From the September 1999 issue of Entrepreneur

With all the business blossoming on the Web, it's no wonder Internet tax issues are still rearing their ugly heads. Although Congress put the brakes on new access or discriminatory taxes from the states with the enactment of the Internet Tax Freedom Act in October 1998, it still left a host of e-commerce tax issues untouched.

What exactly are discriminatory taxes? In the case of e-commerce, they refer to taxes that designate certain Internet transactions as being taxable, while similar transactions executed through mail order or other means are not. Even though the new Internet law placed a moratorium on these taxes until 2001, state and local levies enacted prior to passage of the law still apply. Thirteen states, for example, are allowed to collect Internet access taxes. Other existing laws, such as one in Vermont holding companies that act as electronic malls responsible for remitting sales tax, are also unaffected by the act.

Even with the moratorium in place, state governments continue to eye e-commerce as a source of considerable tax revenue. Significant stakes are involved. According to Deloitte & Touche LLP, Internet business-to-business transactions could exceed $300 billion by 2002, making the potential for tax revenue enormous. This means entrepreneurs must be ever-vigilant about their potential tax liability when conducting business on the Web.

Loose Ends

The new law doesn't address several other important issues, including use taxes, which accrue when items purchased in one state are used in another state. Many states require purchasers to pay this tax when they buy goods in a different state.

Use taxes definitely apply to purchases made on the Web, says Scot Grierson, Deloitte & Touche's director of Multistate Taxes in Costa Mesa, California. But consumers haven't been all that good about voluntarily paying these taxes and the states really have no way to enforce or collect them.

In addition, the new law doesn't resolve one of the most important tax issues facing e-commerce: nexus. A source of significant conflict between states and businesses for some time, "nexus" refers to the degree of business activity or physical presence required before a state or local tax jurisdiction can tax a business, or require it to collect taxes.

How the nexus issue can create tax difficulties for businesses can be illustrated using a Texas law as an example. Retailers who have Web sites housed on servers in Texas have taxable nexuses. The state's policy is a nexus exists if a Web site is hosted on a server in Texas, even if the site's owner doesn't own the server. As a result, Texas requires the retailer to collect and remit the Texas sales and use tax in these cases. Housing a Web site on a server located in California, however, won't create a taxable nexus because the state amended its tax regulations to avoid this situation.

The many variations in tax laws from state to state make it difficult for Internet entrepreneurs to understand what applies to them. To help on that front, here are five pieces of advice to help you ready your business for the taxes involved in selling on the Net and minimize your tax liability:

1.Know the tax rules in the states where you conduct e-commerce. There are 30,000 taxing jurisdictions that can require you to file as many as 6,500 different tax forms in the United States, says Grierson. Many small businesses feel overwhelmed by such a confusing array of rules, but there's no way around it because tax simplification probably won't be achieved for some time yet.

The best way to understand your liability under the tax rules affecting e-commerce is to check with the state and local government tax offices where you conduct business. Also keep abreast of any state and local legislative proposals that could impact selling on the Net. Knowing the tax rules will help you plan where to locate your company's servers so you can deliver your products and services in the most tax-efficient way.

2. Don't ignore your nexus. In most cases, your nexus is determined by where your e-commerce server resides or even where your fulfillment company is located. In general, you have nexus in a state if you own property or inventory in the state or have an agent there, such as a sales representative.

Grierson recommends setting up your e-commerce operations in tax-friendly states, including states without sales tax, such as Delaware, Nevada and Oregon. Don Griswold, national partner in charge of state and local tax technical services for KPMG LLP in Washington, DC, says you may want to consider setting up a separate corporation for the part of your business that sells via the Internet. This way, only one segment of your business will be hit should there be new nexus standards. However, the pros and cons of such a move as it would affect your company in particular should be thoroughly investigated. For many businesses, setting up a separate corporation would hurt more than it would help, but keep in mind that the consequences of not knowing your nexus could result in a whopping tax bill, causing financial difficulties--possibly bankruptcy--for your business.

3. Make your Web site tax smart. Grierson says it makes sense to build tax information and tax collection fields into Web sites that already send information on inventory availability back and forth to your customers. Your aim is to adequately prepare for the time when you'll need to add the tax data.

4. Nail down international tax rules on e-commerce. Similar to states, each country has its own tax laws and filing requirements.

The Organization for Economic Cooperation and Development (OECD) Committee on Fiscal Affairs has taken the lead in developing the necessary international tax and treaty guidelines that will apply to e-commerce transactions. The OECD is the coordinating body for tax, legal and policy issues that arise among industrialized countries that are engaged in cross-border trade.

Groups within the OECD are studying tax issues that affect e-commerce and hope to craft rules that would apply to businesses on the Net. These include income tax treaty rules, transfer pricing and consumption tax issues such as value-added and sales taxes. Unfortunately, says Nilesh Shah, a tax partner with KPMG in Costa Mesa, California, "The business community needs answers today."

But don't let the lack of clear-cut rules stand in your way. Until the international tax situation is clarified, Shah recommends talking with other companies involved in e-commerce overseas and staying in touch with tax officials in the countries where you do business.

5. Plan now for future tax liability. Tax experts say it makes good tax sense to know the long-term cybertax plans for the states where your server and business partners are located.

Some Internet tax solutions are already receiving attention. For example, at a recent meeting of the National Governor's Association, the country's governors passed a resolution for each state to move toward adopting uniform sales tax rates inside its boundaries, thus eliminating disparities from sales taxes assessed by counties and towns. Another idea would be to require states to provide companies with copies of the existing tax rates for each ZIP code and then require them to collect the proper sales tax for each area.

Whatever the outcome, Griswold says, "At the end of the day, the same rules should apply to everyone, whether [they're doing business] on the Internet, via mail order or in a traditional retail setting."

In the meantime, entrepreneurs are advised to stay one step ahead of the tax curve. As you expand your e-commerce business, keep in mind our five pieces of advice for dealing with cybertax. Your aim is to minimize your tax liability so you have more revenue to keep your business growing.

Next Step

For additional information on Internet taxation and your potential tax liabilities, order the reference book Taxation of Cyberspace from Deloitte & Touche LLP and the Information Technology Association of America (ITAA), a trade association of the U.S. information technology industry. The book contains a state-by-state update on tax issues pertaining to e-commerce, including state income taxes, sales and use taxes, and telecommunications taxes. To order a copy, visit the ITAA Web site (http://www.itaa.org/news/pubs/list.htm). It's $175 for ITAA members and $225 for nonmembers.

Joan Szabo is a writer in Great Falls, Virginia, who has reported on tax issues for more than 13 years.

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By Robert McGarvey

Get the scoop on breaking tax news of interest to small businesses at Small Business Taxes & Management. There's plenty of information on the ins and outs of limited liability corporations, deducting automobile-leasing costs, IRAs and more. As with any such sit, always double-check your findings with a tax advisor you trust--but stop by here regularly, and you'll be well-informed about the tax news than can cost or save you money.

Contact Sources

Deloitte & Touche LLP, (714) 436-7846, sgrierson@dttus.com

KPMG LLP,nkshah@kpmg.com