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By Michael E. Miller, Merit Advisors LP
It is no secret that there has been a long-standing feud between the “brick and mortar” retailers, led by the megalithic Walmart, and the “online” retail giants, led by Amazon.com.
The battle is over what is “fair” when it comes to sales tax collection responsibility, and recently it seems that the brick and mortar bulwarks have achieved a major legislative victory. While some will celebrate that “fairness” has finally come about, the reality is that what is fair for big box brick and mortar retailers will have wide-ranging unintended consequences for many companies.
Prudent professionals and business owners must educate themselves on the potential implications of this new legislation and plan accordingly. Due diligence can make “fairness” more palatable and mitigate these additional risks.
The Senate in May passed the Marketplace Fairness Act of 2013 (S. 743) (the Act), which would authorize states meeting certain criteria to require online and other out-of-state retailers to collect and remit sales and use taxes, even if the retailer has no other physical presence in the state (a concept commonly referred to as “nexus”). With an almost identical bill (H.R. 684) working its way through the House, the legislation, if it becomes law, will result in significant changes in the compliance burden for many companies.
Under the current nexus legal framework, because of constitutional limitations imposed by the commerce and due process clauses, states cannot require out-of-state retailers to collect sales and use tax unless the company has some physical presence in the state. Supreme Court cases, such as Nat'l Bellas Hess, Inc. v. Dep't of Revenue of Ill., 386 U.S. 753 (1967), and Quill Corp. v. North Dakota, 504 U.S. 298 (1992), have developed and reinforced this concept. Consumers in those states are required to self-assess and pay use tax but the reality is that while business use tax compliance is commonly enforced, consumer use tax compliance is practically nonexistent (“I have to pay use tax on that laptop?!”).
Unfortunately for the brick and mortar retailers, the vast majority of consumers assume that all online purchases are tax free, thus giving online retailers a distinct competitive advantage. Even the few consumers who are aware of use tax have little incentive or convenient means to remit the tax. It was this reality that led to the call for fairness.
Initially the concept wasn't popular with Congress or the general public and was seen as either a new tax or the federal government forcing companies to collect an additional tax. To counteract this and build popular support, previously proposed legislation used the term “Main Street fairness,” to invoke thoughts of meager “mom and pop” stores fighting a futile economic battle against faceless online giants (what politician can resist?).
However, as this trend has built momentum, the dialogue has shifted away from emotive Main Street appeals to a broader concept of “marketplace” fairness. The result is a trend that taxpayers neither can, nor should, ignore. Support for the new legislation is widespread from both political parties.
The reality is, of course, a little different than the initial narrative of saving Main Street, and at least the new term marketplace fairness is a better reflection of the real situation. Simply put, large companies are fighting over market share, and the online companies have been content to exploit the advantage given to them by the current nexus legal framework. The proposed legislation seeks to change that.
The brick and mortar companies are fighting back, and the Senate bill is just the most recent and dramatic success of this inexorable trend. Their weapons have included vigorous lobbying at both the state and federal level, multiple websites, traveling professional “fairness” speakers and public advocacy through organizations such as the Retail Industry Leaders Association, which emphatically declares that it intends to “close the loophole” (that certainly sounds fair).
In reality, with the swelling growth of online commerce because of its appealing convenience, traditional retailers are losing market share. The occasional lost customer to a mail order catalog has now become a significant economic loss that they cannot afford to ignore.
States as diverse as New York, Virginia, Rhode Island, North Carolina, Colorado and Arkansas have enacted legislation (to varying degrees) to impose affiliate and click-through nexus on online retailers, and Oklahoma's new law requires retailers to inform customers of their use tax liability. In fact, many states are considering legislation that touches on this issue and it would seem that the advocacy of the brick and mortar retailers has been somewhat successful at the state level.
These Amazon laws serve to create an agency relationship with non-employee affiliates and, therefore, deem them to have established a presence and, therefore, a collection responsibility for their affiliated company. Online companies, led by Amazon, have resisted on a state-by-state basis, closing affiliates, relocating inventory and engaging in lobbying; but clearly the trend is against them.
