Income Tax - The Next Big Battle For eCommerce Sellers
Michael J. Fleming is the founder and president of Sales Tax and More, a full-service consulting and solutions firm with a passion for state tax. He is one of the country's leading authorities on sales tax issues such as consulting and research, registrations, returns, nexus, drop-shipping, eCommerce, and service providers.
Michael is a renowned writer and speaker, and he regularly presents on webinars. He is also the host of the Sales Tax and More Podcast, where he shares his wisdom and learnings with his audience in order to help them navigate the tricky world of taxes.
In this episode…
We started talking about income tax and the potential issues it will cause for sellers about 18 months ago but it's really starting to pick up steam.
A lot of this is centered around PL 86-272
Northwestern Cement - 19 months
7 months congress acted
BTW - 62 years
Economy has changed
Net income tax - sales of TPP - accepted - fulfilled
Not great protection to begin the program in PA
Here’s a glimpse of what you’ll learn:
Why do we have these issues now
Why FBA sellers are low-hanging fruit for auditors
Foreign sellers have an income tax responsibility
Pennsylvania compliance program update
Materiality
Connect with Michael
Episode Transcript - Audio Version
[0:10] Intro: Welcome to Sales Tax and More, your go-to resource for all things state tax-related. Now, here is your host, Michael Fleming.
[0:28] Mike: Hi everyone. Mike Fleming here, founder of Sales Tax, and More and today's co-host of the Sales Tax and More podcast where we talk about everybody's favorite topic, which is of course sales tax. Today my co-host Ellie Moffat and I are going to be discussing why income tax is the next big battle for eCommerce sellers. But before we get started, I'd like to introduce you to Ellie.
[0:54] Ellie: Hey, everyone, it's really great to be here. Sales tax, as we know, is one of my favorite topics. And before we jump in, I want to give a quick introduction to Sales Tax and More. Sales Tax and More is a full-service consulting and solutions firm. We have a really great team here of experienced tax professionals who are very dedicated to fulfilling your state tax and related needs. So we do a lot of sales tax returns, sales tax registrations, consulting, research, and like our name states more. So if you have questions about our services or you'd like to work with us, please reach out to us. We would love to hear from you. So, Mike, we have been talking about income tax being the next big battle for online sellers for a while now, and in light of Pennsylvania's actions, could you explain this to everyone again?
[1:47] Mike: Yeah, absolutely Ellie. We first started talking about this oh 18 months or so but it's really starting to pick up steam in a lot of this is centered around public law, 86-272. Public law, 86-272...it's a federal law passed by Congress. It was a direct result of the Northwestern cement case, which was a U.S Supreme court case that pretty much said that you could tax interstate commerce any way that you wanted. Congress got upset and the big business got upset. They said nexus is so confusing. The whole country is going to go into another depression if we don't do something about this. So Congress acted very swiftly and within seven months they passed the interstate income act of 1959, which is also known as public law, 86-272. By the way, this nullified the Northwestern cement court's opinion. But that was 62 years ago. And Congress at that time said this is so complex. Nexus is so complex. We've got to form committees, we've got to do studies and once we get our arms around this, then we'll go out and make a permanent rule. That was 62 years ago and we still have this antiquated temporary solution. The economy has changed so much in the last 62 years. Some of you out there, have thought that Congress is doing nothing less for 4 years or 8 years or 10 years or 12 years or 20 years. But when it comes to some things. It's always been to do nothing congress, 62 years, we've had this temporary solution and the U.S Supreme court reminded Congress in 1992 that, Hey, this is the job you need to go out there and handle this nexus thing. And they did not. So finally the Supreme court stepped in and that's how we got Wayfair. So what public law 86-272 actually says is that a state cannot impose a net income tax on you if your only activity in the state is the sale of tangible personal property. The orders are sent outside the state for acceptance, and then the orders are fulfilled from a point outside of the state. Back then, not too many companies were offering services. So this protected some companies, but it was really all about this Northwestern cement case. That's the fact pattern in that Northwestern cement case. But as the economy begins to change, less and less companies are protected by public law 86-272.
[4:41] Ellie: So we have all these issues, Mike, it's been 62 years. Why now?
