Sales Tax Compliance: How to Avoid Penalties and Stay Updated

As the economic space continues to dissolve state borders, it has become especially critical that states comply with sales tax, and increasing pressure seems to exist from regulators to enforce it. The penalty for failing to pay can be 0.5%. per month and 25% of unpaid tax for the penalized period, along with the possibility of compounding with interest for underpayment, 7% for any normal-sized company, and 9% for large corporations, is generally calculated annually. Then, aside from just financial penalties, reputational risk and disruption are taken into account for any audit results, and additionally states may impose additional fines for failure to file a return or incorrect filing. Where a violation can occur is when a compliance deadline is missed, thus triggering management which will equal 2% of delinquent tax, per month, at a minimum, and of course, subject to state caps, and potential multiples across states, that can be a drain on internal resources, and processes. This blog will provide practical suggestions on how to streamline your processes, reduce manual burdens, and protect your margins from the ever-escalating nexus and facilitator obligations.

Overview of Sales Tax Compliance:

In its simplest form, sales tax compliance is the complete process of legally collecting and ultimately remitting tax on transactions that are taxable, to a state, and/or local governmental body.

This involves four main components:

• Registration: First, a business needs to determine, or ascertain, nexus (the relationship to a jurisdiction that creates a duty to collect tax) and register for sales tax licenses in any state, county or city which meets either economic or physical presence nexus requirements (e.g., Threshold of sales).
• Collection: When completing a transaction, the business assembles the appropriate tax rate(s), which are jurisdiction-specific based upon product or service classification, may include special district assessments, and includes tracking for exemptions.
• Reporting: Periodically businesses file sales tax returns, monthly, quarterly, and/or annually that identify gross sales, taxable sales, exemptions claimed, and tax remitted.
• Remittance: Finally, businesses transmit the amount of tax due, by check, electronic transmission, or otherwise, to the appropriate agency by established deadlines to avoid penalties and interest accruing.

For example, although exemption certificates and sales records will help an organization prepare for an audit as part of an internal control review. It is not too difficult to comply manually, in a compliant manner, with increasing sales channels as it involves e-commerce, marketplaces, or B2B direct portals but fit into limited workflows when approached with many levels of automation given the significant amount of options to scale.

Consequences of Non-Compliance:

States apply penalties in relation to under-collection or late filings. The IRS failure-to-pay penalty is 0.5% of the unpaid taxes for each month (or part of a month) outstanding until maximum penalties of 25% of the total tax due. Interest on unpaid amounts to the IRS accumulates at rates of 7% for individuals and 9% for large corporations on an annual basis. State revenue departments can also separately assess interest charges—often ranging between 1% and 1.5% per month—compounding the total burden.

The real cost of non-compliance is audit exposure. According to TaxJar, if tax returns do not match, if exemption claims do not align with prior returns, or if a business files late regularly, these findings will trigger audits in many jurisdictions. For example, the Washington DOR estimated that sales tax non-compliance equals $54.8 million or 1.0%, on a total sales tax liability basis, a percentage based on non-compliance for business and occupation tax is 2.2%. Such audit findings could threaten an organization’s reputational standing, the standing of its banking relationships, or its overall financial standing while committing resources to remediate the audit. Organizations ought to view compliance as an opportunity to protect its financial well-being and reputation.

Economic Nexus & Marketplace Facilitator Laws:

The physical presence nexus standard was lifted by the 2018 U.S. Supreme Court ruling in South Dakota v. Wayfair, giving states the ability to impose sales tax collection obligations on remote sellers if they merely meet an economic threshold. South Dakota’s initial law created a nexus threshold of $100,000 in sales or 200 transactions in the state of South Dakota; In February 2023, South Dakota eliminated the 200 transaction requirement with Senate Bill 30. More than 40 states have enacted economic nexus laws since Wayfair, and the most common thresholds are $100,000 or $200,000 in gross sales for the year and 200 transactions.

Marketplace facilitator laws now put the obligation to calculate, collect, remit and refund sales tax from both remote sellers and marketplace facilitators to platforms like Amazon, eBay, and Etsy, in states where they operate. The failure to comply with these facilitator laws allows assessments to be made against both the platform and the sellers highlighting the importance of having clear contracts and compliance policies in place.

