When you conduct business in California, you are opening yourself up to being responsible for California taxes. A fair question to ask is, “well what constitutes doing business in California?” California’s Franchise Tax Board (FTB) lists three general criteria that constitutes “doing business”:
- You are engaged in any transaction for the purpose of financial gain within California.
- You organized or commercially domiciled in California.
- Your California sales, property holdings, or payroll exceed the specified amounts or are at least 25 percent of your total business.
Federal Law known as Public Law 86-272 will also apply to businesses out of state. We will discuss this in greater detail below.
There are many charts and infographics available online that include state-by-state comparisons of sales tax eligibility/collection guidelines (“State-by-state guide to marketplace facilitator laws”) and (“State-by- state guide to economic nexus laws.”)
While this information is a good starting point, you really need to dig into the specifics for each state in which you believe you have nexus. It is confusing. We agree. If you are trying to sort this out yourself and getting nowhere, give me a call.
My firm, Brotman Law, has years of experience in untangling the web of regulations and questions surrounding doing business in California. Let us see what we can do for you.
Impact on Remote Sellers
Physical presence is no longer the singular threshold for nexus, and it’s important for businesses to know that rules involving nexus now apply to all remote sellers. The definition of remote seller is relatively simple: If you sell to a customer in another state, then you are a remote seller.
Economic contacts exist when a retailer has significant sales or transactions for delivery into a state.
Virtual contacts are even less clear than economic contacts. Virtual contacts can best be described as targeted advertising and instant access to most consumers through the internet. Since this represents millions, if not billions of dollars in potential sales tax revenue, states are aggressively racing to adopt economic nexus and then make provisions for remote transactions.
Courts have determined that a hypothetical “virtual showroom” that provides an interface to consumers in a state is “substantial virtual connections” a state should not ignore.
Presently, 27 states, which have their own definitions, impose sales tax on some digital products including, but not limited to data processing, information, software, SaaS, books, music, movies, and other (video games).
There is some debate over the significance of streaming versus downloading with respect to determining the existence of nexus, as streaming services are less tangible than a product that is downloaded and saved to a consumer’s device.
Seventeen states impose sales tax on SAaS but there is a problem in defining products/services as SAaS as there is no uniform definition. Some of the questions that states may use to determine whether a product or service constitutes SAaS are as follows:
- Is it software only? Data Processing? Information Services? Communications? Admissions/Amusement (eg, online games)
- Is it for all access or only transfer of use and control?
Another problem is that there are no uniform rules in sourcing or “situsing” (determining the proper jurisdiction(s) in which taxes may be assessed) transactions. The user location must be taken into consideration. But often there are multiple points of use. Mobile use is also another factor.
The customer billing address could come into play, which may encourage forum shopping, a practice in which litigants bring their cases to be heard in the jurisdiction that promises the most favorable outcome.
Possible Outcomes for the Development of the Law Surrounding Virtual Contacts:
- Changing interpretations of existing laws to cover more services
- Increase in lawsuits and resulting decisions
- Congress will most likely not step in here
- Marketplace facilitators will begin charging consumers for compliance services, if they haven’t already
- Remote sellers will experience a heightened risk of exposure, which presents an opportunity for states to work with the marketplace for more information on remote sellers.
- Some states (California, Washington, Rhode Island, Minnesota and Pennsylvania) are using the information provided through the compliance efforts of marketplace facilitators to enforce compliance against remote sellers selling on the marketplace platforms.
Another point to keep in mind is that many states such as Hawaii, Massachusetts, Pennsylvania, Texas, and California are now incorporating nexus standards for income and other business tax purposes.
Some states have adopted a bright-line rule such as a factor, presence, and/or economic nexus standards for corporate income tax – which are often different from the Wayfair economic nexus thresholds applied for sales tax.
Many states’ economic nexus laws are so broad that a remote seller who meets the economic nexus standard for sales tax could easily be interpreted to have met the same state’s broad economic nexus standard for corporate income tax.
The concept of some national standard being applied to determine nexus may be unrealistic. However, in the not-so-distant future, it is possible that more and more states will start using nexus as the basis for income tax.
Registering with the California Secretary of State (SOS)
You may ask yourself if you should register with the Secretary of State in every state in which you do business. State laws on “engaging in business” for foreign qualification purposes are often vague. Many describe activities that will not require an out-of-state business to register with the secretary of state while failing to address what activities will require such a registration.
