As businesses new and old start to expand their customer base, there are several state tax reporting requirements worth considering. Legislation, as it pertains to technology, still varies greatly from state to state, and continues to change. Regardless of whether you’re just beginning your expansion or you’re growing and want to make sure your bases are covered, the first step is understanding your products and your presence in different states. Taking this initial step will ensure you’re handling state tax compliance correctly.
Tax nexus
Defines the level of connection between a taxing jurisdiction such as a state and an entity such as your business.*
The concept of tax nexus is a fundamental pillar in state taxation and describes a business’s tax presence in a particular state. It defines the required amount of business activity before a state can tax a company’s sales or income. Historically, businesses without employees or properties in a state did not have tax nexus and were not required to collect and remit sales taxes. However, according to the 2018 decision in South Dakota v. Wayfair, Inc., states can now require out-of-state sellers to collect and remit sales tax from in-state buyers even if the seller doesn’t have a physical presence in the buyer’s state.
Understanding the Different Types of Business Taxes
To effectively manage state tax compliance, it’s critical to understand the different types of taxes. Three of the primary taxes that businesses incur are traditional income tax, gross receipts tax, and sales tax. Income tax is imposed by governments on the income generated by businesses within their jurisdiction. Gross receipts tax, unlike income tax, is taxed directly based on a company’s sales without the deduction of their costs. Lastly, sales tax is paid to a government on the sale of products or services — this tax type is driven by tax nexus.
With sufficient sales tax nexus, businesses are obligated to collect sales tax from customers and remit to the state. This is known as an indirect tax because the tax expense is imposed on the customer, however, if a business has nexus and doesn’t collect tax on a sale, it can be held directly liable for the tax. The only instances in which a business isn’t held accountable for any unpaid tax are if it can prove the sale wasn’t subject to tax, or if the customer paid the tax. In some situations, the state may even take action to impose the tax directly on your customer — this has the potential to cause major reputational damage to a company.
Bright-Line Thresholds for Sales Tax Nexus
Businesses can recognize if they have established nexus as they begin to sell and hire from a wider geographic market. Sales and payroll thresholds are both key indicators to help companies determine if they have nexus and are required to file and pay taxes within a state.
Many states have adopted bright-line thresholds to help businesses understand the financial standards for jurisdiction presence. Bright-line thresholds are factors including property, payroll, and sales for a business to presume nexus within a state. These are typically either a set dollar amount or 25% of the total property, payroll, or sales.
One commonly adopted bright-line threshold is $250,000 in sales. For some businesses, this can easily be reached in a single transaction. It’s also important to note that 25% of total sales can be much lower than $250,000, particularly in the early years of business. For instance, if your business has total sales of $800,000 with $200,000 in a specific state, you wouldn’t have reached the $250,000 threshold – however, you have reached 25% of the total sales.
Another example of a bright-line threshold is $50,000 in payroll. Within today’s job market, this can be reached quite easily, especially in with higher salary ranges. Moreover, as the workforce becomes increasingly remote, top candidates may be based in other states, which contributes to a decentralization of payroll. While $50,000 is a standard threshold, bright-line payroll thresholds vary among states and can be higher or lower depending on your location.
State Taxation on Digital Goods, Products, and Services
In addition to the various levels of tax thresholds, businesses must also understand the difference between taxing products and services. In general, Tangible Personal Property (TPP) is taxable, while services are not. TPP includes any physical goods that can be moved or touched. As a business, it’s crucial to make the distinction between whether you’re selling a TPP or service, particularly as digital products become more commonplace.
One digital product example is a digital good, or a digital version of an item that would be classified as TPP in the real world. Some examples of digital goods are books, music, and movies, all of which can be subject to state sales tax.
A second example of a digital product is software, which can be customized or canned. Custom software is developed for the specific needs of a business, while canned software is ready-made and built for an industry niche. Customized software is not taxed, whereas canned software is taxable.
The most commons example of a digital product is software as a service (SaaS), such as online platforms and apps. In general, SaaS products are not taxed; however, there are exceptions among states like Massachusetts, New York, Pennsylvania, Rhode Island, and others.
The Basics of NFT Taxation
Non-fungible token (NFT)
For purposes of sales taxability, a non-fungible token (NFT) is commonly defined as a digital code that grants buyers the right to obtain a product and is associated with a specific digital or physical asset.
For purposes of sales taxability, a non-fungible token (NFT) is commonly defined as a digital code that grants buyers the right to obtain a product and is associated with a specific digital or physical asset. For example, an NFT can come in the form of art or video. The underlying digital or physical asset of an NFT determines the tax treatment. For instance, if an NFT is associated with a digital good like music or a TPP like memorabilia, these are often taxed.
Despite the explosion of NFT sales, there are still many nuances to taxation that remain unclear. Sellers must ask themselves key questions to understand if they’re subject to sales tax.
- What if the underlying product isn’t determined at the time of sale?
- What is the treatment of secondary income?
- How do you source where an NFT is purchased?
States including Minnesota, Pennsylvania, Puerto Rico, and Washington have announced plans to apply sales tax to NFT transactions; however, there is still much uncertainty about the specifics of NFT taxation.
As businesses continue to expand their product lines, there are key factors to consider in relation to taxes. Consider these taxation circumstances as your organization grows in sales and revenue:
- Although a new product may fulfill the same customer need as an existing product, it may not be taxed the same.
- Your target market can impact taxability — particularly from a geographic standpoint. (E.g., the same SaaS is taxable in MA but not in CA.)
- Commodification can change taxability. For instance, if you take a non-taxable custom software solution and begin selling it to others, it becomes canned software and is now subject to taxation.
- Bundled transactions can make a good taxable. For example, selling a taxable digital product with a non-taxable service can ultimately make the whole transaction taxable.
Addressing the Changes in State Tax Compliance Across Tech
Keep in mind that state tax compliance with regard to technology is still very much a moving landscape. Without the push to address a third category, states historically have looked at products in black and white – as either a service or a tangible good. It was just in 2017 that Wayfair prompted states en masse to recognize that the world is moving away from a brick-and-mortar marketplace and the need to address the implications of an online marketplace for tangible goods. Now that “online” is becoming the default, you can be sure that policy makers will be playing catch up to adjust to the fintech
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