Multi-State Compliance Challenges:

• Identifying nexus in all jurisdictions is the critical first step since a business’s nexus determines where the business will need to register and collect a sales tax. Economic nexus thresholds vary considerably; while most jurisdictions use a $100,000/200 transaction threshold, some states have an even higher threshold—for example, California does not use an economic threshold, only sales of $500,000 of goods, services, or otherwise in-state. If a business does not register quickly after exceeding the threshold, it is possible to incur a retroactive liability for that amount, including back taxes, fines, and interest.
• State rate bases only tell part of the story. Local taxes on those bases (think of home rule jurisdictions) create hundreds of combinations of rates, each with a different set of rules. Special district taxes may apply to state and local rates (e.g., transportation, education, public safety) creating even more possible rates. With the rate changes occurring frequently (sometimes occurring multiple times within the year), daily rate changes will need to occur; without automation, the taxing authorities will likely charge the wrong taxes and incur penalties. Also, states differ considerably on origination versus destination, so sellers will need to determine if they should charge the rate at the time of sale or the buyers’ location.
• Filing schedules can occur monthly for the high volume filers to quarterly, semi-annual, or annual in lower volume jurisdictions, with prepayments on a weekly or bi-monthly schedule following prior year tax liabilities, making cash flow more complex. The payment types vary; some states require electronic funds transfers over certain dollar amount thresholds, others only allow paper remittances, creating different methods in each state. The myriad deadlines and payment processes adds administrative burden and also increases the risk of late filings and penalties to the business.
• The collection, verification and retention of exemption certificates must take place in accordance with each state’s rules. Some states utilize their own exemption certificates. Different states allow their own versions of exemption certificates, so companies must maintain different versions of their exemption certificates based on jurisdiction. Poor management of exemption certificates leads to disallowed exemptions in an audit that result in unforeseen tax assessments and penalties.
• Using sales tax automation involves interfacing tax engines with the organization’s ERP or POS and e-commerce systems. This work includes mapping comprehensive product taxability rules with their respective rates and maintaining the API connections. Many organizations do not have sufficient technical personnel to manage the ongoing API updates, exception handling, and custom rates for the complexity of their transactions. The use of manual spreadsheets and other outdated tools inflates an organization’s error rate and significantly delays the needed filing, putting the organization at risk of compliance accuracy and operational cost.
• States typically change economic nexus thresholds, marketplace facilitator requirements, and taxability definitions at any point in the year, meaning companies are required to stay diligent on watching these changes. Having said that, every leader in a compliance role needs to subscribe to every state’s revenue department newsletters, and join a professional organization like the Council On State Taxation where they will get alerts in real time for anything that is being legislated. Other resources should be provided as well, and the Sales Tax Institute has its state guides and Avalara has a Tax Changes newsletter where they centralize updates around hosted aggregation to provide companies with needed time for adapting the compliance process.

Top Audit Triggers & How to Preempt Them:

Recognizing the audit triggers is critical to avoiding surprise state reviews. Audit red flags can include:

• Discrepancies between what is reported on filed returns to the state and what is reported to third parties like Amazon or Shopify.
• Differences in exemption claims, like using expired or unsupported exemption certificates.
• Newly securing sales in a state where a nexus does not exist or from a sudden rise in sales due to lack of nexus registration.
• Repeatedly filing returns late or filing zero-dollar returns in states where you are making considerable sales.

Organizations can proactively defend against audits by conducting quarterly internal compliance reviews strongly tied to quarterly reconciliations of their sales tax reports to the general ledger and third-party sales data. A properly supported and documented, documented, standard process for collecting and renewing exemption certificates will limit the risk of non-deductible exemptions. External consultants or a managed service provider engaged to conduct a voluntary pre-audit assessment offer a second set of eyes regarding hidden liabilities and other recommendations for remediation before a state audit. A robust check-list covering audit triggers–addressing registration status, sales tax rates, and previous remittance supporting documentation–will serve as a map for either a company to follow or to guide a company as part of a managed audit process.

Best Practices for Penalty Avoidance:

To keep penalties and interest to a minimum, senior leaders can take proactive compliance actions:

• Timely filings: Create methods to automate the filing of returns and ways to remind you of due dates from multiple methods to comply with state deadlines.
• Accurate product classifications: Update taxability matrices on a regular basis through jurisdiction updates of goods and services.
• Centralized compliance calendar: Utilize a centralized calendar of due dates for permits, filings, and certificate expirations.
• Exemption certificate controls: Use digital storage of certificates and develop a schedule to obtain certificates to validate and store them, along with reminders for expiration dates for renewal.

Leaders should continue to train staff periodically so that the finance teams understand evolving tax laws, updates to systems, and processes. Automating the reconciliation of the amounts of tax collected to amounts reported helps identify when tax receipts don’t match tax returns, allowing the organization to correct tax reporting before states are filed. In complicated organizations, and where significant resources have been allocated to compliance programs, it is recommended to create a compliance center of excellence that can provide dedicated resourcing for maintaining policy documents, internal audits, and vendor management of compliance. It has been shown in independent surveys that the use of compliance measures would reduce costs related to audits which are often 30% lower.