Understanding Sales Tax for eComm: A State-by-State Guide for Growing Startups

eComm startups already have unique business models, relying on subscription-based services and marketplace platforms. Yet, another often overlooked aspect of running an eComm startup involves sales tax. Specifically, managing sales tax in the different states that you’re selling to.

Failure to collect sales tax appropriately from the states your eComm startup is selling to can have dire consequences, underscoring the importance of having the right systems in place to account for this. Graphite Financial, a leading accounting services partner for startups, is here to help you navigate complex multi-state sales tax compliance.

Sales and use tax for eComm businesses became more complex in 2018 when the Supreme Court ruled on South Dakota v. Wayfair. Essentially, the Supreme Court ruled that states can require online sellers to collect sales tax based on economic activity in that state, overturning a previous standard that required a physical presence to do so.

Read on to learn more about scaling your eComm startup across state lines and the importance of understanding sales tax regulations.

Economic Nexus and Physical Nexus Requirements for eComm Startups

Economic nexus refers to the connection between your eComm startup and a state that triggers sales tax obligations, even if you don’t have a physical location in that state. States are permitted to establish economic thresholds based on dollar and transaction amounts that mandate when your startup has to collect sales tax. The most common threshold is $100,000 in sales or 200 transactions. Another common threshold is $100,000 in sales without transaction requirements. Some states tend to have higher thresholds. For instance, New York’s threshold is $500,000 in sales and 100 transactions.

While economic nexus is based on sales activity or transaction volume in a state, your startup may also have a physical nexus if it has a tangible presence there. Physical nexus also establishes a sales tax obligation. Triggers include:

• Warehouses
• Third-party fulfillment centers
• Employees located within a state, whether they’re full-time, part-time or independent contractors

Post-Wayfair Economic Nexus Thresholds

Following the Supreme Court’s 2018 decision in South Dakota v. Wayfair, states are empowered to collect sales taxes on online sales. This is most commonly done when sales revenue or transaction volumes are met. Some states require a combination of both.

The most common threshold is $100,000 in sales or 200 transactions, with examples including Georgia, Hawaii, Illinois, and Louisiana. States like Idaho and Kansas, conversely, rely on sales, not transaction amounts. The economic nexus is $100,000 in these states. Some states, like Alabama ($250,000), California ($500,000) and New York ($500,000 in sales and 100 transactions), have higher thresholds, while a handful of states don’t have a state sales tax and therefore no economic nexus.

Some states also measure revenue and transactions using lookback periods. Lookback periods are timeframes used to determine whether an eComm startup has met or exceeded thresholds. For instance, while some states use the current calendar year, others may use a rolling 12-month calendar.

Physical Presence Triggers Beyond Traditional Offices

Physical nexus is triggered when an eComm startup has a physical presence in a state, usually in the form of an office, warehouse or a certain number of employees. However, there are less obvious triggers that your startup should be aware of as well. Some of these less obvious activities that establish nexus include:

• The presence of independent contractors and/or remote employees
• Affiliations with subsidiaries
• Drop shipping scenarios, where both the eComm startup and the drop shipper can create nexus
• The use of third-party fulfillment services
• Attending trade shows or conferences in other states can potentially trigger nexus

Affiliate and Click-Through Nexus Considerations

Affiliate nexus occurs when an out-of-state startup has a relationship with an in-state entity that helps promote or increase sales.

There’s also a click-through nexus, which triggers when your startup enters an agreement with either an individual or another business in a state to refer potential customers to its website. Most states have adopted click-through economic nexus laws, though thresholds and requirements vary.

Another consideration is cookie nexus, which is the connection established by a startup’s use of website cookies to track user activity within a geographical area. This connection potentially triggers nexus.

High-Impact States for eCommerce Sales Tax Compliance

Your eComm startup is likely to achieve a nexus in the states with the highest consumer populations and highest online shopping rates first. These tend to include California, Texas and New York.

California’s Complex District Tax System

California, specifically, has a unique multi-layered tax structure. Statewide, there’s a 7.25 percent sales and use tax, which includes a 6 percent state tax and a 1.25 percent local tax that’s allocated to cities and counties. However, many cities and counties impose district taxes, which may range from 7.25 percent up to 10.75 percent. California’s economic nexus is $500,000 in annual sales.

