By Alexander Korzhen, featured in the Journal of State Taxation
Alexander Korzhen provides us a view of Wayfair from the trenches describing some of the hurdles and traps confronting businesses trying to comply with the new economic nexus provisions.
On June 21, 2018, the U.S. Supreme Court handed down one of the most important decisions in 25 years regarding state tax nexus. Many brilliant articles, blogs and webcasts have been written and proffered about the Wayfair case. Some are introductory in nature, and some examine various legal concepts regarding thresholds, retroactivity, stare decisis, the dormant commerce clause and the due process clauses. While this article is about Wayfair, it presents the topic from another perspective. The intent is to present the granularity of what Wayfair-related compliance has meant for our clients, and what it might also mean for you and your organization.
What the Supreme Court Liked About South Dakota’s Law
Put briefly, South Dakota v. Wayfair removed the physical presence requirement from the meaning of substantial nexus for sales and use tax purposes. This is a major shift in how nexus will be interpreted, applied and, in the future, audited. In dicta, Justice Kennedy identified several elements in South Dakota’s law that mitigated any unreasonable burdens on interstate commerce and, accordingly, on remote sellers. Specifically, South Dakota’s law:
- Was not retroactive.
- Had a small business exception. In other words, the now familiar $100,000 sales and 200 transaction thresholds.
- By virtue of the state’s membership in the Streamlined Sales Tax Agreement, contained certain elements of standardization and simplification that reduced administrative and compliance costs for remote sellers.
It is the last two points that will draw our focus. Specifically, how clients have approached and managed their paths to compliance, the role sales tax software played in those compliance decisions, and how States have responded to increased compliance through the adoption of economic nexus laws.
The Path to Compliance
The Wayfair case was big news. Articles on the subject were published by various professional organizations, virtually every CPA firm had a blog on the topic, it was covered by the Wall Street Journal, the New York Times, Forces, and almost every daily newspaper had stories on the decision and its potential ramifications. Businesses immediately became painfully aware of the change, and the challenge required to become compliant.
Two questions undoubtedly circled every stakeholder’s mind: how are we going to get compliant, and what about any past liability? The answer to the first question is deceptively easy, buy a software product. The answer to the second question is much more challenging.
Voluntary disclosure agreements, amnesty programs, and penalty abatement requests were available to taxpayers long before the Wayfair case, but now, the equation was not just about historical exposure, but also managing the prospective economic nexus thresholds.
There are businesses that truly did not have any physical presence in a given state prior to the enactment of Wayfair and the accompanying state economic nexus laws. Within this group, there are two sub-categories: businesses that were in timely compliance with the effective/enforcement dates of the state thresholds, and businesses that were late to comply with the thresholds. This group did not have nexus until the Wayfair decision so let’s call this group, Post-Wayfair Nexus.
There is another group of businesses, those that may have had some physical presence nexus in certain states prior to the enactment of Wayfair but chose not to register and collect tax because of various reasons including immateriality and lack of resources. Let’s call this group of business’s “Pre-Wayfair Nexus”.
The path to compliance and the hurdles that a business will face is largely dependent on which of the two groups in which the business falls. However, our small/medium sized clients generally follow this path: engage with a consultant(s) to get a deeper understanding of the legal requirements and timing (such as nexus and taxability), evaluate the sales tax software options, take steps to implementation, and finally “go-live”.
Post-Wayfair Nexus Group
Timely Compliance with State Economic Nexus Thresholds
This is the most favorable scenario for a business to find themselves in. They were fortunate enough to have the necessary resources and systems in place to evaluate their sales volume in relation to the economic nexus thresholds, timely file and receive state sales/use tax licenses and account numbers, and turn on sales/use tax collection and remittance in accordance with the various enforcement dates.
This is a rare situation for many small/medium companies. Most businesses that we have seen in this space are those that had a relatively small nexus footprint before Wayfair, and were already progressing with sales tax software implementation. Once those systems and processes are in place, it’s significantly easier to add new states.
Untimely Compliance with State Economic Nexus Thresholds
Nevertheless, due to the timing of the various economic nexus effective dates across the various states, many businesses found themselves non-compliant with the new economic thresholds. More likely, many businesses found themselves in this category. A company may have not been ready to comply with, for example, Maine’s law, which was enforceable as of July 1, 2018, but will be in a great position to comply with Arizona law (enforceable September 30, 2019) or Texas’s law (enforceable October 1, 2019).
