Understanding Physical and Economic Nexus: A Critical Guide for Sales Tax Compliance

Most U.S. states charge sales tax. Sales tax is added to the sales of goods or services. Retailers charge end consumers sales tax when they sell the final product. They must remit the sales tax to the local government to fund programs like education and transportation.

Sales tax obligations have become increasingly complicated as businesses expand to operate digitally across state lines. The 2018 South Dakota v. Wayfair Supreme Court case altered the requirement for physical presence. Companies must now pay state sales taxes for both physical and economic presence.

While an international company might not be physically present in the U.S., it may still owe state sales taxes based on its customer base. Certified public accountants can aid international companies in navigating these complex tax issues.

Physical Nexus: Traditional Foundation of Sales Tax Obligations

Before the South Dakota v. Wayfair decision, companies were only required to pay state sales taxes if they held a physical presence in that state.

Definition and Historical Context

Physical presence is typically the first consideration when determining sales tax nexus. A physical presence might include the following:

• Office or retail locations
• Inventory storage or warehouses
• Having an employee or independent contractor
• Affiliation, such as attending a trade show or business meetings

If you have established a physical presence in any state, you are required to pay sales tax.

State-Specific Variations

Having employees, physical locations, or inventory storage automatically establishes a physical nexus in most states.

One of the most common variations in state sales tax laws relates to trade shows and temporary presences. Most states require that you pay sales tax if you attend trade shows to make sales or maintain a market.

Some states may have additional requirements and exceptions for temporary presences. For example, Maine requires you to pay sales tax if you attend trade shows, but only if you solicit sales. Exempt activities include meetings or company retreats, banking, and using printing vendors.

Each state will define “temporary presence” differently. Some will require sales tax for as little as one day, while some will require stays of at least two or three days. Still, others will only charge sales tax for temporary presences that include specific activities.

Economic Nexus: The New Standard

Following South Dakota v. Wayfair, economic nexus became the new standard for determining whether a business is responsible for paying state sales tax.

Wayfair Decision Impact

As businesses began selling online across state lines, state governments searched for ways to impose nexus for tax obligations. Some states sought to use “click-through nexus” by establishing nexus through affiliates or “cookie nexus” that used digital cookies as physical nexus. But these policies were legally questionable.

The Wayfair decision overturned physical nexus requirements, now only requiring economic nexus for state taxes. States can now establish economic nexus guidelines but cannot unduly burden interstate commerce.

South Dakota’s laws became a framework for many states because they accounted for small sellers, efficient administration, uniform business definitions, and business software that continued encouraging interstate commerce.

Economic Nexus Thresholds

Each state has requirements that dictate when your business must pay sales tax. Many states require businesses to pay sales tax once they exceed $100,000 in sales or 200 transactions within the state’s jurisdiction. However, this can vary. For example, California, New York, and Texas have significantly higher thresholds at $500,000.

Take a look at the table below for current state tax thresholds.

Unfortunately, varying measurement methods complicate these thresholds further. Some states measure based on gross revenue, while others only account for taxable transactions. In addition, some states use the calendar year to set tax deadlines, while some have a 12-month rolling measurement period.

Special Considerations

Remember that additional provisions are in place to add and remove tax obligations from your business. For instance, marketplace facilitator laws place the burden of collecting and remitting tax on marketplace platforms. Sites like Amazon or Etsy must collect sales tax for you.

Some transactions are also exempt from paying sales tax. In these cases, the purchaser must have a valid exemption certificate. Otherwise, your business must collect tax. If you don’t ensure that the certificate is valid, you may be held responsible for paying the tax.

Digital product sellers, service providers, and wholesalers must also conduct additional research. Consider:

• Each state has a variable definition of digital products and whether they are taxable.
• While most states don’t tax services by default, this isn’t the case in Hawaii, South Dakota, New Mexico, or West Virginia, where only a few exemptions exist.
• Wholesalers are generally not required to pay sales tax, since they are not selling products to the end user.

Proper Sales Tax Accounting

If your business has a physical or economic nexus in any state, your accountants are responsible for maintaining accurate sales tax records. They must record proper journal entries for sales tax payments, integrate records with accounting software, prepare businesses for audits, and more.

Journal Entries for Collected Sales Tax

Even though you charge your customers and collect sales tax, it does not fall under revenue. Instead, it is entered as sales tax liability since you owe it to the corresponding state governments. Accountants record sales tax using journal entries outlined by Generally Accepted Accounting Principles (GAAP).

You can organize your books by creating a Sales Tax Payable account, which includes sales tax that you have collected from customers but not yet paid to the appropriate states. Since payable accounts are liabilities, you increase them with credits and decrease them with debits.

