Tax Man Eyes Internet

November 23, 2005
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GRAND RAPIDS — With the mainstream Internet roughly a decade old, states are only now figuring out ways to combat the tax complications created by e-commerce and the virtual workplace. How effective these measures will be remains to be seen.

The first issue is the Internet sales tax.

As an example, when the Apple Store moved into Woodland Shopping Center this past summer, Daniel Konder, co-owner of AMS-TSD and one of only two Apple Specialists in the region, welcomed the competition. If he was going to compete with Apple, he explained, he would much rather do so against a brick and mortar store than the company’s Web site.

“Too many people are going on the Internet to make large equipment buys because they don’t have to pay taxes,” he said. “When I give a quote, they constantly try to chew my price down because they can save $120 by not paying taxes. Even though we tell them you still have to pay your taxes, they don’t do it.

“For us to drop our price $120, that’s giving up every inch of margin on our product.”

According to Joe Levan, an attorney with Varnum Riddering Schmidt & Howlett LLP, out-of-state retailers have a huge advantage: They don’t collect use tax and most people don’t pay use tax.

“The guys in-state would love for the out-of-state retailers to collect, but the state can’t make them,” he said.

Here’s how it works: The Commerce Clause of the U.S. Constitution prohibits a state from imposing a sales tax on a retailer that doesn’t have a physical presence in that state. Most states impose a use tax on its citizens in place of the sales tax, but that system, as demonstrated by Michigan, is flawed. Beginning last year, there was an item on the back of the Michigan 1040 for that purpose.

“The compliance rates for that are incredibly low,” said Richard Spengler of BDO Seidman LLP.

Effectively an honor system for individuals, a University of Tennessee study estimated the combined loss of all states over this decade to top $440 billion.

But through efforts like the Streamlined Sales Tax Project and aggressive auditing, the states appear to be gaining some ground. To better integrate their brick and mortar and online sales channels, many large big-box retailers, including Wal-Mart, Sears and Toys R Us, have started charging sales tax online.

In other cases, states have become more creative in efforts to establish a physical connection, referred to as nexus, of the retailer within the state.

Levan used California as an example. There, the state will routinely audit its resident businesses, and in the process, examine each company’s top vendors for in-state sales. If any of those vendors aren’t paying state sales tax, it will send out a nexus questionnaire.

“Odds are, if any employees have been there for more than a day, (the state is) going to at least attempt to establish nexus and assert that the company should be collecting tax for the state of California,” Levan said.

While the nexus may be questionable at best, a bill from the state likely will force a protest from the company, and then maybe an expensive court battle.

“You might not think you have nexus with Tennessee because you don’t have an office there, but if they figure out you’ve had an employee in the state for a number of days or have trucks passing through, that might be enough,” Levan said. “And since you didn’t collect the tax, you’ll have to pay that amount, because you can’t go collect from the people you already sold to.”

As the country grows smaller, similar scenarios are emerging in other areas of taxation. Take the case of Tennessee computer programmer Thomas Huckaby. The Supreme Court last month refused to hear his complaint against New York’s system of taxing income, causing him to pay taxes on a full 100 percent of his salary to a state he doesn’t live in.

Most jurisdictions use a time-spent-on-premises test, but New York uses a necessity-of-employer test. The telecommuter spent roughly 75 percent of his time in Tennessee and 25 percent in New York, and assumed he would pay taxes accordingly. The state of Tennessee agreed, but the state of New York did not, arguing that because it was his choice to telecommute, he should pay taxes on 100 percent of his income to New York.

In the end, he paid taxes on 75 percent of his income to Tennessee, and on 100 percent of income to New York.

“The current literature suggests at times it may be better to do that than to move to New York,” Levan said. “But I think it’s going to change the way people who telecommute look at jurisdictions like New York.”    

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