How to Talk to Your Clients About Sales Tax
In 2018, the Supreme Court overturned the physical nexus stipulation, a holdover from the 1992 Quill case ruling, calling it “unfit and unsound” for today's economy. In the process, SCOTUS deemed South Dakota's concept of “economic nexus” a better fit for modern commerce; a revolutionary change that opened up the floodgates of states rushing to revise their nexus laws to increase sales tax revenue.
It's important to note that economic nexus does not replace physical nexus - it functions as an addition to physical nexus. In fact, it's likely that businesses pulling in healthy revenues from remote sales will meet the criteria for both types of nexus. States will continue to pursue remote sellers that have triggered other nexus-creating activities within their jurisdiction prior to Wayfair. As a result, it’s more important than ever to consider whether a voluntary disclosure agreement is the right path to registration for your exposed clients.
Voluntary disclosures have long been a tool for CPA firms to utilize to assist their clients. In this unprecedented time, however, a growing number of states are facing catastrophic budget deficits and are seeking to increase revenues. A primary source of increasing revenues is to enforce the taxation of out-of-state businesses authorized under the Wayfair decision. This increases exposure risk for many businesses and, as a result, the CPA community must be prepared to offer advisory services that relate to nexus, including the preparation of voluntary disclosure applications, when applicable.
The Road to Compliance
The good news here is that the current environment presents a window of opportunity to be proactive with your clients in the review of sales activities for current and prior periods. Being proactive is likely to reduce exposure or tax liability assessments. Here are some critical considerations when assessing the business activities of your installed client base:
A thorough evaluation must consider both economic and physical presence nexus. Physical presence activities did, and still do, create nexus for unsuspecting sellers.
An evaluation of sales amounts and transaction thresholds must go back to 2017 if you want to ensure that your client doesn’t have any “prior-period” economic nexus exposure under Wayfair
Fact patterns must consider whether your client has/had any physical presence activities sufficient to constitute nexus, and the date(s) of first occurrence.
Depending on the scenario, you will need to make a determination on remediation efforts for your client.
Possibilities include registration, voluntary disclosure agreements, or participation in amnesty programs.
At this point in time - nearly two years since the Wayfair ruling - most businesses are painfully aware of the resulting changes and are scrambling to become compliant. More than ever, they need their CPA to be a trusted advisor on this topic. Specifically, businesses need help identifying states where they may have exposure, calculating the amount of any exposure in dollars and, ultimately, getting compliant.
Types of Exposure
Generally speaking, there are two broad categories of exposure your client may fall into: 1) Pre-Wayfair exposure; and 2) Post-Wayfair exposure. Pre-Wayfair exposure is probably the most common and also the most complex. Post-Wayfair exposure actually breaks down further into timely compliance versus untimely compliance.
This is the most common, complex, and concerning situation. These businesses have a physical presence nexus for sales tax in the jurisdiction prior to the enactment of Wayfair. The pre-Wayfair physical presence nexus might have been limited or minor, but these businesses chose not to register and collect tax. Due to the recently enacted economic nexus laws, the business will have no choice but to prospectively comply. Unfortunately, due to the attestation requirement of state sales tax registration applications, your client will have to disclose the unresolved physical presence nexus. This creates exposure dating back to the time when physical presence nexus first occurred.
This is a classic example of when a voluntary disclosure agreement (VDA) should be used to address the historical exposure and bring your client into current compliance. Be prepared for your client to be on the hook for back taxes and interest for the applicable lookback period (usually 3-4 years). As part of the VDA, years prior to the lookback period are generally waived. Additionally, penalties are generally waived in the VDA process, but your client is likely to have a pretty steep bill for the prior-period tax liability.
There are a smaller group of businesses that truly do not have any physical presence footprint in a given state prior to the Wayfair decision. They may still have economic nexus issues, but these will more likely relate to timely versus untimely compliance of the Wayfair decision. Either way, you need to have a thorough understanding of the applicable rules to advise your client effectively.
This is a less than ideal, yet common, scenario. Now that all but two states (Florida and Missouri) have enacted economic nexus laws, it is likely that you have a significant number of clients that are faced with untimely compliance exposure. Nevertheless, it is incumbent upon you, as their trusted advisor, to get them in compliance as soon as possible.
Unfortunately, this scenario presents a predicament. A decision must be made by the company to either ignore the interim period of non-compliance, or file the late returns, incurring penalty and interest. As their trusted advisor, you must inform your client that the registration document is generally signed under penalty of perjury. The registration specifically asks a representative of the client to declare the business start date in the taxing jurisdiction. If the start date is prior to the timely registration date, it is likely to trigger an inquiry for the missed filing periods. If your client enters the present date as the start date, there will be a problem with the attestation on the registration.
Voluntary Disclosure Agreement
While the states are coping with the COVID-19 pandemic, CPA firms have an opportunity to get ahead of the enforcement initiatives that are bound to follow. The primary solution for your clients with pre-Wayfair or untimely post-Wayfair exposure is the administrative procedure known as voluntary disclosure. The advantage of using this process is that you can anonymously approach the state on behalf of your client and negotiate a settlement of past tax liabilities and secure penalty waivers. However, look before you leap, as each state has different requirements and nuances regarding their VDA program. Become familiar with the specific states where you intend to file a VDA on behalf of your client. Be cognizant of preserving your clients anonymity until an agreement is reached between the state(s) and your taxpayer.
A typical voluntary disclosure agreement will require the company to register and pay its current and future taxes. Additionally, most states require that the company pay the back taxes and interest for the stated lookback period. Each state has its own lookback period, but most range from three to four years. The states will, in most instances, waive penalties associated with the back taxes. Most importantly, the states will usually agree to waive audits of the tax years preceding the lookback period. Make sure to negotiate an agreement that covers your client’s prior period obligations.
It is the taxpayer’s responsibility to submit the voluntary disclosure agreement. As their trusted advisor, you should be aware of the sales activities for the lookback periods in each state and have an understanding of the “good faith” estimate of liability. The more thorough your analysis, the less likely your client will encounter surprises. Being prepared to file back tax returns for the lookback period, and support the tax liabilities is essential. Sales audit worksheets should form the basis of the agreement and apprise your client of the financial implication.
Typical VDA Details
The majority of states follow the Multistate Tax Commission model for the type of data they require during the application process.
- Name and contact of CPA or taxpayer’s representative
- Last digit of taxpayer’s FEIN
- Entity type (C-corp, S-corp, LLC, etc.)
- Fiscal year
- Nature of the business
- Does the taxpayer have any property in the state?
- Employees, independent contractors, or representatives activities in the state
- What activities does the taxpayer have that constitute nexus (i.e. remote sales, employees, inventory, etc)?
- Date on which nexus first occurred
- Did the taxpayer collect sales taxes and not remit them?
- What gives rise to the voluntary disclosure application?
- Has the applicant been previously contacted by the state?
Voluntary disclosure agreements are an important tool for CPA’s to use, when applicable, to reduce your clients’ exposure to prior tax liabilities. You, as their trusted advisor, must be prepared to apply a vast array of economic nexus rules, physical presence tests, lookback periods, transaction audits, registration timelines, marketplace facilitator implications, and calculated exposure amounts to properly protect your taxpayer client and minimize their overall risk. Using the LumaTax cloud-based Sales Tax Hub™, you never have to worry about tracking all of these varying parameters to deliver this advisory service efficiently and effectively. You can learn more about the Sales Tax Hub™ by visiting www.lumatax.com.
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