If you’ve become an avid online shopper, you’ve likely noticed – and enjoyed -- not paying sales taxes on many of your Internet purchases. However, just because the online merchant didn’t add sales tax to your bill, it doesn’t mean that you’re home tax-free. In fact, your state would very much like you to make payments directly to them, in the form of a "use" tax. Some states have a place on their 1999 income tax forms allowing you to fess up and pay what you owe, according to CCH.

But, if you’re like most Americans, you’re likely not keeping track of, or letting your state treasurer know, how much you owe. As a result, states that are concerned about the erosion of current or future sales tax revenues are taking a serious look at how to apply sales tax in cyberspace.

"While Internet sales still only account for a small number of purchases, they’re growing exponentially," said John Logan, JD, senior state tax analyst for CCH. "States are more and more concerned that unless they can come up with a way to effectively tax online purchases, they’re going to lose out on this revenue source."

From Main Street to the Information Highway
One of the key issues surrounding the Internet tax debate is that current sales and use taxes are outdated and increasingly don’t reflect the purchase patterns of today’s consumers.

"Most sales taxes haven’t really changed since the 1960s and were designed for Main Street commerce," said Logan. "But local commerce is now challenged by other forms of business and the states are now struggling to come up with taxation methods to protect their revenue bases."

Sales vs. Use Tax
Under existing tax rules, the only way you’re taxed for your online purchases is if the online merchant has a physical, or "bricks and mortar," presence in your state. If the online merchant does, it has sufficient connection, or "nexus," with your state to be required to apply the state’s applicable sales taxes to your purchase. For example, an online retailer based in Ohio with warehouses in California and Texas, would only have to apply sales taxes to purchases made by residents of those states.

But that doesn’t mean shoppers from the other 43 states that impose sales taxes aren’t expected to pay taxes. Rather, these shoppers are supposed to pay the use tax directly to their home states. In reality, however, this often doesn’t happen.

"Most people aren’t familiar with the use tax; they make a purchase and expect that any applicable taxes are included," said Logan. "Even once they’re aware of the tax, many aren’t inclined to pay. Most people don’t keep careful track of where they make purchases and states, for the most part, aren’t going to know you made an untaxed purchase unless you tell them."

Virtual or Local
With such little incentive for taxpayers to pay use taxes voluntarily, states are using the only key tool they have to go after the online merchants: nexus.

Under a 1992 U.S. Supreme Court ruling, states can force a merchant to collect sales and use taxes only if that business has a physical presence – or nexus – in that state. This doesn’t necessarily mean that the business must be headquartered in that state or have a warehouse or store there. In fact, some states are going after businesses that may have an individual employee in that state or an employee that visits the state often enough for the courts to agree that a physical presence exists.

While showing a business has nexus and must collect the applicable taxes is helpful in state’s attempts to regain revenues, it’s also not the best solution for the states.

"States that are very aggressive in establishing nexus have to spend a lot of time and resources identifying which businesses they believe are in violation and then prove individually that they are," said Logan. "they are successfully recapturing some lost sales tax revenues, but it’s a step-by-step process."

From Short-Term Fix To Long-Term Solution
How the sales and use tax finally will be resolved remains up for debate and to some extent appears to be divided by federal and state perception.

Through the 1998 Internet Tax Freedom Act, the federal government placed a three-year moratorium on states from taxing fees consumers pay for Internet access and from imposing discriminatory taxes on electronic commerce – such as a sales tax collected only on purchases made on the Internet. In addition, the Act ordered the U.S. Advisory Commission on Electronic Commerce to be formed to assess the impact of taxation on the Internet.

"Some members of Congress have been very vocal in expressing that they want to foster the growth of Internet commerce since it's viewed as a significant part of our future economy," said Logan. "At times it seems to many states that such nurturing could come at the expense of their revenue base. They often see an increase in e-commerce as a reduction in collected sales and use tax."

While the federally appointed advisory commission continues to examine Internet taxation and the states continue to push nexus where they can, one possible long-term solution may be imposing a national sales tax with a revenue-sharing scheme.

"Right now, virtually every state, and often municipalities within those states, have their own tax schemes – from different sales tax rates to different definitions of when sales taxes apply," said Logan. "This total lack of uniformity is one of the biggest objections businesses have when they’re asked to collect sales and use taxes."

While a federal sales tax would simplify collection for businesses, it likely would be difficult for states to agree on an equitable revenue-sharing formula.

Another possible solution would be if Congress were to pass laws enabling states to impose collection responsibilities on out-of-state vendors that don’t have a physical presence in the state. While this would mean that each state could continue to establish its own sales tax laws, it also would mean businesses have to come to terms with these complexities.

A possible compromise would be placing the tax management and reporting obligation on third-party vendors. These vendors would calculate the applicable taxes made on purchases, for which the online business would bill the buyer. When taxes made on purchases, for which the online business would bill the buyer.  When the bill was paid, the online business would then forward the tax payment to the third-party vendor for payment to the appropriate state and/or municipality.

While the final outcome is not yet known, change is certain.

"States that have no income tax and, therefore, rely heavily on sales tax revenues are among the most concerned that the Internet sales tax issue is resolved," said Logan. "But we can expect that as the economy slows and income tax revenue stalls, more states will have to come to grips with the erosion of sales tax revenues to Internet commerce."

CCH INCORPORATED, headquartered in Riverwoods, Ill., was founded in 1913 and has served four generations of business professionals ans their clients. The company produces more than 700 electronic and print products for the tax, legal, securities, human resources, health care and small business markets. CCH is a wholly owned subsidiary of Wolters Kluwer U.S. The CCH web site can be accessed at www.cch.com. The CCH Federal and State Tax web site can be accessed at www.tax.cch.com.

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