Sales Tax Nexus: The Hidden Tax Pitfall That Puts Your Profits and Business at Risk

Sales Tax Nexus: The Hidden Tax Pitfall That Puts Your Profits and Business at Risk

Are you making a little-known accounting mistake that could cost you millions of dollars in profit loss — and even bankrupt your business?

Picture this...

You sell to customers all over the United States. You drum up business every way you know how: attending trade shows, using independent contractors, and buying affiliate advertising online.

You hustle. You grow, new customers are coming in at a steady pace, and you’re on your way to the kind of success you’ve dreamed about.

Then BAM…lawsuit.

According to the suit, your business didn't comply to sales tax nexus laws. That is, you never collected sales taxes to buyers in another state. It’s true you never paid those taxes — but you didn’t know you had to.  

As far as you were concerned, with no locations in the other state, you didn’t need to collect sales taxes and file a return. You’re in the right, right?

Wrong — and as one company learned last month, it could cost you…big.

Dream a Little Dream of Tax

In August, a Minnesota-based pillow manufacturer was forced to pay $1.1 million to settle a whistleblower suit in the State of New York. The whistleblower, a Chicago attorney who has filed many lawsuits after finding companies aren’t collecting sales tax, personally stands to make over $200,000, according to the terms of the state’s False Claims Act.

Why did the pillow maker settle for so much? It started when they sold some pillows at New York trade shows. While the company had collected sales tax on the pillows sold at those shows, they didn’t on purchases made online by New York residents.

That’s one pillow company owner who won’t be sleeping well for a while.  

The scariest part? Many small and mid-sized companies all over the United States are unwittingly ignoring sales tax nexus laws, totally oblivious to the fact that they could be putting the future of their business at risk.

Why is sales tax so tough to navigate for remote sellers? The confusion got started back in 1996 — with a company selling not pillows, but office supplies.

Quill and the Establishment of “Sales Tax Nexus”

Before ecommerce, remote sellers were catalog retailers, accepting orders via mail order and telephone. They collected and paid sales tax only on transactions with buyers in states where they had a physical location.

That changed when North Dakota passed a law requiring sales tax collection from all retailers that advertised to customers in the state. Quill Corp. was a Delaware catalog retailer selling office supplies with locations in Illinois, California, and Georgia. The company sold office supplies to North Dakota customers by phone and mail order and shipped catalogs to residents.

Quill refused to pay the sales tax, and North Dakota sued. The ensuing court case resulted in a Supreme Court ruling: Quill didn’t have to collect sales tax from North Dakota customers — and neither did any other company that didn’t have a substantial physical presence in the state.  

The level of physical presence necessary to trigger a sales tax obligation kept a name it had received in a 1967 Supreme Court ruling: Nexus.

Rise of the Internet Giants

Quill created a law that seemed reasonable for the time when it was decided. At that time, remote sales accounted for only a small fraction of total commerce, and few people even had an email address — much less an ecommerce website.

One fledgling internet company saw the Quill decision as an opportunity to grow unhindered by tax regulations that could hamper the growth of traditional retailers: Amazon. So long as it didn’t maintain a physical presence in a state, Amazon wouldn’t have to charge and remit sales tax.

With over 12,000 sales tax jurisdictions in the United States, it would have been difficult and costly for the company to collect and file in all 45 states with a sales tax. Quill had another benefit for Amazon, as well: consumers realized they could save a little money at purchase time from websites that didn’t charge sales tax, bringing more shoppers online.

The myth quickly spread that internet purchases from out-of-state retailers were tax-free. In reality, consumers are supposed to pay use tax on these sales, but almost none do.  

As sales shifted from traditional retail stores to ecommerce websites, state and federal legislators began to sound the alarm.

Sales tax revenue losses amounted to billions. Something had to give: taxes would need to be increased significantly, critical state services would need to be cut.

Or somehow, in spite of the Quill decision, internet sales would have to be taxed.

Casting a Wider Net: Nexus Evolved

In Quill, the Supreme Court left open the door for Congress to create legislation superseding the physical presence rule for nexus. Each bill that has attempted to change sales tax collection ito allow collection from remote retailers — most notably the Marketplace Fairness Act, proposed in 2011, 2013, and 2015 — has faced too much controversy to even reach the president’s desk for a signature or veto.

While waiting for comprehensive federal legislation, several states have attempted to expand nexus in ways the courts will find acceptable.

After New York’s attempt to broadly expand nexus in 2008 was found constitutional by courts, other states have had success in expanding what types of connections can trigger an obligation to collect.

For example, using affiliate linking to sell products can trigger nexus in some jurisdictions. Drop shipping programs like Fulfillment By Amazon (FBA) can make you responsible for collecting and filing in states like Texas and Florida.

Nexus can also established by attending trade shows — as the pillow manufacturer found out — or by having an employee in another state doing anything business-related (even checking email).  

And even if a company doesn’t have any association with a state except for selling to customers there, a new kind of nexus could still create sales tax obligations.

The Final Frontier: Economic Nexus

Some states solved the nexus problem a different way.

Starting with Ohio in 2005, these states have required all sellers meeting certain sales thresholds to collect sales tax. Ohio requires $500,000 in sales before collection requirements start, but in other states, these thresholds are significantly lower. In South Dakota, 200 transactions — of any dollar value — trigger nexus.

States with economic nexus can present a major risk for fast-growing companies. Meteoric growth doesn’t go unnoticed by the media, and auditors are reading the same publications as everyone else.  

In states like New York, whistleblower lawsuits even make it profitable for attorneys to sue the non-compliant.

Hitting the Wall: Sales Tax Scalability

Many small businesses are vaguely aware that they may be out of compliance. According to a Wakefield Research report conducted in 2014, 48 percent of accountants believe that their company would be found to have problems in a sales tax audit — even though 96 percent of accountants in the same survey said they believed their companies were using correct tax strategies.

Why the discrepancy?  

A lot of companies start by complying with sales tax law manually, using Department of Revenue notices for one or two states where they know they are required to file. This is a method that doesn’t scale. What took just a few hours a month with one state could take 20 hours or more once a business’s collection obligations expand due to trade show attendance, drop shipping, or economic nexus.

Here’s the reality: growth happens — and as the example of nexus shows, the complications of growth can happen whether a business is ready or not.  

To avoid the risk of an expensive, difficult audit (44 percent of accountants think an audit is more stressful than divorce), a different kind of solution is needed.

Automation: Growing Smarter, Not Harder

New sales channels, and new hires don’t have to result in a cascade of extra work for employees or extra risk for businesses.

Scalable, cloud-based solutions like Avalara offer up-to-the-minute calculation accuracy, geolocation to pinpoint districts and rates, and automated filing. Avalara works with Shopify Plus to get sales taxes right, whether you’re filing in one state or dozens.

Automation saves time and lowers risk. That’s a great combination, since taking risks with sales tax can never legally result in higher profits.  

When collection and filing are automated, companies don’t have to avoid growth strategies that complicate their sales tax picture — they’re free to expand where, when, and how they want, without the red tape and hassle.

Click here to learn more about how automation with Avalara and Shopify Plus can work together to simplify sales tax for your business.

About The Author

Jeanette works as Avalara’s lead copywriter, learning something new about sales tax (and more!) every day. She lives with her husband, baby, and cats in western Washington.