When you collect sales tax, you will increase your Sales Tax Payable with a credit and your Cash account with a debit. You can also credit your Sales Revenue account. When you pay the sales tax to the government, you will debit your Sales Tax Payable and credit your Cash.

For example, let’s say you sell a product for $100 with a 5% sales tax. To calculate sales tax, multiply $100 by 0.05, which equals $5 for a total charge of $105. In this case, you would debit your Cash account for $105, credit your Sales Revenue for $100, and credit your Sales Tax Payable for $5. When you remit the sales tax, you must credit your Cash for $5 and debit your Sales Tax Payable for $5.

Sales Taxes and Financial Statements

The three primary financial statements—balance sheet, income statement, and cash flow statement—reflect assets and liabilities in different ways. A current liability is any liability that is due within 12 months, which typically includes sales tax due to a state government.
The cash flow statement will list your Sales Tax Payable account and any sales tax payments made within the cash flow period as decreases in that account.

Income statements can be used to estimate tax payments. It calculates both pre-tax income and net income after taxes.

Maintaining Documentation for Compliance

Accountants must maintain complete and accurate records and financial documentation to ensure sales tax compliance. This begins with keeping journal entries in a general ledger detailing the collection and remittance of sales tax. Your Sales Tax Payable account is crucial for clearly identifying transactions related to sales taxes. You should also keep accurate returns and credit records, since you are no longer responsible for paying sales tax for the returned items.

Accountants and other financial professionals should also work together to save and organize supporting documents, such as receipts, invoices, exemption or resale certificates, tax returns, inventory records, and any other documentation you can use during an audit or nexus study to prove that your books are accurate.

Sales Tax Reconciliation

Sales tax reconciliation is the process of verifying that your business has paid the right amount of sales tax. Start by gathering all of your accounting books and supporting documents. Separate taxable sales from non-taxable sales, as well as sales from different sales tax jurisdictions.

Calculate your total taxable sales and total sales tax liability for each state where your business has a nexus. If your business claims credits for sales tax paid on purchases, you should also gather documents detailing those purchases.

If you’ve already filed state sales tax returns, compare your sales tax liabilities to the amounts entered on your returns. If the numbers don’t match, review your records for errors. You may have inaccurate journal entries, data entry errors, or misclassification of taxable sales.

You can reconcile the differences by paying the amount you owe or filing for a refund if you overpaid. You should also update your financial records with detailed documentation about the errors and how they were reconciled.

Importance of Economic Nexus Studies

Performing a nexus study can help your business determine which states you owe tax to by evaluating your revenue, transaction counts, and more.

Risk Management

You risk being fined or imprisoned if you don’t comply with state sales tax laws. Monetary penalties could include a standard fine as a percentage of tax owed, interest, and additional fines if you don’t pay for multiple years.

States can audit your business within their lookback periods to verify how much tax you owe. Lookback periods are typically three prior filing years (although this statute of limitations doesn’t apply to fraud or tax evasion).

If you owe tax from previous years, you may be able to submit a voluntary disclosure agreement (VDA) to avoid penalties, interest, or criminal prosecution.

Nexus studies can help you prepare for audits by having your documentation organized and accounts balanced. Both nexus studies and audits require a complete view of your business’s accounts and financial transactions. Your accountant should help you gather the required documentation, such as bank statements, invoices, expense receipts, inventory records, asset information, debt agreements, and business structure documents.

A nexus study can also help your accountant prepare a variety of other audit defense strategies, including:

• Assessing potential outcomes after the audit, such as fines or legal repercussions
• Disclosing information that can reduce the risk of prosecution or other consequences
• Sharing data and evidence for quick and easy responses to audit queries
• Establishing processes for litigation and disputes
• Tracking deadlines, legal proceedings, and state-specific court systems
• Updating accounting procedures to reflect audit findings
• Documenting the audit process, findings, and conclusion

Your accountant should have everything they need to defend your business as needed. They should have all the data necessary to understand the reason for the audit, how you can fix any errors or mistakes, and how to defend your business’s credibility.

Business Benefits

A nexus study can also have the following overall benefits for your business:

• Allows you to plan and budget for tax liabilities
• Identifies potential cost savings through proper business structuring
• Improves your competitive advantage by ensuring compliance
• Provides information for better decision-making regarding market entry

Tax professionals are adept at helping companies reduce their tax burden through nexus studies. Each state has exemption opportunities. If your business offers products or services that qualify for exemption, a nexus study could help you categorize these transactions and discover new savings potential.

Study Methodology

A nexus study involves an in-depth analysis of sales transactions and revenue.

You must gather data to interpret your sales by state, transaction counts, and taxable sales to determine whether you meet economic nexus thresholds. Financial statements, employee/contractor locations, inventory management data, and other documents are all helpful in evaluating economic and physical nexus.