Given the district tax variations, it’s important for eComm startups to institute accurate zip code mapping, as orders shipped may require different tax rates depending on location. Some products may be exempt from sales tax, but your startup must collect exemption certificates to maintain compliance.

Texas Origin-Based Sourcing Rules

Texas uses an origin-based system for eComm sellers, where the sales tax rate is determined by the seller’s location rather than the buyer’s. For in-state sales, sellers collect taxes based on combined state and local sales taxes, while out-of-state sellers collect taxes based on the buyer’s location. Remote sellers reach economic nexus in Texas if their revenue exceeds $500,000 in the preceding 12 months.

New York’s Aggressive Enforcement Approach

New York’s nexus thresholds are $500,000 and 100 transactions. Sales made through a marketplace facilitator also count toward the seller’s economic nexus. Marketplace facilitators are those who facilitate sales, process payments or conduct other activities (i.e., advertising, handling returns, etc.).

There are some exemptions to note in New York. For instance, clothing and footwear less than $110 are typically exempt from the New York state sales tax. However, not all clothing-related items are exempt. Costumes, rented clothes, athletic equipment and clothing for animals are not exempt.

Digital Products and SaaS Taxation Across States

What about state taxation for digital products? It’s becoming increasingly complex for SaaS startups. While some states tax digital products, others don’t. However, those that do tend to tax them differently than physical products.

Some states consider downloads to be tangible personal property and tax them accordingly. This includes streaming services, music files, e-books, and movies. However, keep in mind that states vary in their approach. Some states tax downloads and streaming services, while others tax only downloads or streaming.

States with Comprehensive Digital Taxation

Washington, Tennessee and Pennsylvania have broad digital taxes that apply to both downloads and streaming services. Staying compliant can be a challenge, and often involves robust record keeping and integrating advanced tax software with your eComm platform to streamline nexus tracking. Additionally, it’s important to know that state tax laws are constantly changing — and there are 50 states to monitor.

Digital Product Exemption States

Some states, such as California and Florida, exempt most digital products from taxation.

When bundling digital and physical products, it’s still important to apply the correct sales tax on physical goods — even if digital products are exempt. Again, all states are different when assessing bundled goods. Some consider the transaction non-taxable if the taxable portion of the bundle falls below a certain percentage, regardless of the items. Others apply a “true object test” to determine if the consumer’s intent was to acquire a tangible good or non-taxable product/service.

Building a Scalable Sales Tax Compliance Infrastructure

Establishing the right framework is important to comply with sales tax in the states your eComm startup is selling to.

• Register: Register for sales tax permits once you’ve established nexus in a state.
• Collect: Calculate and collect sales tax appropriately where the sale occurs.
• Remit: Remit sales tax returns with the appropriate authority.

If your eComm startup is in growth mode, it’s often beneficial to work with a professional to ensure compliance. Rather than hiring a professional in-house, many startups elect to work with a qualified external partner.

Registration Strategy and Voluntary Disclosure Agreements

Startups should proactively monitor activities to identify when they’re likely to meet nexus in a specific state, which can thereby help with registration for a sales tax permit.

It’s also best practice to periodically review your startup’s current sales tax practices and compliance levels to identify any risks or gaps. If you’re in non-compliance, consider entering into a voluntary disclosure agreement with the specific state to reduce penalties as you meet your obligations.

Automated Tax Calculation and Collection Systems

Establishing a robust collection system and automating programs accordingly is the best way to ensure compliance with state sales tax laws. The best tax automation platforms seamlessly integrate with your eComm startup to streamline collection. Such programs can also help with filing.

API implementation is another strategy that allows external applications to interact with and exchange data with core platforms. This can further help streamline order processing and payments and comply with sales tax obligations.

Filing Frequencies and Remittance Optimization

The higher your eComm startup’s sales volume, the more frequently you’ll have to file. This helps ensure the state gets its tax revenue more regularly. If your startup has lower sales volume, it will likely need to file less often.

