About $20 billion is lost by state governments every year to uncollected online sales tax, according to independent accounting research company Bay Street Group. As states become aware of this monumental shortfall, they are beginning to aggressively audit companies doing business across jurisdictional lines and stiffen the penalties for tax violators, as well as redefine the term "nexus," or what it means for a company to have a tax-liable physical presence in a state.
For small businesses dependent on an online sales presence, the crisis looms large. To ease the transition to more efficient cross-jurisdictional tax collection, 19 states have enacted the Streamlined Sales Tax (SST) initiative, a technological solution that simplifies the compliance process and will reduce the number of necessary audits.
These states, including Indiana, Michigan, and New Jersey, are now equipping companies with free access to compliance software and services (CSPs), granting amnesty for past tax violations, and ensuring them freedom from any future sales tax audits.
In the last month, state governments collectively approved three certified service providers (CSPs) to help businesses conform to the new SST regulations. Of these, Bainbridge Island (Wash.)-based Avalara says it offers the only automated sales tax compliance software and service package that is focused on small- and medium-sized businesses.
BusinessWeek.com intern Douglas MacMillan recently spoke with Jared Vogt, Avalara's founder and chief executive, on what the SST means for small businesses and what compliance procedures seem to be the most efficient and inexpensive. Edited excerpts of their conversation follow.
What does the term “nexus” mean, and why is it important for small businesses to have a thorough understanding of it?
For small businesses that are starting out, nexus is a key element in paying sales tax. It means that they have a physical presence in a state. The bottom line for the small business is, they're at great risk and they don't know it.
They don't understand what nexus is, they don't understand that going to a trade show could create nexus, and they don't understand that if a state decides to audit you—even if they're wrong—you can't afford the legal process of appealing. That's why states are encouraging companies like Avalara to provide an automated solution for acknowledging and keeping track [of nexus].
What is the most confusing part of cross-jurisdictional taxing for small businesses?
The real challenge for small businesses is that there are in the U.S. more than 7,500 tax jurisdictions.
And each one of those has its own set of regulations?
Exactly. A whole bunch of regulations. For example, when you're in downtown Seattle you pay a state tax and a city tax and a regional transit tax—and all of those together make the rate that you pay. So the money is actually going to different things. Trying to figure out what jurisdictions apply to a given address is a big challenge.
When and why did the Streamlined Sales Tax (SST) begin?
It was started in 2000. It was started specifically to deal with that $20 billion in lost revenue. In a Supreme Court ruling in 1992, the federal government told the states that they were not going to give them the authority to collect taxes across state lines. They also said that on the practical side, you can't make a small business in Florida know 8,000 tax jurisdictions across the country.
No way could you ever dump that burden on business. It would be crushing. So SST was the state governors getting together and saying we know the battle that we're up against and one of the things we'll have to do to ever make it fly—the collection of this tax—is to provide some kind of technological solution to businesses so that they don't actually have to know all those tax jurisdictions.
So the SST is an attempt to create standard definitions?
Exactly. Until now, every state has acted basically autonomously in the evolution of its sales tax. So the rules are completely different. You've got states that categorize a Milky Way bar as a candy and some of them that categorize it as a food because it has greater than 50% wheat content. As a business, first you have to figure out the jurisdiction something is in, and then you have to figure out what rules apply to get the appropriate tax.
How many states are in compliance with SST now?
There were 42 states that signed onto the project and 19 of them have fully conformed their internal laws. I think this is what you'll see happening: the bigger states like New York, California, and Texas haven't changed their internal laws yet to [comply with] SST. I think that there's going to be a lot of looking to see how the project goes [in the first 19 states].
Is this kind of a testing phase?
Yeah. If the states that have gone live start to collect that lost revenue, you can bet that the other ones will come along. It's going to take the SST being successful for the other states to kick in on this. Every state that changed had hearings at the legislature, regulatory committees, and public juries. It's a process of several years to change your internal tax codes. Some states have done it, and some are in the process.
How has technology changed the process of sales tax collection and compliance for small businesses?
Automation is the next step. First there was paper—totally manual. Then for the biggest companies, software solutions. But that requires IT people and dedicated computers and monthly updates, which were quite expensive, so only the biggest companies could do it. Now, you've got on-demand [tax compliance solutions] like ours. [You] say where [the transaction is taking place], we say here's the rate, [depending on] the tax [jurisdiction] for that physical location.
How does Avalara's on-demand solution cater specifically to small businesses?
We've done the connections to the small- and medium-sized-business accounting applications, [whereas] the other CSPs have really focused on the enterprise and high-end accounting [applications].
We calculate the rates, we report them, we collect the money, we remit the money, we produce the forms … the whole nine yards. If you're a company that's not on SST, you can theoretically be audited [in the 19 SST-active states]. We can produce a complete audit trail of every transaction, because they've all come through our [system].