A state can require a seller to collect its sales tax only if the seller has a sufficient connection, called nexus, with the state. Until 2018 the connection for sales tax had to be a physical presence. South Dakota v. Wayfair, Inc. removed that requirement, and states now assert nexus over sellers based on the volume of their sales into the state. For an auditor, the practical result is a question on every client that sells across state lines: has the entity crossed a threshold somewhere it has not registered?
An unregistered seller that should have collected tax can owe it anyway. That makes the exposure a loss contingency under ASC 450-20, and it is how a sales tax issue reaches the financial statements. This page covers the legal background, how thresholds work, and what the auditor tests. The rules differ by state, so the state revenue department's current rules and a tax professional govern any specific client.
What did Wayfair decide?
The Supreme Court decided South Dakota v. Wayfair, Inc. on June 21, 2018. It held that the physical presence rule of Quill Corp. v. North Dakota (1992) was unsound and incorrect and overruled both Quill and National Bellas Hess v. Department of Revenue of Illinois (1967).
The Court looked at South Dakota's law, which applied to sellers delivering more than $100,000 of goods or services into the state or engaging in 200 or more separate transactions for delivery into the state. It pointed to features that reduced burdens on sellers: a safe harbor for those who transact only limited business in the state, no retroactive application of the obligation to remit, and South Dakota's membership in the Streamlined Sales and Use Tax Agreement. The Court left other questions under the Commerce Clause for remand. It did not set a national threshold.
States then wrote their own economic nexus rules. Thresholds, how they are measured, and when the obligation begins differ by state. Some states measure sales only and others also count transactions. Some look at the current or prior calendar year, others at a rolling period. A client's analysis has to be done state by state against the current statute or regulation.
Does economic nexus apply to income tax?
No. Wayfair concerned a state's power to require collection of sales tax. A state's net income tax is a separate matter. Under 15 U.S.C. 381 (P.L. 86-272), a state may not impose a net income tax on a business whose only in-state activity is soliciting orders for sales of tangible personal property, where orders are approved and filled from outside the state. That protection does not cover sales tax collection, and it does not cover services or most activity beyond solicitation. A company can be protected from a state's income tax and still be required to collect its sales tax.
What changes for the auditor?
The nexus question touches the audit in four places:
- Revenue and receivables. Check whether sales tax billed to customers is recorded as a liability rather than revenue, and that exempt sales are supported by exemption or resale certificates.
- Liabilities. Look for sales tax collected and not remitted, and for tax not collected that the entity may owe.
- Loss contingency. The exposure for unregistered states is evaluated under ASC 450-20. A loss is accrued when it is probable that a liability has been incurred and the amount can be reasonably estimated (ASC 450-20-25-2). When no amount in a range is a better estimate, the minimum of the range is accrued (450-20-30-1). A loss that is reasonably possible, or probable but not estimable, is disclosed under 450-20-50. See ASC 450 loss contingencies and loss contingency.
- Open periods. The assessment period for a state's tax generally depends on that state's law, and in many states the clock does not start until a return is filed. A seller that never registered can have years open. That is a state-law question, not an accounting one.
Marketplace facilitators
Many states require the marketplace that facilitates a sale, rather than the individual seller, to collect and remit tax. If the client sells through a marketplace, the question becomes which channels the facilitator covers in each state. Sales through the client's own website remain the client's responsibility. The facilitator's remittance does not remove the client's need to analyze its direct sales, and the client should keep evidence of what each marketplace collects.
An illustrative exposure
Illustrative numbers only. A company sells online and ships into State X. It is not registered there. Sales into State X are $35,000 per month for 12 months, $420,000 in total. Assume State X has a $100,000 sales threshold and the obligation to collect starts with the sales after the threshold is crossed. Cumulative sales reach $105,000 in March, so the company treats April through December as taxable: 9 months x $35,000 = $315,000. The combined state and local rate is 6%, no sales are exempt, and the company did not collect tax from customers.
| Item | Amount |
|---|---|
| Taxable sales April to December | $315,000 |
| Tax at 6% | $18,900 |
| Penalty at 10% of tax (assumed) | $1,890 |
| Interest to the balance sheet date (assumed) | $700 |
| Estimated exposure | $21,490 |
The tax is the seller's cost when it did not collect it from customers, so the debit is an expense, not a reduction of a receivable, unless the sales contracts let the company bill customers for the tax. Many states set a separate rule for when the obligation starts after the threshold is crossed, so the March sales may or may not be included. The point of the illustration is the method: sales by state, the threshold test, the taxable base, the rate, penalty and interest, and a range if the facts are uncertain.
If the company decides to register, a state voluntary disclosure program can limit the look-back period and reduce penalties. The terms depend on the state and on the company's history. The company's tax adviser should deal with the state before any accrual is finalized.
What do auditors test?
These are practice procedures, not steps the standard names:
- Obtain management's nexus analysis. It should show sales and transaction counts by state for the current and prior years against each state's threshold.
- Check the data behind it. Sales by ship-to state should tie to the general ledger, and the analysis should include all channels.
- Compare registrations with the analysis. Ask for the list of states where the entity files returns and compare it with the states over threshold.
- Read correspondence from state revenue departments and any voluntary disclosure filings.
- Recompute the accrual and check how penalty and interest were estimated.
- Evaluate disclosure where a loss is reasonably possible.
- Consider a legal letter or inquiry of the tax adviser where the amounts are significant. See legal letter.
Common mistakes
- Treating the 2018 decision as a single national threshold.
- Assuming the marketplace platform handles every sale.
- Testing only the current year when the threshold was crossed in an earlier one.
- Accruing the tax but not the penalty and interest.
- Using billing addresses where the state rule turns on the delivery location.
Frequently asked questions
What is economic nexus?
It is a connection to a state created by the volume of a seller's sales into the state, rather than by a physical presence. Each state sets its own threshold, which commonly uses a sales dollar amount and in some states a transaction count.
Did Wayfair set a $100,000 or 200-transaction threshold for all states?
No. Those figures were South Dakota's, and the Court discussed them. The decision did not set a national rule, and states set their own thresholds.
Is an unrecorded sales tax liability an ASC 450 issue?
Yes. If it is probable the entity owes tax it did not collect and the amount is reasonably estimable, ASC 450-20 requires an accrual. If it is only reasonably possible, disclosure is considered.
Does P.L. 86-272 protect a seller from sales tax?
No. It restricts state net income taxes on certain solicitation activity. It does not apply to a state's sales tax collection requirement.
Sources
- South Dakota v. Wayfair, Inc., No. 17-494 (U.S. June 21, 2018), 585 U.S. 162: law.cornell.edu
- Quill Corp. v. North Dakota, 504 U.S. 298 (1992); National Bellas Hess, Inc. v. Department of Revenue of Illinois, 386 U.S. 753 (1967)
- 15 U.S.C. 381 (P.L. 86-272): law.cornell.edu
- FASB ASC 450-20-25-2, 450-20-30-1 and 450-20-50, Loss Contingencies
- Each state's revenue department rules on economic nexus thresholds, which differ by state
Related
- Sales tax nexus
- ASC 450 loss contingencies
- Loss contingency
- Search for unrecorded liabilities
- Revenue recognition audit procedures
- Principal vs agent
- Legal letter
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