Activities that do not require foreign qualification might include things like holding officer meetings in the state and having a bank account in the state, as such activities would generally not create any substantial presence in the state.
After you register your business with the Secretary of State in each state where you conduct business, you can visit their FAQs section to see if there is information about how to proceed with sales tax issues. That is, if you are lucky, as many states do not have that information readily available.
Instead, what you will probably find is a list of what you cannot do. Becoming familiar with the Secretary of State and its functions is important because you must first register your business before you can proceed to work with the state department of revenue or taxation.
However, before you proceed to register with every state in the country, read the next chapter here which covers issues surrounding compliance. If you do not think you have nexus in a state, there is no need to register with either the SOS or department of revenue.
Steps Towards Nexus Compliance
The first thing to remember when thinking about nexus is that physical presence still creates nexus whether it is through inventory, click-through, cookies, SaaS, or other digital medium. In order to determine nexus, you should first create a ledger for each state listing the number of transactions and their corresponding dollar amount.
You may then look up the nexus standard for each state and cross reference it with your transactions ledger to determine if you have nexus. These guidelines will also outline which types of sales activities constitute presence.
To take this a step further, you need to examine what type of remote entity your business is. Does your website list products from other companies while your company processes orders, collects payment and coordinates shipping? If so, your business would likely be considered a marketplace facilitator.
The most familiar marketplace facilitator model is Amazon. Your business may instead serve as a web host, where merchants use your site to promote their products and are themselves responsible for billing and shipping to customers. An example of this type of business model is Shopify.
Three key steps to ensure compliance:
- Determine the taxability of your business’ products and services.
- Figure out whether you must obtain resale/exemption certificates for exempt sales.
- Implement a process to monitor taxable purchases (e.g., select accounts, problem vendors, materiality) to ensure vendors are properly charging sales tax or that you accrue/remit use tax.
Additional information to track:
- Map each tax decision and tax category code to:
- Customer profiles – Gather the answers to the following questions: Are they exempt? Do you have a resale/exemption certificate?
- Product code – Keep records on what is being sold.
- Invoice date and title/possession transfer – Make note of the shipping terms (FOB Origin v. FOB Destination) and their timing.
- Jurisdiction – Track the locations to where your inventory is being shipped and where services are delivered/performed.
- Method of delivery – Make note of whether your products or services are delivered electronically, through direct shipping, or through drop shipping.
- Create, validate, store, manage exemption/resale certificates.
It will be considerably easier to keep record of this data if you automate the process. There are many software packages out there that you can purchase to help you manage your sales tax activities in each state where you have nexus.
Additional Compliance Tips
This may sound crazy, but another option you have is non-compliance. This would be most successful if you have a small business where your average transaction amount is low. You may find that paying the tax is considerably less than going through the hassle and expense of registering with each state where you might have nexus. If you opt for this route, keep in mind the following best practice tips:
- Clearly spell out sales tax obligations in your sales contracts and invoices.
- Mitigate any historical exposure proactively via a Voluntary Disclosure Agreement (VDA). A VDA is a legal agreement for taxpayers to self-report back taxes owed for income, sales, property, and other taxes in exchange for a waiver of penalty and longer period (usually 3-to-4 years) to collect any potential taxes. The benefits include limited lookback, penalty waiver, and payment plans if you get audited.
- Register to file sales and use taxes.
- Provide/obtain appropriate resale certificates, particularly on drop shipment transactions.
- Continually monitor and update your data to reflect changes in state standards.
Determining Your California Business
Determining if you do business in California or not can be confusing as it is not cut-and-dried. Many factors are in play such as nexus and remote sales — which includes virtual and economics contacts. Digital products are particularly hard hit, as each state has its own definitions.
In order to keep from drowning in the myriad of state requirements, you need to develop a multistate tax compliance plan for your business. This will address the California issue as well as meet requirements of other states.
Honestly, unless you have hours and hours each week to stay on top of the ever-changing state regulations, it is in your best interest to hire an experienced tax professional to take care of your compliance issues for you. I invite you to call me to schedule a consultation. We can lay out the components of your business to determine nexus and in which states you are responsible for sales tax.
Focus your time and energy where it matters … on growing your business. Let us take care of the tax compliance issues.