Software is available to help businesses compile all necessary data. When combined with human expertise, this technology can ensure tax compliance efficiently and accurately.

International Business Considerations

International businesses are also responsible for ensuring compliance with state sales tax regulations. Even if you don’t have a physical presence, you must consider economic nexus.

Special Challenges

The foreign entity registration process is often more complicated than for domestic businesses. States may deny or delay your tax permit if you don’t have proper U.S. business registration and documentation. The process may vary slightly for foreign entities when registering through a state’s Department of Revenue.

State sales tax focuses less on entity structure and more on the taxability of your products or services. However, international businesses should know how likely their entity structure is to establish a nexus. For example, a partnership with one partner living in the state is more likely to create a nexus than a C corporation with a shareholder living in the state.

If your business resells goods, you may be eligible for a resale certificate that exempts you from collecting sales tax. However, international businesses may encounter varying requirements for each state that exceed the requirements for domestic businesses.

Some other challenges that international companies face include:

• Distinguishing between VAT and sales tax while complying with all tax obligations
• International tax treaty implications (state sales taxes are typically not protected by tax treaties)
• Currency conversions when paying sales tax

Compliance Strategies

To register for state sales tax, you must have an individual taxpayer identification number (ITIN) assigned by the IRS. Then, you can register as a taxpayer in each state where you have a nexus.

Filing requirements and deadlines vary by state. You must file monthly, quarterly, or annual returns depending on the state’s requirements. Most states provide online payment methods and access to account information for more compliance strategies.

Before you file, conduct a self-audit to ensure you don’t owe taxes for previous periods. You should retain business and financial records for lookback periods that typically span three to four years prior.

Technology Integration

Technology can be a valuable tool for international businesses managing sales taxes for multiple jurisdictions. Existing programs can aid in calculating sales taxes, tracking sales tax obligations, compiling returns, managing supporting documents, and more.

Various data management solutions can also be integrated to improve interdepartmental access and efficiency. For example, enterprise resource planning (ERP) systems allow you to store data from multiple business processes, including finances, human resources, sales, inventory, etc.

When choosing an automated tax engine, look for technology tailor-made for your specific industry and that understands the complex regulations that come with industries like healthcare, energy, retail, insurance, etc. Tax software that is known to integrate with your ERP is also essential for a seamless technology system. Finally, consider finding a tool that streamlines e-invoicing and makes the sales tax process easier for online payments.

Action Steps for Businesses

All businesses should have policies and procedures established to ensure sales tax compliance.

Initial Assessment

A nexus study and state exposure review are beneficial first steps in initiating sales tax compliance programs. You should analyze your sales data to determine your sales tax nexus.

Assess your available resources for information and assistance. While sales tax software is helpful, it can’t replace the value of experts with experience compiling and analyzing data, interpreting sales tax laws, and aiding international businesses with complex tax systems.

Implementation Plan

Your compliance procedures should encompass multiple parts of your business. You must provide proper training to staff and work with professionals who have an in-depth knowledge of the state tax systems.

Planning is an essential step in complying with tax regulations. Each state will have slightly different deadlines for registering and filing. You may need to file at differing frequencies if you have nexus in multiple states. And you must be aware of lookback periods that might require longer retention of business documentation.

Ongoing Monitoring

Consider having a compliance calendar that can be updated as needed. Your team should be up to date with the latest tax laws as states make changes to thresholds, registration deadlines, or sales tax rates.

Schedule regular assessments of legislative updates to make sure you comply. It’s important to understand updates in all states, even if you don’t currently have nexus in a particular jurisdiction. Laws can change, which could then give you a nexus.

How Our Firm Can Help

Prager Metis International Services specializes in providing cross-border tax solutions. Our team of accountants and financial advisors can help conduct economic nexus studies, register with state tax departments, file for exemption or resale certificates, and fulfill audit requirements.

Outsource your entire compliance program to our experts, who can advise you on various international tax-related subjects. Our team of highly respected tax specialists holds years of industry-specific experience helping multinational companies manage tax compliance.

We also have access to technological solutions for a combined effort to produce efficient and accurate results. Our long history of successful client relationships demonstrates Prager Metis’ knowledge and determination to keep your business running smoothly.

Stay On Top of Sales Tax

Don’t wait to address your tax compliance strategies. Your business will have a higher chance of long-term success if you take a proactive approach to state sales tax laws.

Rather than paying penalties and fines, consider investing in a professional partnership to ensure your business stays compliant. Not only will you likely save money in the long run, but you’ll also be protecting your company’s legacy.

Contact Prager Metis today for a consultation to learn more about how our tax experts can help you implement a strong sales tax compliance program.