In this scenario, a state’s economic nexus law has become enforceable, but the business is not yet ready to comply, even though it has a duty to do so for exceeding the economic thresholds. The omission is likely due to delays in analyzing thresholds, understanding the economic nexus requirements, implementing software, and acquiring sales tax licenses.
This presents a predicament, does the company ignore the short interim period, or does it file the late back-returns? The trap for the unwary in this situation is that the registration document is generally signed under penalty of perjury. In the registration, a company representative must declare a business start date in the jurisdiction. If the company is late, filling out the true and accurate date on the form may trigger an inquiry for the missed periods, while entering the present date may prove problematic given the attestation.
We have already seen some of our clients start receiving notices from states regarding their latency in filing. For example, one of our clients exceeded Maine’s thresholds effective October 1, 2018, but received a letter asking for confirmation that we should not have gone all the way back to July 1, 2018, Maine’s enforcement date.
Pre-Wayfair Nexus Group
We see many businesses fall within this category, the most complex of the three scenarios. As mentioned above, businesses in this category have physical presence nexus for sales/use tax in a state prior to the enactment of the various economic nexus provisions. A business may find it has little choice but to start complying with the prospective requirements, but it has a history of physical presence in the state. This physical presence nexus was unresolved, either purposefully, or out of ignorance of various unintuitive nexus triggers (one common example is third-party sales representatives creating nexus on behalf of the company). Again, due to the attestation requirement on the sales tax registration document, this is a predicament not dissimilar to the one discussed above. However, in this instance, the offence likely goes back further and the associated sales/use tax exposure is greater.
In this case, a voluntary disclosure agreement (VDA) might be a great option for resolving the historical problems, and getting current with the account. Often times, the company is responsible for the back taxes and interest, but only for the applicable look-back period, generally three to four years. All older years are usually forgiven. Penalties are generally waived in a VDA. Needless to say, paying past due tax and interest can easily get expensive.
Sales and Use Tax Software
The availability of sales tax compliance software has been a consideration in the development in sales tax laws since the Supreme Court’s previous 1992 landmark decision in Quill. In Quill, the Court framed the cost of sales and use compliance requirements by stating that, “in light of today’s modern computer and software technology, appear to be nominal.” Regarding more modern software solutions, in its opinion, the Wayfair Court wrote:
State taxes differ, not only in the rate imposed but also in the categories of goods that are taxed and, sometimes, the relevant date of purchase. Eventually, software that is available at a reasonable cost may make it easier for small businesses to cope with these problems. Indeed, as the physical presence rule no longer controls, those systems may well become available in a short period of time, either from private providers or from state taxing agencies themselves.
This makes sense to us, on an academic level. Technology has advanced dramatically since 1992. Sales tax compliance solutions have indeed come down in cost and are now more accessible to smaller businesses than before. However, have they become affordable enough for small/medium sized businesses?
We believe this is a difficult question to answer, because it’s a matter of perspective. To many of the businesses that we have helped over the last year and a half, walking down the path of sales tax compliance has not come at a reasonable cost. The reasons are three-fold: (1) the initial and recurring costs of the software license, (2) the timeliness/availability of implementation due to the surge, and (3) the costs associated with the need to hire an outside tax consultant.
Picking a Software Solution “A Products” Strengths and Weaknesses
There are several newer software solutions available to companies affected by the onslaught of economic nexus legislation. They each have their strengths and weaknesses, and work wonderfully for companies that fit well with the software’s strengths. But, the opposite is also true, if the software happens to be a poor match for the company, turbulent times may lie ahead.
The strengths and weaknesses of specific sales tax software arise from the following:
Its ease of integration with the company’s general ledger system. Does the software company provide connectors to only the larger general ledger systems like SAP, Oracle, PeopleSoft, or can it easily connect with mid-market systems such as Microsoft Dynamics, Intacct, NetSuite, or even QuickBooks? Additionally, can connections be made with the various online shopping carts such as Big Commerce, Magento, Shopify, etc. The connection between an external sales tax engine and a general ledger system is crucial for effective, efficient, and timely sales tax calculations. Without that connection, a custom application programming interface (API) is required. Custom APIs can be cost prohibitive for many smaller companies, and the development time involved can create other problems with timely compliance.