In Quill, the Supreme Court gave an invitation to Congress to act on the nexus issue, saying, “Congress is now free to decide whether, when, and to what extent the states may burden interstate … concerns with a duty to collect use taxes.” Now, after 20-plus years, Congress has taken notice, and there will be winners, losers and unfortunately unintended consequences for the unsuspecting business owner.
In other words, the current nexus framework is the result of a vacuum of congressional action. The court acted because Congress hadn't, and this means that Congress has sweeping authority to regulate the nexus issue and the court will likely support the new law even if challenged on constitutional grounds. Although the provisions of the final legislation are uncertain, there is broad support in both houses, so it seems inevitable that something will eventually become law.
The Act (S. 743) would authorize “each Member State under the Streamlined Sales and Use Tax Agreement [the SSUTA] … to require all sellers not qualifying for the small seller exception … to collect and remit sales and use taxes with respect to remote sales sourced to that Member State pursuant to the provisions of the Streamlined Sales and Use Tax Agreement,” regardless of the sellers' lack of physical presence. States that aren't members of the SSUTA but that meet similar minimum simplification requirements would also be authorized to require sellers to collect and remit sales and use taxes with respect to remote sales.
The SSUTA is a multistate agreement created in 2002 to simplify the administration of sales and use taxes by imposing certain requirements on member states, including single state-level administration, and a basic uniform tax terminology. As stated above, the Act would allow an exemption for small sellers, defined as retailers with remote sale gross receipts in the U.S. not exceeding $1 million annually. The threshold is the amount of remote sales in the entire U.S. for the given year, and not for a particular state.
For example, if a taxpayer only makes $20,000 in remote sales in New York, but sells $1 million remotely in aggregate across all of the other states in the given year, then the taxpayer would breech the threshold for the purposes of the exemption in New York (assuming New York becomes a “fairness” state). The term “remote sale” is defined as a sale into a state in which the seller would otherwise not legally be required to pay, collect or remit state or local sales and use taxes, absent the provisions of the Act.
Assuming similar legislation passes the House, what are the implications for taxpayers? Unfortunately the potential effect reaches well beyond the targeted online Goliaths and can have severe implications for many companies across multiple industries. Even the Small Business Administration defines small retailers as sellers with sales of $5 million to $21 million per year, which is much larger than the miniscule $1 million threshold established in the Act. The reality is that now many companies may find themselves required to register and collect sales taxes in states where they have no employees, no offices, no assets and little tax experience.
Under the auspices of “fairness,” the sales tax nexus standard will fundamentally change. Previously, states were required to establish some physical presence of the retailer in their jurisdictions before imputing nexus and requiring the retailer to collect tax. A nexus questionnaire or other documentary evidence showing that a company has an employee in the state, an office, substantial assets or that deliveries were being made in a company vehicle would ordinarily be used to assert nexus.
Under the Act as proposed, states will be able to assume the existence of sales tax nexus despite the lack of physical presence or supporting documentary evidence, unless taxpayers can prove the remote sale threshold hasn't been met. A single sale believed to be a remote sale and identified in an audit of a company's customer or vendor could result in a state nexus questionnaire demanding that the company prove it hasn't met the threshold or isn't making remote sales. This can be time-consuming, and as anyone who has experienced an adversarial compliance audit will note, proving a “negative” can be extremely difficult (if not impossible) as well as expensive for the taxpayer.
Fortunately, businesses can prepare themselves to deal with “fairness” and mitigate risk with careful planning. Listed below are some of the more likely implications resulting from “fairness,” and recommendations for how to address them.
States typically send out nexus questionnaires in order to gather information about taxpayer business activity within the state. These notices take many forms but all serve the same purpose as a means whereby states seek to ensure compliance with their tax and regulatory laws.
