For small business owners, sales tax can feel like a confusing part of running your business. After working with hundreds of entrepreneurs, including online sellers using all sorts of platforms, I can tell you that sales tax mistakes are incredibly common, but they’re also completely avoidable with the right knowledge.

In today’s post, I’m answering the most frequently asked sales tax questions I hear. I’ll also connect the dots between sales tax, your income, and your overall financial picture. You might be surprised to see how closely related these numbers really are!

What is sales tax and do all small businesses have to collect it?

Sales tax is a tax you collect from your customers on behalf of a state or local government when you sell certain goods or services. The important thing to remember here is that sales tax is not your money. You’re just acting as the middleman.

Whether or not your business needs to collect sales tax depends on 2 main factors:

1. What you sell (products are typically taxable, but taxable services vary by state)
2. Where you have nexus (a connection to a state)

For example, if you sell handmade products in Indiana, you must collect Indiana sales tax on those sales. If you also sell online and ship to customers in Florida, you may need to collect Florida sales tax if you meet certain thresholds in Florida (more on that in a second).

What does “nexus” mean, and why does it matter for sales tax?

When it comes to sales tax, the word “nexus” means that you have a sufficient enough connection to a state that you must collect sales tax on products that you sell in that state.

There are 2 main types of nexus:

1. Physical Nexus: This happens when you have an office, warehouse, or employees in a state.
2. Economic Nexus: This happens if you exceed a certain amount of sales (often $100,000) or number of transactions in a state.

For example, if you live and work in Indiana but you sell $150,000 worth of products to customers in Illinois through your website, even if you never set foot in Illinois, you likely have economic nexus there, so you must collect Illinois sales tax on those transactions.

How do I pay sales tax?

Typically, the first step in paying sales tax is registering for a sales tax ID number. You’ll need to do this for each state where you operate, hire employees, or have a tax nexus.

Keep in mind that a sales tax ID number is not the same as an Employee Identification Number (EIN), which the IRS uses to identify your business.

How often do I need to file and pay sales tax?

How often you’ll need to file and remit sales tax depends on your state and your sales volumes. Typically, you’ll complete the process on a regular schedule of monthly, quarterly, or annually. As you’d expect, higher sales volumes usually means more frequent filings are required.

You should also check with your state to make sure you don’t need to file a “zero return” to officially declare that you had zero sales during any given collection period. This is important because in some states, if you fail to file a zero return, you’ll be charged a penalty.

Do I pay sales tax out of my pocket?

No, and this is where many business owners get tripped up.

Sales tax is collected from the customer at the point of sale. You then hold it and remit it to the state. However, if you fail to collect it when you should have, you may end up paying it out of your own pocket.

For example, if you sold an item for $1,000 but forgot to charge 7% sales tax on it and then were audited, you could owe $70 plus penalties and interest. You can’t then go back to the customer months later to collect it.

How does sales tax affect my income and profit?

First of all, remember that sales tax does not count as income on your tax return. It should never be included in your revenue.

So if we stick with my example above, if you collected $1,070 from a customer, $1,000 would be your revenue and $70 would be the sales tax amount you owe to the state.

If you accidentally record the full $1,070 as income, you’ll overstate your revenue and potentially overpay for your income tax bill.

I recommend that you set up a separate liability account in your accounting system and name it something like “Sales Tax Payable.” This will keep the sales tax amounts off of your income statement and help you avoid any confusion about what money goes where.

Can sales tax mistakes impact my income taxes?

Yes, sales tax mistakes can impact your income like this:

1. Overstated revenue: If you include collected sales tax in your income, your reported profit increases, and this can lead to higher income taxes.
2. Deduction Errors: If you accidentally pay sales tax out of pocket (because you didn’t collect it to start with), the cost may be deductible depending on how it’s handled, but no matter what, it will reduce your true profit.
3. Cash flow problems: If you don’t set aside collected sales tax, you may end up short when it’s time to pay both your sales tax liabilities and your income tax estimates.

Let me give you an example: If your business collects $20,000 in sales tax over the year but spends it unknowingly, then when it’s time to remit your sales tax, you’ll be scrambling for cash. And the kicker is that the remittance window often falls during the same time that you’ll be paying any income tax bill you may have.

What happens if I don’t collect or remit sales tax correctly?

States take sales tax very seriously because sales tax is considered trust fund money. This isn’t what you normally think of when you hear “trust fund.” It just means that when you collect sales tax, that money doesn’t belong to you. Instead, you’re holding it “in trust” for the state government until it is remitted.

Consequences for not remitting sales tax correctly include:

• Penalties and interest
• Audits
• Personal liability (even if you operate an LLC or S-Corp)

You should also keep in mind that it’s possible for a business owner to be personally liable for thousands of dollars in unpaid sales tax even after closing their business.

Are services subject to sales tax?

This varies widely by state, which is why it can get confusing. Some states like New York tax many types of services and other states like Florida tax very few.

This, of course, also means that if you provide services in more than one state, you need to make sure you know which ones require you to charge sales tax. If you offer both products and services in multiple states, you can see how it would become even more important to have a good tracking system and work with a CPA to help you understand the sales tax rules in each state.

How can I stay organized and avoid sales tax problems?

The best approach to avoid sales tax headaches is to build good systems for your business.

Some tips to keep in mind are:

• Use accounting software to make sure you track sales tax separately and accurately.
• Automate where possible by using tools like sales tax automation software that can calculate the correct rate based on location.
• Set aside sales tax funds so that you’re moving collected sales tax into a separate bank account where you won’t accidentally spend it.
• Review nexus regularly as your business grows.
• Work with a CPA to help keep you informed about sales tax changes (these can happen regularly!). They can provide guidance that will save you money and stress.

How does sales tax fit into my overall financial strategy?

Sales tax isn’t just about compliance issues. It is a cash flow and profitability issue as well. If it’s handled incorrectly, it can inflate your income, reduce your real cash, and lead to unexpected tax bills and penalties.

Abridged by Amy

Sales tax is one of those areas where small mistakes can turn into big problems, but it’s also an area where a little upfront learning can go a long way. The most important thing to remember is that sales tax is a liability you’re managing and not revenue you’re earning.

Set aside time now to make sure you understand when to collect sales tax, where you owe it, and how it impacts your income and cash flow. Those are the three keys to ensuring that your business stays compliant and that you have an accurate picture of your business finances.