Decoding US Sales Tax Sourcing Rules: A Comprehensive Guide for Businesses

In the United States, taxes are imposed at the federal, state, and local levels. The Internal Revenue Service (IRS) is the federal agency responsible for collecting taxes, while state and local tax authorities handle taxes at their respective levels.

This article will dive into each approach and help you navigate the complexities of sales tax sourcing.

There are several types of taxes in the US, including:

1. Income taxes: These are taxes on the income earned by individuals and businesses. The federal government imposes income taxes on individuals and corporations, while most states also have their own income tax systems.
2. Payroll taxes: These are taxes imposed on employers and employees to fund social security and Medicare programs. The federal government imposes payroll taxes, and some states also have their own payroll tax systems.
3. Sales taxes: These are taxes imposed on the sale of goods and services. The federal government does not impose a national sales tax, but most states and some localities do.
4. Property taxes: These are taxes imposed on real estate and personal property. The federal government does not impose property taxes, but most states and localities do.
5. Excise taxes: These are taxes imposed on specific goods and services, such as gasoline, tobacco, and alcohol. The federal government imposes excise taxes, and some states and localities also do.

When it comes to sourcing, the US generally follows a destination-based system for sales and use taxes. This means that the tax is imposed based on the location where the goods or services are delivered or used, rather than where they are produced or sold.

Home state rules refer to the tax rules that apply to businesses operating within a particular state. These rules can vary from state to state, and businesses must comply with the rules of each state in which they operate. For example, a business operating in California must comply with California's income tax laws, sales tax laws, and other tax rules.

In terms of types of taxes, the federal government imposes income taxes on individuals and corporations, payroll taxes, and excise taxes. States and localities can impose additional taxes, such as sales taxes, property taxes, and other excise taxes.

For VAT/GST professionals, US sales tax can be a challenging subject, especially when determining what sales tax rate to charge and collect. Non-US companies doing business in the United States need to know about sourcing rules.

What are sourcing rules?

Sourcing rules determine which jurisdictions have the right to tax a particular transaction. VAT/GST professionals can think of them as “place of supply” rules for sales and use taxes. However, with over 11,000 taxing jurisdictions in the US, it is crucial to understand where a sale takes place and which jurisdiction’s tax rate applies.

Sourcing rules are complex, and states differ in their approach to sourcing. Navigating these rules is critical. It is the only way to ensure that you collect sales taxes correctly and remit the appropriate tax amounts based on the correct sourcing rules in the right jurisdictions. These rules become increasingly complex as your business expands in geographical reach across the US and increases its product or service offerings.

Overall, there are three main approaches to sourcing, which essentially determine where a transaction takes place for sales tax purposes:

• destination-based sourcing,
• origin-based sourcing, and
• mixed sourcing.

What is destination-based sourcing?

Under destination sourcing, the taxable sales are sourced based on the location where the customer receives the product or service, which is often the “ship-to” location. However, it's worth noting that the "ship-to" location does not always reflect where the customer receives the product or service. For example, for concert tickets, the sourcing location could be based on the location of the event, rather than the customer's address.

In general, the tax rate applied is determined by the destination of the product or service. For example, in a state that applies destination sourcing, if you sell a product and ship it to the customer’s home, the customer’s address serves as the location of the transaction for sales tax calculation purposes. On the other hand, if the customer shops and purchases the product at your brick-and-mortar store, the store’s address serves as the location of the transaction.

Destination sourcing applies in the following cases.

1. US inbound transactions: As a first rule of thumb, destination sourcing applies to US inbound transactions. For example, if a French company sells a product to a customer in New York, the sales tax rate will be based on the location where the product is delivered in New York. Since the US Supreme Court’s decision in South Dakota v. Wayfair in 2018, states can require foreign sellers to register and collect sales tax upon exceeding certain economic nexus thresholds, even if the seller lacks a physical presence in that state. In such cases, the sales tax rate will be based on the location where the product is delivered, which can vary depending on the specific location in the state, as different counties and cities may have their own sales tax rates.
2. US interstate transactions: As a second rule of thumb, destination sourcing applies to US interstate transactions. Interstate transactions are sales from a business located in one state to a customer located in another state, such as a sale from Pennsylvania to Florida.
3. Intrastate transactions in most states: Destination-based sourcing is the most widely used method of sourcing intrastate transactions. Intrastate transactions are transactions that take place entirely within a state, such as a sale from a business in Atlanta, Georgia, to a customer in Columbia, Georgia. The state’s tax law controls whether the state applies destination or origin sourcing for intrastate transactions.

If a state follows destination-based sourcing, sales tax is collected based on the purchaser’s location. This does not affect sales tax calculations in single-rate states because the tax rate is the same regardless of where the purchaser is located within the state. For example, the general sales tax rate in Massachusetts is the same throughout the entire state, regardless of whether you are in Boston or Worcester.

However, there are certain states that have unique intrastate sourcing rules, which means they don't always follow destination-based sourcing for intrastate transactions. For instance, some states follow origin-based sourcing or mixed sourcing rules for intrastate transactions.

What is origin-based sourcing?

In origin-based sourcing, the taxable sales are sourced based on the location where the supplier/seller originates the product or service. In such cases, the tax rate applied is determined by the origin of the product or service. This means that if you sell a product and ship it to a customer in a different state, the sales tax rate will be based on the location where you shipped the product from.

While destination-based sourcing is commonly used in US sales tax law, there are still a few states that use origin-based sourcing for some or all transactions. Origin-based sourcing can also apply in a few other situations, such as for digital sales.

1. Interstate transactions: For interstate transactions, the sales tax rate will be based on the location where the product is shipped from, as the state with the highest rate in both states may be collected. For example, if a California company sells a product to a New York customer, both states would have the right to collect sales tax. However, only the higher of the two rates would apply.
2. Intrastate transactions: Some states use origin-based sourcing for intrastate transactions, which means that sales tax is collected based on the location where the product or service is shipped from. For instance, in Pennsylvania, origin-based sourcing is used for intrastate transactions, so sales tax is collected based on the supplier’s location.

What is mixed sourcing?

In mixed sourcing, both destination-based and origin-based sourcing rules are used for different types of transactions. Mixed sourcing rules typically involve origin-based sourcing for intrastate transactions and destination-based sourcing for interstate transactions. This is because interstate transactions can involve multiple taxing jurisdictions, so destination-based sourcing provides a clearer framework for tax collection.

However, some states still use mixed sourcing rules for intrastate transactions as well. This is often because they have not updated their sales tax laws to adopt the simpler and more consistent destination-based sourcing rules that are more common in the United States.

Mixed sourcing can lead to more complex sales tax compliance obligations, as businesses need to be aware of and comply with different sourcing rules for different types of transactions. This complexity can make it challenging for businesses to accurately calculate and remit sales taxes to the appropriate taxing jurisdictions.

In conclusion, sourcing rules play a crucial role in sales tax compliance, as they determine where a transaction takes place and which jurisdiction's tax rate applies. Businesses should carefully review their sourcing rules to ensure they are collecting and remitting the correct amount of sales taxes based on the location of their customers and transactions. Regularly reviewing and updating sales tax software and tools can also help businesses stay compliant with evolving sourcing rules.

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