Some states even offer timely filing discounts as an incentive to file and remit on time or early. Such discounts can range from 0.25 percent to 5 percent of the tax due, thereby lowering your startup’s tax liability and improving cash flow.

Common Sales Tax Compliance Pitfalls for Scaling eCommerce Startups

Collecting state taxes can be complicated, and startups may be prone to error if they’re not careful. Some of the most common mistakes that trigger audits and penalties include:

• Drop-shipping complications and resale certificate management
• Managing marketplace facilitator law nuances
• Failure to properly collect and remit sales tax in states where you’ve achieved nexus
• Lack of sales tax permit in states where you’ve achieved nexus

Marketplace Facilitator Law Complications

Sell directly via your website or work with marketplace channels like Amazon and Etsy? It’s a decision that your eComm startup has to make — and it can have an impact on state taxes. As your startup grows, a combination of each approach is what most opt for. While sellers are responsible for sales tax obligations in direct sales, marketplace platforms are responsible when these platforms are involved.

Note that seller responsibilities are still present in marketplace scenarios, and there may still be a nexus in certain states. Multi-channel inventory can make this more complicated.

Product Taxability Classification Errors

Incorrectly identifying goods and services can lead to tax classification errors, which can thereby lead to over- or under-taxation.

Common classification errors include those involving food, clothing, digital products and services. For example, in New York, clothing is exempt up to $110. In New Jersey, authentic fur clothing is taxable, but synthetic fur is exempt. The taxability of food is also very nuanced.

eComm startups also often have to manage seasonal and promotional pricing impacts. For instance, during the holidays, some items may be temporarily exempt.

Conclusion: Partnering with Graphite Financial for Comprehensive Tax Compliance

If you’re overwhelmed managing the always-evolving state sales tax regulations in your eComm startup, contact Graphite today for help. As a professional accounting services firm that specializes in working with startups, our integrated approach combines bookkeeping, tax compliance and CFO advisory services. Contact us today to learn more and schedule a consultation.

FAQs

Which states have the lowest economic nexus thresholds for eComm sales tax?

States with the lowest economic nexus thresholds for eComm sales tax include Oklahoma, Kansas, North Dakota and South Dakota. Oklahoma, for instance, has an economic threshold of $10,000.

How do marketplace facilitator laws affect my direct-to-consumer sales tax obligations?

While marketplace facilitator laws mostly impact sales made through online marketplaces rather than DTC sales, there are some things to note. For instance, nexus still applies to DTC sales, and sales might count toward economic nexus thresholds. Given this, it’s important to understand nexus, register for sales tax permits and file returns accordingly, and maintain clean records.

What happens if I’ve been selling in states without collecting sales tax?

If your startup is selling in states without sales tax collection, you could face some big problems. For starters, you’ll be the entity that needs to pay sales tax or uncollected taxes and some states may impose penalties on overdue amounts. Your startup also becomes more likely to be audited. Perhaps most significant of all, your startup could face operational and reputational damage.

Do I need to collect sales tax on shipping charges to customers?

This largely depends on the state you’re delivering to. Some states tax shipping charges if the items are taxable, while they may be exempt in other states. Another factor is invoice presentation. If shipping costs are listed separately on the invoice, many states may exempt shipping charges.

How do product returns and refunds affect sales tax remittance?

It’s a fairly simple concept: When customers return items for a refund, your startup must also refund the sales tax that was collected. This may require your eComm startup to adjust its sales tax filings to accurately reflect the reduced taxable sales.

What’s the difference between origin-based and destination-based sourcing for eComm?

Origin-based and destination-based sourcing refer to how sales taxes are determined during a transaction. In origin-based sourcing, sales tax is based on the location of the seller. Conversely, in destination-based sourcing, sales tax is based on the location of the buyer. Most states operate under destination-based sourcing.

How do I handle sales tax for subscription boxes with products shipped monthly?

Start by determining the sales tax nexus and registering for a sales tax permit. Most states consider subscription boxes tangible goods, yet taxability also depends on the specific items in the box and the specific state’s sales tax rules and laws.

Should I register for sales tax permits before or after reaching nexus thresholds?

Generally speaking, your eComm startup should strive to register for a sales tax permit in a state once it establishes a sales tax nexus there.