- The robustness of the software’s nexus map. Does the software handle all state, local and special taxing jurisdictions, or does it assume nexus for all localities if state level nexus is selected
- The depth and breadth of its taxability map (e.g., how granular are the software’s tax codes and how does it handle state versus local jurisdictions in states like Alabama or Colorado). One of the software products boasts 400,000 tax decisions in their taxability tables, versus approximately 10,000 for its nearest competitor. For some businesses, such as e-commerce, even 10,000 decisions may be too many. But more complex businesses (from a taxability perspective) may need the granularity a 400,000 tax decision matrix can provide.
- International tax compliance, if the company operates internationally, can the software ably calculate VAT, or Canadian GST/PST/HST.
Implementation and Availability of Technical Resources
Once an external sales tax engine is chosen and the licensing agreements signed, the next step is integration with the company’s general ledger system and/or e-commerce platform. Not surprisingly, there has been a surge in demand in the wake of the Wayfair decision.
With that, we have noticed a general corresponding latency in responsiveness from the software providers. Not necessarily from a sales perspective, but from a technical support and implementation perspective. With limited technical resources available to meet rising demand for integrations, the wait times for integrations have increased. In a vacuum, this may not be a huge consideration. However, given the specific effective dates and enforcement dates of the economic nexus laws around the country, the timing of the implementation and “go-live” becomes much more critical for compliance and is often delayed.
For most businesses, cost is a factor. While today’s software products are significantly less expensive compared to 10 or 20 years ago, we found some of our clients still consider the cost of initial one-time fees and recurring licensing fees an important and limiting factor in their decision.
The two more popular solutions have a widely differing pricing structure. One solution uses graduated buckets based on transaction count. The cost of the other is calculated off of the company’s net revenue, based on certain assumptions of company activity and assumed transaction count. Needless to say, this pricing structure will affect different companies in radically different ways.
For example, one client is a large e-commerce company that sells nationally at both retail and wholesale. Their transaction count is enormous. Using the transaction-based pricing model, their expenses related to the sales tax software were correspondingly high. However, if comparing the pricing of the revenue-based software product, their expense would have been less than half.
We have another client that is in a low-volume, high margin business. Using the transaction-based pricing model is significantly more affordable than compared to the revenue-based pricing model.
Another important cost consideration is the initial, one-time fees. Costs to consider are the initial software implementation fee and technical support, and the cost of professional tax advice for properly setting nexus and the taxability matrix within the software engine. Additional costs can include a historical nexus study and transactional analysis to better understand a company’s options for remediation, such as proceeding with prospective registrations, amnesties, or voluntary disclosure agreements.
The states have also seen increased demand and stress on their resources as a result of the influx of new registrants, and corresponding filings. While serving our clients, we have noticed this in two predominant areas: changes to the rules relating to sales sourcing, and online filing system changes/updates.
Sourcing the Sale: Origin Versus Destination Based Sourcing
Colorado and Missouri are two good examples of statutory sales tax sourcing changes that overwhelmed both state tax administration and taxpayers.
Ignoring, for the moment, the added complexity of the home rule jurisdictions in Colorado, the Colorado Department of Revenue switched from origin sourcing methodology to destination sourcing methodology. Many of our smaller Colorado-based clients grew very concerned about this change because virtually overnight, they went from a remitter of sales tax at a single source (the origin), to a collector and remitter of sales tax in potentially all statutory localities.
Okay, I hear what you’re thinking, you’re still not convinced this is a big deal. The issue is not related to the what or where, but the how. The Department’s e-filing portal was not originally configured to allow companies to automatically remit in all the statutory jurisdictions. Each jurisdiction had to be either manually added one-by-one, or the taxpayer was required to contact the Department and request that all statutory local jurisdictions be added to the account.
Many smaller companies, that originally filed in just one Colorado jurisdiction based on origin sales, found themselves in a position requiring time consuming troubleshooting on how to “turn on” all the statutory local jurisdictions in Colorado to be able to remit sales tax (assuming it was properly collected to begin with. We’ve heard from many clients that were forced to eat the marginal difference in tax based on the rates in the origin and destination jurisdictions) to the correct locality.
