emptively register for a sales tax permit with that jurisdiction. This may be done to avoid a potential late registration should the nexus threshold of that state be met shortly after the analysis is conducted. It is important to remember, though, that registration creates a filing and reporting obligation within that jurisdiction. Bear in mind too that each state has its own sales tax deadlines.

4.2 Compliance obligations and ongoing monitoring

Ongoing compliance of the sales tax process in the new ‘economic nexus’ era will require a commitment from the business to keep abreast of tax laws and establish policies and procedures to avoid the imposition of tax assessments by the various taxing jurisdictions. It is the responsibility of businesses to understand the state-level rules and regulations, and how a state interprets and classifies different products and services. This requires significant investment both in terms of time and human resources to thoroughly review the tax obligations and ensure the e-commerce business is compliant. For example, the business must ensure that it has adequate resources to run and monitor the compliance process with the potential for returns in 50 states, plus some 1,200 local jurisdictions if the business has a robust e-commerce business.

A key consideration will be whether the compliance should be conducted with in-house resources or outsourced. One potential alternative would be to engage a certified service provider (CSP). A CSP is a designated agent that has been certified under the Streamlined Sales and Use Tax Agreement. They can perform all sales and use tax functions, other than remitting use tax on the business’ own purchases. See How-to guide: Streamlined Sales Tax.

The business will also need to consider the resources required to conduct and monitor state-initiated tax audits, notices and inquiries, in addition to revoking registration registrations in jurisdictions where it no longer conducts business.

Additional resources

David Agrawal and William Fox, Taxing Goods and Services in a Digital Era, National Tax Journal (March 2021)
Baker, et al, Shopping for Lower Sales Tax Rates, American Economic Journal: Macroeconomics (July 2021)
Bruce McDonald and Sarah Larson, Implications of the Coronavirus on Sales Tax Revenue and Local Government Fiscal Health, Journal of Public and Nonprofit Affairs (22 July 2020)
IRS Fact Sheet FS-2006-9, January 2006
IRS Fact Sheet FS-2005-6, January 2005
IRS, Publication 600 (2006), State and Local General Sales Taxes