Businesses Face Challenges with Sales Tax Compliance and Lease Agreements

25 June 2024

Sales Tax Compliance: A Complex Landscape

Sales tax compliance is a bit of an unknown quantity in the US. Calculating the tax gap—the difference between taxes collected and taxes owed—in sales and use tax is much more difficult than the income tax gap. For income tax, there are secondary sources of information available from employers; in sales tax, there is no regular function by which consumers report their transactions or calculation that can be made of what taxes should have been collected and remitted but weren’t.

Thanks to the nature of sales tax and an overall lack of tax transparency, we can’t know for sure which corporate taxpayers are, and which aren’t, collecting and remitting sales tax. Often, we first become aware of sales tax collection on transactions when a corporation announces it will begin doing so. Microsoft Corp. subsidiary GitHub—announced late last month that it would begin collecting and remitting sales tax in August. More transparency is needed.

There is substantial administrative overhead placed on businesses seeking to comply with patchwork state policies. GitHub had $1 billion in revenue in 2023 and has over 1.3 million paid subscribers, but smaller businesses with fewer resources will expend a larger percentage of their operating capital navigating state policy waters.

States shouldn’t wait for corporations to decide to comply or publicize existing compliance. Instead, they should be proactively enforcing compliance among major corporations and allocating a portion of additional revenue to services aimed at helping small businesses.

Compliance Post-Wayfair

The US Supreme Court’s 2018 decision in South Dakota v. Wayfair altered the sales and use tax landscape by allowing states to require businesses to collect and remit sales tax regardless of physical presence in the state. The decision sought to level the playing field between stores with a physical presence and their online-only competitors.

Wayfair set broad thresholds, but states are free to enact their own bespoke sales and use tax legislation within them. The result is a patchwork of different tax policies that makes the playing field for small businesses anything but level.

Often, the financial and administrative costs of developing compliance systems is a substantial cost for a new business. Smaller businesses especially may struggle with these burdens, and there’s a cottage industry of services that exist solely to sort out these calculations. An Avalara/Potentiate survey found that small and medium-sized businesses spend on average $2,455 per month on sales tax calculation—over and above the tax they remit.

Corporations such as GitHub announcing they will begin collecting sales tax suggests there is some state sales and use tax gap—even if we can’t put a specific value to it.

The state sales tax gap should be tackled by working from big to small: Ensuring compliance among large corporations and providing services to aid small and medium-sized businesses. State sales tax compliance isn’t a small undertaking, even for a billion-dollar company. For a small business or startup, the challenges of navigating and ensuring compliance can be exponentially more daunting.

Level Playing Field

States should consider following the IRS’s stated goal to focus audit and compliance attention on corporations. Otherwise, states may be leaving a considerable amount of money on the table by not enforcing sales tax thresholds on services and instead waiting for companies to voluntarily comply.

Post-Wayfair, every state with a sales tax now has a policy reflecting an economic nexus requirement. States including Hawaii, New Mexico, and South Dakota tax nearly all services, including electronic ones, and without diligent enforcement may be missing out on significant revenue from non-compliant corporations.

Digital services such as those provided by Twitter/X Premium, ChatGPT Plus, Dropbox, and Snapchat+ are subject to state sales tax in many jurisdictions and the service providers should be collecting and remitting those amounts on behalf of users.

Large corporations with massive user bases may lag behind smaller businesses in keeping up with the changing landscape of sales and use tax compliance. This may be owing to the simple fact that the number of jurisdictions in which they must calculate, collect, and remit sales and use taxes are that much higher. Despite this, larger businesses are most able to shoulder the administrative burden of compliance—and should be made to do so.

Corporations choosing when to begin collecting sales and use tax puts compliant businesses at a competitive disadvantage for the time in between. The result is a skewed business environment, with many small businesses at pains to ensure perfect adherence while their larger corporate counterparts pick a date to begin complying.

Proactive Approach

To address potentially non-compliant corporations, state departments of revenue should implement targeted audits beginning with the largest corporations; increase penalties for corporations that are non-compliant, including estimates of back taxes owed; and provide support for smaller businesses seeking to meet their obligations.

By recommitting to corporate compliance and directing some of the additional revenue toward projects that can aid small businesses in calculating the taxes they need to collect, states can do two things at once.

With proper funding, state departments of revenue could provide databases of state and local tax rates and an application programming interface that third parties can use for automated calculation purposes.

This would eliminate a major cost point for small businesses and could provide them with a safe harbor. Taxes collected and remitted consistent with the calculations made by state software will be presumed in good faith for purposes of fraud penalties.

Most state sales tax rates range between 5% and 7%, and 45 states have statewide sales and use tax policies. Approximately 30 states have a sales tax that’s applied to digital services.

For illustrative purposes, let’s imagine TaxHub, a fictitious software development platform that had $1 billion in revenue in the US in 2023. If TaxHub saw 60% of its revenue come from services that are taxable, that would mean at an average sales tax rate of 5%, it should have collected $30 million on behalf of its users—and remitted the same to the corresponding state departments of revenue.

Spread out across 30 states, that’s an average of $1 million of sales tax per state from that merchant alone. Although state departments of revenue are chasing down restaurants and retail establishments they suspect of suppressing sales, they could be seeing a much higher return on their compliance investment by simply targeting major technology service providers.

The fictitious TaxHub example shows why states should begin scrutinizing other technology service providers and enforce those companies’ adherence to sales and use tax laws. This would ensure fair contributions to state budgets and level the playing field for small and medium-sized businesses struggling to comply, creating a virtuous cycle of a business-friendly environment and increased tax revenue.

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What makes calculating the sales tax gap harder than the income tax gap in the US?

Calculating the sales tax gap is more challenging than the income tax gap due to the decentralized nature of sales tax administration across numerous state and local jurisdictions, varying tax rates, and the complexity of tracking cash transactions and online sales.

Can calculating the sales tax gap be more complex due to the lack of secondary information sources?

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