[4:49] Mike: A couple of reasons and some of it has to tie back to be careful of what we wish for. Most of these issues are due to Wayfair either directly or indirectly. So let's look at indirectly first. So everyone wanted the marketplaces to be responsible for collecting taxes. That is a result of economic nexus, which is a result of Wayfair. States have a constant need for new revenue. The sales taxes are less of a battle right now. So income tax, these laws have been around forever, the states have had a hard enough time getting some sales tax money. Now they're getting all this sales tax money and they're looking for new sources of revenue and lets it start enforcing some of the older rules that are already on the books. And that is for the income taxes. So that's one big reason. The second reason is, and this is to really be careful of what you ask for the marketplaces are collecting sales tax for you now. But most of the states have written into their agreements that the marketplaces have to provide them with any information that they believe is pertinent to make sure the taxes are being done correctly. So all of this information about where you have inventory, all of this information about your level of sales is right at the state's fingertips we're seeing states like Pennsylvania take advantage of this and California also. So that's the indirect reason. The direct reasons, while most states did not require a physical presence, two states that did, prior to this were Pennsylvania and Texas, but most states don't require a physical presence. In other words, intangibles could create nexus for you, but only about 10 states or so had a bright line, physical presence. In other words, you cross this number and you have a nexus for income tax once Wayfair passed that changed. And now these states, all of a sudden are adding economic nexus thresholds for income tax. For example, Texas doesn't have an income tax; they've got the franchise tax, but we're going to, allude to that as an income tax for today's purposes. They now have an economic nexus for their Texas franchise tax. It's $500,000. So you no longer need a physical presence in Texas. Pennsylvania is the same way $500,000 for the income tax in the state of Pennsylvania. Those were the last two states that required a physical presence. No more since Wayfair. And we're also starting to see a bunch of cities jump on board here. So not only do we have to worry about states, but we've got to worry about cities. A real big one is Philadelphia. If you have more than a hundred thousand dollars of sales into Philadelphia you now have an economic nexus in so long as you're not protected by public law 86-272. They want you to pay that and Philadelphia is one of the more aggressive cities out there. They actually use collection companies to collect their taxes. Historically they've been very aggressive even when we're talking about a physical presence and now. You just need an economic nexus. I think that they're going to become a lot more aggressive on a going-forward basis. The other thing has to do with public law 86-272. Also, remember we said that only protects you from a net income tax. We're seeing states, take an end-run around this state, like Oregon. They have an income tax. They don't have a sales tax and they can't get their hands on any remote revenue because most remote sellers are protected by public law, 86-272. So their income tax doesn't apply and they have no sales tax. So what they did is they came out with a gross receipts tax. It's another CAT just like Ohio, I believe it's a commercial activities tax. But it's a fairly high threshold when you hit 750,000 of sales into Oregon, you need to register and you don't need to actually file a return until you hit a million dollars. That's the way I believe that one works, but the moral of the story is, gross receipts taxes they're not income taxes, so they're not protected by public law, 86-272. Massachusetts believes that public law 86-272 is unconstitutional in light of Wayfair. So they're going to be looking for a case that they can send to the Supreme court to try to get this overturned. Finally, perhaps this is the biggest issue. The multistate tax commission, the MTC, provides guidance that many states follow in whole or in part as to what protected activities are. In other words, if you're doing just these activities then they are going to be protected activities. If you're doing these activities, they're not protected and therefore that's going to create nexus. Most of those in the past, the last time the MTC changed their guidance was 2001, maybe 2002. But it was a long time ago. And, these unprotected activities were all based on a company doing something physically in the state. Now in light of Wayfair, they're changing their guidance in the executive committee of the MTC has already accepted this and now they're putting it out to the states, circulating it amongst the states. To see if they're going to adopt it. As of now, it's not been adopted by many states, but it basically eviscerates the protections of public law 86-272. If you're using cookies on your website, most websites nowadays, do. They consider that a type of physical presence. So therefore you don't have the protection of public law 86-272. Post-sale emails or chat features if you provide any type of customer service on a post-sale basis. And a lot of companies do that, which is no longer protected by public law 86-272. In other words, it exceeds the sale of tangible personal property or the act of soliciting tangible, personal property. It's very narrow protection there. And then even inviting people to apply for a job. If you have any type of language, asking people to apply for a job, even if they don't apply for a job. That's enough to invalidate the protections of public law 86-272, based on this new guidance. Now we may see some lawsuits about this. We may see Congress get back involved. I don't think they will, Hey they may. It’s been 62 years, maybe they'll weigh in again. There's an all-out assault on public law, 86-272 at this point. So that's why we're starting to see this become a bigger and bigger issue now for multiple reasons.
[12:25] Ellie: Thank you for going into some detail on those Mike. I want to talk about FBA sellers. I've heard you say the FBA sellers are low-hanging fruit for the states. Can you expand on that a little?
