Here’s the skinny on Internet sales tax: who pays it, who doesn’t and why it makes a difference to state governments and brick-and-mortar retailers.
It’s hardly a secret that shoppers hate paying sales tax and love a tax-free bargain. Case in point, the tax-free shops in airports that are so successful at separating Bahama-bound travelers from their Mai-Tai money. But because you need an international boarding pass before you can buy a bar of tax-free designer soap, sales from these shops pose little threat to either Main Street merchants or tax collectors.
Enter the Internet, which takes tax-free shopping to a new level. In fact, no-tax shopping has become a prime lure of online retailers looking to hook consumers on click-and-charge buying. Despite what you sometimes hear, however, some Internet sales are subject to sales tax and consumers often have a responsibility to remit any unpaid sales tax on online purchases directly to their state.
Collecting Sales Tax: Some Do, Some Don’t
The obligation to pay sales tax is determined by the location of the buyer, not the seller. If a business does not have a physical presence in a particular state, such as a store or warehouse, it is not required to collect sales tax for sales from customers in that state. In legal speak, this connection between sales and location is referred to as a “nexus” and was established by the U.S. Supreme Court in Quill v. North Dakota, 504 U.S. 298 (1992).
Exceptions to the Rule
Many big retailers with local stores can sell their products tax free over the Internet because they have established separate legal subsidiaries to handle Internet business. Put another way, the Barnes & Noble you buy a book from online is a different company from Barnes & Noble at the mall. Since the online Barnes & Noble doesn’t have a physical presence in your state, no sales tax is charged for online purchases. The practice of establishing a separate legal entity principally to avoid sales taxes has raised the ire of thousands of brick-and-mortar retailers whose customers must still pay tax.
The issue becomes even stickier when a company’s online and offline entities experience some customer interaction. For example, a consumer buys tax-free golf clubs from Wal-Mart.com but is allowed to return them offline to the local Wal-Mart store. Whether such entities are legally independent of each other is a matter that has not been tested in the courts.
Your Responsibility to Pay Sales Tax
If you live in a state that collects sales tax but avoid paying it on an Internet purchase, you are still required to pay the tax to the state. When you pay it directly to the state, it is referred to as “use” tax rather than sales tax.
The only difference between sales and use tax is which person – seller or buyer – pays the state. Theoretically, use taxes are just a backup plan to make sure that the state collects revenue on every taxable item that is purchased within its borders. But because collecting use tax on smaller purchases is so much trouble, states have traditionally attempted to collect a use tax only on big-ticket items requiring a license, such as cars and boats.
Now however, some states, including Connecticut, Maine, Nebraska, New Jersey and North Carolina, have changed their attitudes and are stepping up efforts to collect use taxes. But bureaucracy, complex tax rules and limited state resources have thus far prevented most states from pursuing use taxes. Since state governments are losing substantial revenue, the collection of use taxes may become a priority if the federal government continues its ban on Internet e-commerce taxes.
The Internet’s Future as a Tax-Free Zone
It’s difficult to predict whether Internet purchases will remain tax free. In 1998, Congress passed the Internet Tax Freedom Act (ITFA), which established a three-year moratorium on taxing Internet access services at the state or local level. “Internet access service” is defined as any service that allows users to obtain information, email or other online services and includes small Internet Service Providers (ISPs), large information portals such as Yahoo and other websites and companies that provide connectivity and information, such as AOL.
Under the 1998 moratorium there can’t be any new sales or other taxes applied to Internet purchases. The current moratorium on new taxes will last until October 2001. However, this ban does not affect your obligation to pay any sales or use tax owed under previous law.
To determine the future of taxes on the Internet, Congress created a 19-member Advisory Commission on Electronic Commerce to study Internet taxation and report on April 21, 2000. Early reports from the Commission indicate that it will recommend that Congress continue to maintain the Internet as a tax-exempt zone until 2006. Federal legislation following these proposals has already been introduced in Congress.
Naturally, there is a great deal of opposition from state governments and brick-and-mortar retailers. A look at the numbers explains why. Sales tax revenues currently amount to about $150 billion annually and make up approximately one-third of all state revenues. These taxes pay for everything from schools and police to roads, parks and other state services. States that don’t have a personal income tax, like Texas, are even more dependent on sales tax revenue. (The five states that don’t have a sales tax – Alaska, Delaware, Montana, New Hampshire and Oregon – aren’t hurt at all). Based on commonly accepted Internet sales projections, lost revenue in unpaid sales tax from online transactions could go as high as $10.8 billion by 2003.
Many Main Street retailers feel that allowing consumers to avoid sales tax gives online retailers an unfair competitive advantage, especially in states where sales taxes are high. They are particularly incensed by large retailers whose Internet subsidiaries permit tax-free sales but allow online purchases to be returned to brick-and-mortar stores. Supporters of equal taxation for all retailers have expressed anger that the Commission does not adequately represent their interests, and feel that the Commission’s report to Congress will be biased.