One of the easiest ways to burn through hundreds of thousands of hard earned dollars without a match, lighter or incendiary device is by simply not paying attention to your sales tax filings. If you run a startup, and you are selling some products or services and you aren’t managing your sales taxes, eventually you will burn hard-earned cash on penalties, fines and back taxes.
Unlike with income tax, which you have to pay out of pocket regardless of when it is remitted, with sales tax you act as a conduit by typically collecting the taxes owed from your customers and remitting them to the government. If you don’t plan correctly, one day you will find out that you need to dig into your own pockets to make this payment, you and cannot go back to your customers to collect the unpaid tax. This is not because you are intentionally trying to avoid paying taxes. Rather, the U.S. sales tax system, with its 10,000+ different jurisdictions, is just too intensely complicated and unapproachable for a startup team. Sales taxes will occupy time, mindshare and money better spent on growing a business.
Rather than torching cash, I would recommend becoming familiar with the concepts that affect your startup and the blind spots you might miss. If you’re ready to enter the jungle that is sales tax compliance, here are five ways that your startup might get burned:
1. You Have Tax Exposure in XX States…But Didn’t Know It
Wherever you sell your product, you are potentially creating sales tax exposure of some type at some rate. Recently, I met the CEO of a tech startup who was making a few million in sales each year and thought he was doing the right thing by reporting taxes in the state where he was located. Eventually, he realized that he should have been calculating and filing sales tax in 35 different states. He was saddled with hundreds of thousands of dollars in fines, penalties and back taxes, all of which had to be paid out of pocket.
As this CEO learned the hard way, physical presence is not the only way to create tax exposure.
For instance, let’s say you run a data storage startup in Utah’s Silicon Slopes and sell to a Miami -based client who needs help with installation. Your technician flies to Miami, cabs to the client’s offices, installs the data servers and goes back to the airport. This could create what is known as nexus, obligating you to register and file Florida state sales taxes. If technicians install your servers in 35 states, you may have to file for state sales taxes in all of them.
2. You Filed on the 28th… But Your Were Supposed to File on the 20th
Most states require businesses to file for sales taxes on the 20th of each month, but many states deviate from this convenient norm. Some states, like California and Wisconsin, might allow for a later date like the 28th. So more often than you would suspect, a California startup wins its first New Jersey client but doesn’t realize that New Jersey state taxes are due on the 20th of each month. There’s one more penalty. A lot of other startups get busy and simply forget to file on time – what’s one day late? State and local governments are not forgiving – fines are assessed for the slightest of delays, leaving more cash in the fire.
3. You Miscalculate Sales Tax…By A Lot
Shipping to Colorado? Many business owners will use a sales tax tool that gives them the tax rate by zip code. They sincerely believe that they are doing the right thing and are in compliance. However, zip codes are misleading—in Colorado, one zip code can contain five different tax jurisdictions and rates ranging from 2.25% to 8%. Zip codes were created by the post office, purely to determine how postal workers will deliver the mail. They have nothing to do with tax jurisdictions, and this discrepancy is quite common throughout the country. Using zip codes as the basis to determine taxes will inevitably lead to errors.
In other situations, you might not be aware of special tax rules. Do you sell clothes? In many states there is an exemption for the sale of clothing, but it is dependent upon the price per unit (not the price of the sale). If you don’t know what the threshold is in New York ($110), Massachusetts ($175) or other states, there is a good chance that you will miscalculate the taxes owing. If you don’t know that there is a tax holiday, even though the states might provide a 2 week advance notice, chances are you will miscalculate the taxes owing.
4. You Sell Your Product in Multiple Forms…But States Are Picky
So, customers who buy servers from your Utah tech company can download software or have it sent on a disc. Depending on how you deliver software to customers, your tax rate can change. For example, if someone downloads and activates your software in Texas, you’ll pay one tax rate. But, if the same consumer buys the same software and it’s shipped as a DVD, the software is considered a delivered tangible good and therefore taxed differently. Unless you enjoy tracking state laws on taxing digital goods, which change frequently, mistakes will happen.
5. You Use Software…But It Doesn’t Prevent Human Error
Eventually, entrepreneurs who care for their time and sanity will buy software to make sales tax compliance manageable. Unfortunately, a lot of software still requires manual work, like plugging each product price into a sales tax calculator and then entering each output into an invoice, or updating the system each month with the hundreds of rates and rule changes. This is both tedious and prone to error. Someone on your team will eventually plug the wrong number, pick the wrong tax jurisdiction or simply forget to do it. Once your send an invoice, it’s hard to come back to a customer and ask for sales tax, so you will end up paying the difference.
With zip codes holding multiple tax jurisdictions, rules that require taxation based on the ShipFrom instead of ShipTo, weird digital taxation laws, tax holidays and dozens of other factors, a startup can’t win. Even with best of intentions and tax table, managing compliance is too complex, time consuming and risky for a small team. At a startup, a few hundred thousand dollars in back taxes and penalties could be crippling, or at the very least, really disappointing to investors.
Given the amount of cash a business can burn on sales tax errors, entrepreneurs should address compliance before they begin selling. Consult with a CPA or accountant and look for software or a service that will automate as much of the compliance process as possible. Save your revenue for development projects, new hires, or a party to celebrate all the pain and penalties you just avoided.