Sometimes these questionnaires are generated at random but often they result from an audit lead when customers and vendors of a business come in contact with the state, or when a company applies for a permit or otherwise indicates it might be conducting business in the state. This is nothing new, but with “fairness” the number of questionnaires will likely increase and how a company responds will affect whether an audit goes forward.
Business professionals need to understand that with “fairness,” the nexus standard for sales and use tax will significantly change. The determining factors will be whether the company has made remote sales and has breached the small seller threshold.
It is essential that companies maintain thorough and complete records of remote sales by year, and be prepared to respond quickly and effectively to questionnaires with verifiable records that the threshold hasn't been reached.
Understand which of your sales are remote, and develop a method to track and document these transactions. It is imperative to have systems in place that will provide internal notification and documentation of the company having met the remote sale threshold in order to be able to deal effectively with the new “fairness” requirements. Failure to do so may result in registering and collecting tax unnecessarily in multiple states.
Anticipate the inevitable increase in state sales tax nexus questionnaires resulting from “fairness” and prepare your responses carefully. Remember, auditors operating in “fairness” states can now assume you have nexus unless you prove otherwise. Simply ignoring questionnaires or sending a canned response is no longer a viable option to avoid time-consuming and expensive investigative audits.
Know which states have taken advantage of “fairness” under the Act, and become conversant on the taxability of sales there. Become familiar with the state's exemption and resale certificate requirements. In this way, even if and when the “remote sale” threshold is breached, your company won't be caught unprepared and flat-footed.
Common sense dictates that businesses should begin preparing themselves to deal with a particular state from a tax perspective before the threshold is reached in order to effectively minimize liability and risk. Spur of the moment crisis management responses to unforeseen nexus problems are rarely the most effective way to deal with these types of situations, so be proactive.
Consider making targeted investments in modernizing your company's compliance system to address the inevitable increased demands of “fairness.” Yesterday's tax department may not be adequate to deal with the “fairness” of today. Huge tax liabilities can many times be avoided simply by investing more in the compliance function.
This is all the more important with the new “fairness.” An underfunded, understaffed and unsupported tax department is rarely effective in dealing with multiple audits, and is more likely to make mistakes than a tax department that has priority within the company.
The tax department should no longer be considered as mere overhead. Instead it is your first line of defense and a worthy investment to avoid nasty surprises. Professionals see potential risks and plan accordingly and this often requires an investment of capital to be effective.
So be prepared to invest in additional personnel, outsourcing or to bring in more technology (software, systems, tax matrixes and research tools) to mitigate the increased risk. Also, invest in existing personnel and encourage them to stay abreast of new developments. Listen to their needs for more resources.
Ensure that all departments within the company support the tax department in a timely fashion when records are required. Often a few thousand dollars of information technology support can avoid hundreds of thousands of dollars in tax liability.
The tax department, information technology, systems, consultants, accounts payable, inventory, project managers and the sales department all must be conversant with one another to mitigate risk. Lack of communication among departments can result in expensive and time-consuming tax problems.
The sales department and project managers in particular should be encouraged and allowed to communicate with the tax professionals and vice versa. Routine and well-attended internal presentations, newsletters and meetings can go a long way in helping the company manage risk by keeping everyone informed of potential issues and when questions should be raised.
Auditors, even in the current “pre-fairness” world, often will seek to communicate anonymously with sales and project managers to get ammunition for use against a company in a future audit. Poorly constructed responses to auditor inquiries by uninformed personnel can result in tax liability or at least a more expensive audit defense process, so foster internal communication.
The inevitable result of “fairness” will unfortunately be to complicate and expand the existing compliance demands for many businesses. However, with careful planning, effective preparation and adequate investment, the reality of this new and more “fair” business environment will be easier to digest.
Michael Miller, CPA, is a state and local tax services manager at Merit Advisors LP in Tulsa, Okla. Formerly a sales and use tax auditor for the state of Texas, Miller specializes in sales and use tax with an industry focus in oil and gas, health care, construction, manufacturing and software.
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