To Tax or Not To Tax

Every time an out-of-state retailer sells someone in California a product over the Internet—a toy, a book, a CD—the state, and perhaps a city or county within the state, has a right to collect sales tax on the transaction.

But state and local governments rarely see the money. Few Internet retailers collect sales tax and states can’t require them to. It is legally up to the Californians who buy products over the Internet to pay the tax on their own. And hardly anyone does.

But are California tax officials complaining? “It doesn’t offend me a bit,” says Dean Andal, vice chairman of the California Board of Equalization, the state’s elected tax commission.

It doesn’t offend him even though California is missing out on an estimated $200 million a year in sales taxes from Internet purchases. Yet that is less than 1% of the $32 billion the state collected in sales tax last year, and it’s not worth worrying about, Andal says. “I say we just let the Internet grow unabated; let it come to its maturity as fast as possible,” he says. “Then, if we have a tax problem, we can address it.”

While Andal is taking the long view of the Internet, many other governmental bodies aren’t being so forgiving. They want to take advantage of the tax opportunities Internet sales are generating and they want it now. And they want online retailers, like stores in the physical world, to collect the taxes.

For starters, politicians and government trade groups are challenging the legal standards that exempt retailers from collecting sales taxes in states where they do not have a physical presence. State and local government groups would like Congress to pass a law requiring online retailers to charge customers sales taxes based on where the customer lives. Retailers would have to send the money to the states.

“Our top concern is lost revenues as the Internet grows,” says Ralph Tabor, associate legislative director at the National Association of Counties in Washington, D.C. “The growth on the Internet has been explosive, and if we continue to lose that sales tax revenue at the state and local level, we won’t be able to continue to finance services.”

But there are plenty of Web advocates who cringe at the thought of taxation. Not only are they tolerant, as is Andal, of the lack of tax revenue, they are downright opposed to any taxation at all of the Internet. Sen. Ron Wyden, a Democrat from Oregon, sponsored the Internet Tax Freedom Act, “because he doesn’t think the Internet should be strangled in its crib,” says a spokesman for Wyden. And the anti-tax sentiment is a bipartisan issue. Sen. Bob Smith, a Republican from New Hampshire, has proposed legislation to make the 1998 moratorium on new Internet sales taxes permanent.

The debate is picking up steam in Washington and across the country. It’s an issue that online retailers need to be aware of, and one that could affect the way they structure their businesses, analysts say. The federal government has created the U.S. Advisory Commission on Electronic Commerce to investigate the issue. The commission will make recommendations to Congress in April—if it can agree on anything to recommend. Early meetings of the commission have resulted in little common ground.

Online retailers are keeping a close eye on what happens, preparing for the eventuality that they may have to pay taxes. If Congress requires Internet businesses to collect taxes for every state and locality, Macys.com would comply, says Kim A. Miller, vice president of Internet strategies. “But obviously we hope it doesn’t happen that way.”

Retailers who do business over the Internet today are legally required to collect sales taxes in states where they have a physical presence. Macys.com automates the collection of sales tax, so when a customer types an address into the Web site, software automatically checks it and applies the appropriate tax when necessary.

Some nationwide companies, such as Sears, simply collect tax on everything they sell over the Internet. Other retailers have set up their online businesses as a separate entity, which means they have to collect sales tax only on items sold in the state where the Internet business is based.

Technology is helping Art Munson, owner of the Cassette House (tapes.com), collect tax in his home state of Tennessee. Munson sells cassettes and related recording supplies online. When he sells items to people who live in Tennessee, Munson’s Mail-Order Manager software adds sales tax to the customer’s total cost.

If Congress requires online retailers to collect sales tax for every state, Munson’s software would manage that as well, down to the county level, he says. But Munson also has to keep track of the paperwork for Tennessee companies that have tax-exempt status, and he has to fill out forms and mail the sales tax he does collect to the state of Tennessee. Those tasks could be overwhelming if he had to do it for each of the 46 states and Washington, D.C., that impose a sales tax, he says.

Keeping up with tax rules and product definitions for each state also would be a tremendous burden for Internet retailers, says Robin Lebo, director of customer acquisition at Crutchfield, an online seller of electronics equipment for homes and cars. Crutchfield only collects sales taxes for purchases made by consumers in Virginia, where the company is located.

