Officer
For a small business, one of the easiest ways to run into serious tax trouble is to not properly withhold and remit sales tax. There are multiple reasons that this tends to happen, but once a business falls behind, it is typically much harder to catch up than with income tax liability.
Below is an overview of how and why most small businesses run into sales tax trouble. I also discuss best practices for preventing sales tax liability from killing your business.
Gross, Not Net
The Commonwealth of Massachusetts requires retail sellers to collect from customers a sales tax equal to 6.25% of the purchase price of goods. The main reason sales tax issues tend to spiral out of control is that the liability is based on the gross amount of sales rather than the net amount of profits after expenses. This is in contrast to income tax liability, which is created only when business activity results in an economic profit. Consequently, even a money-losing business can generate a lot of sales tax liability.
Sales tax is actually the legal liability of the buyer. However, the laws in Massachusetts and most other states require that a retail seller withhold sales tax at the point of purchase and then remit the tax to the government. If a seller fails to properly withhold sales tax from the customer, the government reserves the right to hold the seller primarily liable. As such, inattentive sellers can easily become liable for taxes that should have been the responsibility of their customers.
Not Just Sales of Goods
Classically, sales tax is due when there is a retail sale of goods in the ordinary course of business . Although this seems like a straightforward concept, it can be difficult to implement in some real-world situations. For example, a particular invoice may include charges for the sale of goods, but also add separate charges for installation, shipping, or tech support. The tax treatment of these add-on line items can vary from state to state and can even depend on how invoices are drafted in some cases.
Trends have also made the general rule increasingly irrelevant; over the past twenty years many states have expanded their definitions of a taxable sale in order to cover a wider variety of transactions. Accordingly, states now collectively tax a variety of service transactions, like the sale of prepared meals, the use of tanning beds, haircuts, downloads of software, and media streaming services. The meals tax, in particular, can result in a significant liability for Massachusetts-based restaurants.
Serious Penalties
The fact that sales tax liability will in many cases fall back onto the seller if there is a mistake means sellers need to be extra careful in determining whether their business is in compliance. Penalties of 20% or more can be assessed for negligence or serious errors. State revenue authorities, and specifically the Massachusetts Department of Revenue, impose additional aggravated penalties on retail sellers that collect sales tax from customers and then fail to remit the amounts collected to the government. Failure to remit taxes collected is a frequent fact pattern in businesses that are struggling; they view the custody of the state’s funds as a source of immediate liquidity that is available to deal with emergencies. Although conceptually this is a fairly easy “loan” to take, it can prove very difficult to repay if 20%, 100%, or 120% penalties and interest are later assessed on the amount borrowed. Because of the potential exposure, small businesses should ensure procedures are in place to both properly compute their sales tax liability, and also pay over whatever is collected on a timely basis.
Legal entities that are taxed as pass-throughs for income tax purposes – such as LLCs or partnerships – are considered primary taxpayers for sales tax purposes. This means any sales tax liability for business transactions conducted by an LLC is the legal responsibility of the LLC and not of the individual owners. In many cases, though, this legal distinction does not offer much protection for individuals actively involved in the management of their businesses.
Where there is serious underpayment of sales tax, a state will go after owners, managers, and staff who are in control of company assets in a personal capacity in order to collect unpaid sales tax and penalties. The state may even pursue multiple parties for the same liability at the same time until the tax is ultimately paid. For this reason, any person in a financial management role who is working for a business that is not in compliance with its sales tax liability should seriously consider their personal exposure in evaluating their position with the company.
Preventing Harm
Because the amount of liability is based on gross sales, sales tax problems for businesses with narrow operating margins tend to be serious. This is especially the case for Massachusetts-based restaurants that are required to withhold and pay the meals tax.
Professionals familiar with sales tax reporting obligations can add tremendous value in protecting small businesses. Often, this means developing the proper strategy to deal with noncompliance prior to an audit or putting together a coherent audit response designed to limit personal liability. If you believe your business may not be in compliance with its sales tax responsibilities, it is advisable that you reach out to a professional as soon as possible for advice.