Expert strategies for e-commerce businesses to stay tax compliant across their multi-state operations

Picture120272024 - Global Banking | FinanceBenjamin Kluwgant, state and local tax expert and Director at Source Advisors explains what e-commerce business owners need to know about navigating state tax regulations to ensure they remain compliant

US e-commerce businesses are at risk of non-compliance with state and local taxes (‘SALT’); a critical aspect for strategic financial planning. Sales tax and state income tax filing requirements continue to be a common pitfall for e-commerce businesses, potentially costing them millions in taxes, penalties, and interest each year.

E-commerce businesses are particularly vulnerable to SALT complexities for three reasons: their nationwide customer bases, diverse product and customer portfolios, and remote workforces. Every connection with a state, irrespective of its significance, creates uncertainties about state tax filing requirements.

What do founders of e-commerce businesses need to be aware of with SALT?

Founders of e-commerce founders have several important SALT considerations to keep in mind when starting out.

1. Customer location

E-commerce founders need to be aware of where their customers are going to be located so they can keep tabs on their revenue and activity levels in those locations.

Internet sales enable businesses to break down geographic borders and sell their products to customers nationally. While powerful and part of the appeal of e-commerce, this national reach brings its own set of challenges.

From a SALT perspective, an e-commerce transaction can create a connection with a state, triggering the requirement to register for and file state taxes. This connection is referred to as Nexus, and its definition varies across states and tax types.

Despite operating physically outside of the states they sell into, e-commerce companies are likely to become connected to a state through meeting ‘economic nexus’ thresholds. These are the state-set volume-based metrics that, once hit, require the company to register for sales tax and state income tax.

2. Product taxability

Sales are not always taxable. Sometimes, the customer is exempted from sales tax, and other times, the product itself is not taxable.

Some locations even have unique local taxes on certain product types.

Whether they sell multiple product types, or to various customer personas, e-commerce businesses need to be aware of whether the product they are selling is taxable.

Collecting tax on the wrong products puts the e-commerce business at risk of having to deal with disgruntled customers, and not taxing certain products can lead to penalties and interest during an audit.

3. Employee, contractor, and inventory location

Physical location of business affairs also needs to be a focal point for e-commerce businesses.

Given the location-agnostic nature of these businesses, there is a strong likelihood that they store inventory in multiple locations, they use third parties for freight and other services, and employ people who are based in different locations.

‘Economic nexus’ is not the only nexus trigger. Another way to establish Nexus is through maintaining a ‘physical presence’ in the state, making every business activity a potential trigger.

If founders want to stay ahead of the curve, they need to know exactly which states they are going to be physically connected with, and keep up with their filing requirements in each.

The consequences of non-compliance in the e-commerce Industry:

The consequences of non-compliance range markedly, but are all of great significance.

It goes without saying, failure to comply with SALT requirements means that taxes, penalties, and interest on those taxes and penalties are lingering, and can threaten to derail the business financially.

However, non-compliance creates other, deeper business issues for e-commerce founders. Without a SALT strategy, the business’s value, bandwidth, and sellability become unstable.

From a business value standpoint, failure to comply means you likely owe the relevant state departments unpaid taxes, creating an unknown but significant ‘ghost’ liability on the company’s balance sheet.

Bandwidth is always at risk too. State tax audits can happen at any point in time, and without a dedicated strategy, these audits can completely consume a huge amount of the Founder’s time, which is a critical commodity in the early stages of running a business.

Even if the founder survives the audit and settles the debt, an entirely new expense of setting up systems to support SALT compliance becomes relevant and potentially crippling.

Lastly, many e-commerce founders build their businesses with the hope to ultimately sell them to larger players. A review of SALT affairs form part of any thorough due diligence process, and non-compliance can put off potential buyers.

Strategies for founders of e-commerce companies:

The good news is that there are ways for e-commerce founders to mitigate risk and proactively manage their SALT affairs.

1. Arrange for a taxability and nexus study to be completed.

As part of business planning, founders should proactively engage a SALT expert to run an analysis of product taxability and nexus exposure.

These studies should consider existing products, locations, and activities, as well as projected additions and changes in the year ahead. A robust study will provide a clear overview (often presented as a matrix) on where the business should (or preparing to) be filing for which state taxes.

Studies like these should be undertaken at least once a year as a matter of process, or at critical junctures of expansion in the business journey.

2. Pair the consulting with automation software (sales tax only).

There are various SaaS platforms that are designed to provide a solution for the complexities of sales tax as they relate to e-commerce businesses. They automate collection, follow pre-set rules based on location, customer, and product, and file the taxes on the business’s behalf.

Once the founder receives a clear study on taxability and nexus, this study should be used as the blueprint for the implementation of such a software, thus creating a robust and defensible sales tax strategy.

3. Provide the study to the CPA for implementation (other state taxes).

Unlike sales tax, other state taxes are generally required to be filed by tax preparers. While most CPAs are not specialists in all the nuances of SALT, once provided with a matrix outlining taxability and nexus requirements, they should be well placed to implement those findings correctly.

Like most things in business, staying ahead of the game is the key to success. Managing SALT complexities is no different. By following these strategies and taking SALT seriously, e-commerce founders will not only avoid the headaches of non-compliance, but be equipped with the bandwidth to catapult their businesses into a successful and sustainable future.