Many retailers are concerned about the sort of tax rules that exist in Pennsylvania, where clothing is not taxable unless it is a luxury item.

A tax nightmare

Retailers’ primary concern is being saddled with the responsibility and all the obligations that go along with the collecting taxes for all states and subdivisions—estimated to exceed 30,000 entities—that want to impose a sales tax, says Mark Nebergall, vice president and counsel at the Software and Information Industry Association, Washington D.C. “You hear a lot about figuring out the correct rate, but that is only the tip of the iceberg.” Varying state filing requirements make compliance a “nightmare” for Internet retailers, he says. For instance, states all have different forms that retailers must fill out and file with different schedules for submitting the taxes collected.

It is that complexity that may keep online stores from having to collect any tax at all, except in states where they have a physical presence, says Joe Crosby, national director of state tax legislative services for Ernst & Young. “If you own a retail store, the tax is imposed based on where your store is located, regardless of where the purchaser lives,” explains Crosby. “But if you are an Internet seller, you potentially could have to deal with thousands of taxing jurisdictions, even if you are only located in one state.”

Until now, a series of Supreme Court decisions has stated that “remote sellers” such as mail-order catalog companies can’t be forced to collect out-of-state sales taxes because the system is too complex. Internet sellers are in the same category.

But rapid growth of the Internet has led state and local governments to re-energize efforts to get Congress to override those rulings and force remote retailers to collect sales tax. The groups have been urging Congress to act for more than two decades. Because of the Internet, Congress may finally pass laws on the issue, analysts say.

“In the next 18 to 24 months, we should have a much more definitive answer about what taxation on the Internet will look like,” Crosby says.The issue is an important one for states, says the National Association of Counties’ Tabor. “We currently lose $4 billion to $5 billion annually from things such as mail-order and Internet sales. Four or five years from now, as the Internet grows, we will be losing another $6 billion each year.”

To enable remote retailers to collect sales taxes, state and local governments are considering various routes to making things simpler. Among policies the National Governors’ Association supports is to enact a single tax rate for each state, says Tim Masanz, group director for economic development and commerce at the association. States would require mail-order and Internet sellers to apply just one tax rate to items being mailed into a state, thus eliminating hundreds of local tax rates. Retailers would submit the money to the state which then would divide the funds among its cities and counties.

“We have to find a way to make the tax easier,” Masanz says. “We’ll have to give up some things, but the advantage is we will get the retailers to collect it for us.”

States have to simplify their tax laws if they want Internet retailers to collect sales taxes, says Walter Hellerstein, a professor at the University of Georgia Law School. “I’m not in favor of tax exemption for anybody,” Hellerstein says. “But businesses have a legitimate complaint that the state sales tax laws are too complicated.”

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Others argue that technology can solve the problem without changing the tax rates. State politicians propose giving retailers software that includes tax rates down to the address level, so that when a customer submits an address, tax rates for that state, county and city automatically would be added to the total price. Or a third-party collection system could emerge in which companies collect payments from consumers, give the retailers their share and send the taxes along to the states, Tabor says.

Ultimately, the decision lies with Congress, which has authority to regulate interstate commerce. “We really need federal legislation to solve this,” Hellerstein says.

Congress probably won’t act until it gets a report from the federal advisory commission researching the issue. But progress is slow. The commission had planned to consider a report from the National Tax Association’s Communications and Electronic Commerce Tax Project, which has been working on this issue since late 1996. Yet it has failed to come up with a unified report.

There is plenty of time to sort this out, Crosby says. Ernst & Young recently completed a study that found that many Internet purchases aren’t normally subjected to sales tax anyway, such as travel services. “So despite the fact that the Internet is growing rapidly, I don’t think it’s entirely clear that there’s going to be an equally rapid increase in the amount of ‘lost’ taxes,” he adds.

Even if states are missing out on an opportunity for revenue, the Internet’s economic benefits outweigh that, California’s Andal argues. “Let’s have a hands-off policy on the Internet and let it grow as fast as possible,” urges Andal. “The economic benefits to the country are by far outweighing any modest tax revenue that states could achieve.” •

MargaretAnn Cross is freelance business writer based in Allentown, Pa.

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