by: Michael Barg, Tax Supervisor
E-commerce sites hold tremendous growth potential for small and mid-size businesses. Partnering with online marketplaces and facilitators can expand customer reach in ways traditional sales channels often can’t match. These new opportunities come with new challenges.
In practical terms, an established New York-based business may sell products regionally and have nexus (the requisite activity that requires it to pay income as well as collect and remit sales tax) in just a few states. Expanding into a new market in the past was a deliberate choice that was pursued in a highly controlled manner that allowed the business time to plan ahead. Moving to an e-commerce platform by working with online marketplaces or facilitators may allow a business to start selling in all 50 states virtually overnight.
The speed at which companies can access and sell in new states by moving to an e-commerce platform brings with it new challenges. Expanding quickly through the use of e-commerce outside marketplaces or facilitators is even more problematic to businesses because of the advent of Wayfair economic nexus sales tax provisions being adopted in more than 40 states.
Engaging in selling through an online marketplace is qualitatively different from traditional sales operations because important aspects of selling are handled by an outside vendor. Such outside marketplace facilitators or e-commerce relationships may create instant nexus for a company in numerous states even though the company does not have a “physical presence” in the remote states. Managing such relationships to identify, as well as potentially contain, in what states a company may create nexus as the result of the relationship is critical to ensuring state tax compliance and minimization of state tax exposure.
Most importantly, businesses need to familiarize themselves with the many state tax obligations that will arise as their e-commerce sales grow. Here are the main points to consider.
Tax Reporting Differences
Companies typically tightly control traditional sales activities and their expansion. But online marketplace providers’ activities are managed outside of the company. When a business sells directly to a customer, it immediately knows who the customer is and generally where the sale occurs. However, when partnering with an e-commerce marketplace, the business will often not have real time knowledge of these state-specific details until after the fact — typically, through an end-of-month report generated by the online marketplace provider. Worse yet, if the online marketplace provider or facilitator has control over the business’ inventory as part of the agreement, the online marketplace provider/facilitator may place the inventory in different states creating nexus for the business without their knowledge. And they’re not required to inform the business of this until after the inventory has been placed in such states.
This time lag poses significant state tax challenges and risks, especially in state sales tax compliance. Such online marketplace providers’ activities may create nexus for a company for sales tax as well as income tax in remote states. If a company has sales tax nexus in a state, that company is required to register as a vendor in the state before it may charge, collect or remit sales tax.
By entering into a relationship with an online marketplace provider, a company as the seller may be selling into a state where they are not yet registered. As the marketplace provider/facilitator’s activities, not the activities of the company itself, are generating nexus in new states, the company may not realize quickly enough that they are required to register as a vendor, as well as charge, collect and remit sales tax in additional states. If the online marketplace provider is not required by its contract with the company to first inform the company of where it is operating or expanding its operations, every month the company may discover new sales tax filing obligations upon receiving its report from the online marketplace provider.
The Wayfair U.S. Supreme Court decision eliminated the requirement that a company must have physical presence in a state in order for that state to require a company to comply with its sales tax provisions. In the more than 40 states that have adopted Wayfair type economic nexus provisions, remote sellers need only meet a certain threshold in order to be required to collect sales tax. Such states have in general adopted a threshold of a total of 200 transactions or $100,000 in sales in the previous 12 months. If a business exceeds either of these thresholds, and hasn’t timely registered as a vendor and collected sales tax in real time, the company will be liable for the sales tax.
Further, if the business only later learns it has met the threshold for sales within such state, yet isn’t registered in the state as a vendor, the company is prohibited by law from collecting any sales tax until it is registered as a vendor in that state. Use of online marketplace providers/facilitators complicate this potential problem. By the time the end of month report arrives, it may be too late to properly register and collect sales tax without incurring significant costs.
Even more problematic and legally dangerous are circumstances where the marketplace provider’s contract allows them to charge and collect sales tax from the company based on where they have sales tax nexus regardless of whether the company has registered as a vendor in the state or states in question. The company will have in effect charged and collected sales tax in a state where it is not registered as a vendor and is prohibited to do so until it is registered. Such situations raise complex and costly sales tax compliance issues.
States are taking an even harder line on collecting delinquent sales tax, now that the Supreme Court has overturned the physical presence requirement. Planning ahead can help mitigate the risk of a sales tax audit.
More Risks and Liabilities
Remote sellers also face state income tax liability.
If a company only sells tangible personal property into a state but does not have any physical presence in the state, i.e. an office, a location or inventory in the state, generally the company will not be subject to a state’s net income tax. However, a state will subject a company to comply with its income tax if a company maintains inventory in the state. Remote sellers that make use of a fulfillment service provided by an e-commerce platform may have inventory in a state and not even know it. This will give rise to nexus for income tax purposes.
Our experience is that the typical online e-commerce facilitator operating model requires that the online e-commerce facilitator store inventory of its remote seller partners within its warehouses and move such remote seller vendors’ products to whatever state, or states, as appropriate for the online e-commerce facilitator to effect timely customer delivery. The remote seller usually remains the legal owner of this inventory – not the e-commerce facilitator. This presence of inventory in new states will cause the remote seller to immediately have sales tax as well as income tax obligations in the states where the e-commerce facilitator places their inventory.
As most states have annual income tax filing requirements, a remote seller’s income tax filing obligations may not be as immediate as its state sales tax concerns. Even so, businesses face significant tax preparation costs when the time comes to file income taxes and filings are required in many states.
Businesses should also be aware of additional local tax liabilities such as personal property tax on its inventory located at its online e-commerce facilitator’s warehouses.
Finally, the potential legal considerations arising from the company having inventory located in warehouses that the company does not manage or control should be addressed. Even though the business loses oversight as soon as the product leaves its warehouse, it may still face liability should an accident occur in a fulfillment center.
Entity Structure Considerations
For all of these reasons, businesses should consider creating a separate entity for sales generated through an online marketplace.
Analysis of the potential tax and legal benefits of isolating any business to be sold through an online e-commerce marketplace provider in a separate legal entity is highly recommended as this approach may limit potential liability to the assets contained within a specific operating structure. Careful design and implementation of the use of a separate entity to sell through e-commerce platforms may yield significant tax and legal benefits.
Thinking of using online e-commerce marketplace providers/facilitators to help grow your business? If yes, then get timely comprehensive legal and tax advice ASAP. The right tax and accounting advisor can identify the tax pitfalls and potential appropriate structure for selling through an e-commerce platform as well as help with managing the complexity and risks of such relationships. This guidance will also facilitate the timely planning and implementation of the proper accounting infrastructure for collecting and reporting taxes. This conversation should be the first step before partnering with any e-commerce giant.