[12:34] Mike: Yeah, absolutely. So let's go back to public law, 86-272. We said that, one of the things that the orders have to be fulfilled from a point outside the state. And if you're an FBA seller fulfillment by Amazon, you probably have inventory inside the state.
[12:55] So at least...in a lot of states out there, not all states, but a lot of states. So at least some of your sales are being fulfilled from a point inside the state, which right away, breaks the protections, and it’s all or nothing protection. You don't, just look at this and say, okay, I'll pay income tax on 20% of my sales, because they were fulfilled from a point inside the state. And I don't have to pay tax on this 80% because they were fulfilled from a point outside the state. It doesn't work that way. It's all or nothing. Once you're not protected by public law 86-272 you are not protected for any of your sales into that state. The states are truly looking at this low-hanging fruit. So we've seen California, they were the first ones to start this. They got a list of people or FBA sellers who had inventory in the state of California. And they started going after them. And they're being a lot more aggressive than the California Department of tax and fee administration ever was California department of the CDTFA. They let this stretch on forever. The franchise tax board out in California is not, they are going after people pretty rapidly. So if you have, if you're an FBA seller, you have inventory in California, you were there first on their list. It's easy to find out that you have inventory in California. Remember we said the states have all this information at their fingertips now. So they have a long-standing position that inventory creates nexus not only for sales tax but also for income tax. They were the ones to start this off. They fired the first shot in this new battle for eCommerce sellers. Pennsylvania started it two months ago. We just talked about this a lot recently. They sent out a letter to mostly FBA sellers reminding them that, Hey, inventory still creates nexus and not just for sales tax, but for income tax also. So they have a special, voluntary compliance program it is the voluntary compliance program, they just extended to June 8th of 2021. And, I think it's something that people should really take advantage of, not just for the sales tax. Amazon has been collecting sales tax. So if you're only collecting on Amazon, you don't have to worry about the sales tax portion of this. If you're selling on Shopify or your own website, now you have to worry about the sales tax, because Pennsylvania is saying, Hey, you may be under my hundred thousand dollar threshold, but you have inventory here. And a physical presence always overrides an economic nexus. So you need to be collecting tax on these other platforms and oh, by the way, you need to be paying the income tax also. Even if you're only selling on Amazon, you still have to pay the income tax.
[16:02] Ellie: So Mike, let's talk a little more about Pennsylvania. I've heard you talking to foreign sellers about them having an income tax responsibility in Pennsylvania. What about the tax treaty?
[16:14] Mike: That's a great question. States are sovereign, so they're not parties to the tax treaty between the U.S federal government and a foreign government. So the tax treaty deals with federal income taxes and does not deal with state income taxes. Now states can choose to follow the tax treaty and the majority of states do, but there are 13 states that actually do not follow the tax treaties. So Pennsylvania is one of those states that does not follow tax treaties.
[16:55] Ellie: Okay and while we're at it here, we've talked about the Pennsylvania special voluntary compliance program for PA in two previous podcasts. I think we've mentioned it in some other places. We've had it all out in our emails, social media. Do you want to share the latest updates?
[17:12] Mike: Yeah, absolutely. So as we were saying, it is extended to June 8th, and what the program is, it limits the lookback period. So instead of going back, a normal VDA, if you want it to do that, goes back three years and change the sales tax for four years and change for the income tax. This special program is only for people who have inventory in the state of Pennsylvania, and it goes back to two years and changes. It goes back to January 1st of 2019. So it's got a very limited look-back period, which is nice. It's going to waive all of the penalties, which is also nice. So to me, it's really a great program and all of these people are getting letters and they think that, Hey, we don't have to pay attention to this. Pennsylvania is not the CDTFA out in California, they are not going to let you ignore this for months. They have told us they are coming hard after everybody. So right now they're in their good guy mood. They extended the date that you can...the cutoff date, where you can submit things, but once they close this out and they're going to start coming after people hard for both sales tax and income tax based on people who have inventory in the state they're going to come after a whole bunch of things, but they're going to be concentrating on this inventory. And, a lot of foreign sellers say Mike, good luck to them trying to get us, we're a foreign seller. They have these reciprocity agreements with a lot of the states that have gotten together and the states that have ports in them, they're making it so that they can impound some of the shipping that says they come into the ports. So that's one way. Pennsylvania has a load of Amazon warehouses and other types of warehouses. They figure out you've got inventory there and they already know you if you're an Amazon seller, they already know you have inventory there. They're going to be going after that. And the accounts receivable, if you're selling on a marketplace, you have money sitting here in the United States and states will go after your accounts receivable. I've seen them do it before and Pennsylvania says, Hey, we're going to do this. And by the way, which is the first state to do this, you're going to see a lot more states doing this. So even foreign sellers should be paying attention to this.