Larger companies with previously implemented sales tax engines were not free of issues. One software provider automatically turned on all the localities for one of our clients: both statutory cities and home rules! During the transition, this taxpayer was over-collecting local sales tax in home rule jurisdictions in which it did not have nexus. It created a proverbial large mess that required many hours of time and costs to correct.
Missouri was in a similar situation regarding the interplay of origin and destination based sourcing coupled with the varied local requirements for sales versus vendor’s use tax. Out-of-state vendors, that were previously collecting vendor’s use tax based on a single state use tax rate, were now required to contend with local jurisdictions that enacted a local option vendor’s use tax in addition to their local option sales tax. The local option sales tax affected only in-state sellers, that collected and remitted sales tax based on an origin based sourcing system, but remote sellers were now required to collect the complex tax on a destination based system.
And, just as in Colorado, many taxpayers found themselves struggling to setup and remit sales taxes using a not-so-consumer friendly e-filing system. Missouri’s system requires local jurisdictions to be added to the ledger one by one, and assigned a “site code.” The site code is not a static number assigned based on the location itself, but instead is a number assigned specifically to each taxpayer based on the order that the jurisdiction was added to the system. For example, for one taxpayer Kansas City may be site number 002. But for another that same location may be site number 834. Additionally, when creating each site, the system asks for an address, including city, county and zip code, and a telephone number! That’s right, the system requires a remote seller to potentially add 900+ local jurisdictions, including certain address and telephone number information. Without software, and even with it, this is a monumental task.
E-Filing and Online Registration Systems
The rigidity of the states’ electronic filing computer systems has compounded the problems created by the change from intrastate origin sourcing to interstate destination sourcing. Generally, we have seen this manifest in reporting the breakout of tax to the local taxing jurisdictions within the given state.
Some states have chosen to enact various “simplifications” that may actually cause unexpected problems. The motivation behind these simplifications is positive, but they may trigger confusion business’s attempting compliance.
For example, Louisiana enacted a simplification system that allows out-of-state vendors to collect at a single 8.45% rate on in-state sales. Thus, out-of-state vendors can bypass the complex local jurisdictional determinations that would otherwise have to be made. Unfortunately, this simplified process is temporary, and is set to phase out and revert back to the standard destination-based system on July 1, 2020. Temporary changes like this add to software costs and implementation.
Another example is Alabama’s Legislative Act No. 2015-448, entitled the Simplified Seller Use Tax Remittance Act. The Act allows eligible sellers to participate in a program to collect and remit at a simplified 8% rate on all sales made to Alabama customers. Among other conditions, an out-of-state vendor is required to apply for the program before it can start collecting at the flat rate.
Texas also enacted simplification for out-of-state vendors in H.B. 2153, signed on May 17, 2019. Effective October 1, 2019, out-of-state vendors have the option to use a single local use tax rate in Texas when collecting the use tax. As with Alabama, the vendor must notify the Comptroller of the election before taking advantage of the simplified tax rate. The single local use tax rate will be set by the state each calendar year. Likely, it will be based on an estimated average rate of local sales and use taxes imposed during the preceding fiscal year.
The above examples in Alabama, Louisiana and Texas are positive developments and demonstrate the states’ sensitivity to the complex undertaking that many vendors now face. However, these optional simplified rates will probably only benefit businesses that have not implemented sales tax software engines, and may often trigger additional software costs for many small/midsize companies who have already adopted programs. Statutory changes are often blind to the differing software capabilities of large versus small businesses.
Complexities of Compliance
These are only a few examples and observations from the trenches. The vast majority of our clients recognize that they cannot comply with the economic nexus laws alone. They need the help of tax professionals in evaluating their historical and present risk, to define their nexus footprint, to map their products and services, and to provide and execute various compliance strategies.
Businesses also need to purchase sales tax software, because manual compliance with the economic nexus provisions, coupled with sourcing changes, is simply an impossible task for multijurisdictional sellers. Their experiences belie the assertions that sales tax compliance is simple, and that there exists available, affordable software as an easy solution.
Alexander Korzhen , JD, MBA, has 15 years of experience managing complex State & Local Tax projects end-to-end. His extensive experience in SALT consulting, compliance and planning delivers positive tax outcomes for clients of all sizes across industries. Reach out to Alexander at firstname.lastname@example.org.
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