Tax on Internet Sales

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 even when a site doesn't collect sales tax, consumers are technically responsible for remitting any unpaid sales tax on online purchases directly to their state. And don''t look now, but the era of tax-free sales may soon come to an end!

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. For example, the Barnes & Noble website that you buy a book from online is a different company from Barnes & Noble at the mall. If the online Barnes & Noble doesn't have a physical presence in your state, such as business offices or a warehouse, 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 technically 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 -- the seller or the 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.

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. In December 2001, President Bush signed a two-year extension of the Internet sales tax ban.

Naturally, there is a great deal of opposition to this tax moratorium 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. California, alone, estimated losses of over a billion dollars per year.

In 2002, state governments organized to fight back. Under a state-led initiative known as the Streamlined Sales & Use Tax Agreement (SSUTA), 40 states and the District of Columbia banded together to simplify their sales tax codes in order to make sales tax collection easier. Under SSUTA, the collection of sales tax still remains voluntary. However, if ten states representing 20% of the U.S. population vote for the rules, the organization will pressure Washington D.C. for federal legislation. Already the SSUTA has gained traction. Several national retailers have negotiated with member states for amnesty deals in return for future collection of sales tax, and more are expected to follow. With all of this pressure from states, many expert believe that within the next few years you'll be throwing a few more dollars into your shopping cart for state sales taxes.