[19:40] Ellie: So does all of this apply to FBA sellers only?
[19:45] Mike: No, FBA sellers, low-hanging fruit because they have inventory in a lot of states. So if you have inventory in the state, public law 86-272 does not apply. So that's why the FBA sellers are the low-hanging fruits and the states can very easily get that information. Other states right now like Texas, Ohio, Washington, Kentucky limited liability entity tax. These are all gross receipts taxes and or their non-income taxes. So you've got to worry about these today. Even if you're not an FBA seller, anyone who's getting registered in a state for sales tax should be worried about these gross receipts taxes. Now in Texas if you only have an economic nexus, then you have to worry about if you're over the 500,000 for economic nexus for sales tax, then you're over the economic nexus for the franchise tax. Same thing in Ohio. In Washington, it's a hundred thousand dollars and that's the business and occupation tax. And that's actually filed as part of a sales tax return. So even if you don't have responsibility for sales tax, you may have a responsibility for the business and occupation tax. For larger sellers, we've got to worry about states like Oregon or Nevada and that's today. That's not in the future. Oregon is, 750,000 and Nevada is 4 million. And all of these are not protected by public law 86-272 because they're not net income taxes. Now, these are not the only states that you have to worry about, but by far, these are the most common states. These are where most of the issues come up. Anywhere you have inventory. You're going to be subject to an income tax over the next 18 to 24 months as there's a continued assault and an assault on the protections of public law 86-272 we're going to find that we need to pay income tax in more and more states. It's not just going to be FBA sellers, for non-FBA sellers. There's a little bit more than a handful of states. You gotta worry about today, but this is going to become a much, much bigger issue over the next 18 to 24 months.
[22:18] Ellie: Mike, you talk a lot about materiality for sales tax. Do we need to look at material materiality for income tax as well?
[22:26] Mike: Yeah, absolutely. Number one. Unlike sales tax a very, I think Tennessee is the only state with a minimum there, but most other states don't have a minimum for sales tax, but there is a minimum for income tax in a lot of states. So you got to look at that. Number one, number two. Your exposure for income tax, generally going to be a lot lower than your exposure for a sales tax is based upon gross sales in tax, usually based upon your net sales. Usually, it's a big difference. Let's look real quickly. A hundred thousand dollars of sales. If we have an 8% sales tax rate, you're gonna owe roughly $8,000, let's say that you've got a 10% profit margin on that same hundred thousand dollars worth of sales. You'll have roughly $10,000 a portion to a state, and then you're going to pay 8 percent of that and that's $800. You have to have a lot higher sales numbers in a state before the numbers start becoming material. And just like sales tax. If the cost of compliance is going to be higher than the actual amount of tax owed, a lot of times, it makes more sense to just let the state come and find you now that it starts getting material, no, that's not an option. If you have exposure and its material that you have to take care of it, but, accountants charge all different types of fees to file state returns. I've seen $350 all the way up to a hundred, excuse me, $1,500. If you're an accountant charging you $1,500, you might want to find a new accountant. But if you don't, if you like them and stick with them, then you know, the amount of money should exceed $1,500. So yes, we still have to look at materiality and most of the states are looking for medium to large sellers. Anyway, they don't want to chase sellers who, by the time, everything's a portion down the net income tax is a hundred dollars. That's a whole lot of work for not a lot of gain. So the small sellers are not at risk as much as the medium-sized to larger sellers and larger sellers really need to be paying attention to this.
[25:02] Ellie: Mike, thank you so much. We've had so much great information here today. Is there anything else you want to cover?
[25:10] Mike: No, just that we appreciate you joining us today. We hope to see you or be with you on the next episode of the Sales Tax and More podcast. If you have any great ideas for an upcoming session of the podcast, please let us know.
[25:29] Ellie: Let us know, and if you'd like to work with us again, or have questions about our solutions and services, please reach out to me directly at emoffat@salestaxandmore.com or just hop on over to our website salestaxandmore.com. Thank you so much, everyone.
[25:38] Mike: Take care, everyone.
[25:41] Outro: Thanks for listening. Be sure to click, subscribe, and check out all of the resources we have out on the web.