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The Death of Ecommerce Startups?

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"Requiring out-of-state businesses to manage the collection and remittance of in-state sales tax would cause an undue burden on the etailer — a burden that would not come with any viable, tangible, or reciprocal benefits."

Imagine having to collect and remit sales tax to hundreds of taxing authorities. For etailers, that nightmare may soon be a reality.

I’m working on several startups concurrently. One which will hard launch later this year is in the epublishing space. The second one is in the biotech space. This startup is in its nascent stages as my partner and I are still building out the founding team and working on the business model. The third, and newest concept, is an ecommerce startup in the health and fitness space.

The last mentioned opportunity is actually not a startup yet as I am in the information-gathering stage. Whether I decide to promote it to a viable startup depends on the results of what I call my startup due diligence process.

Red Flags A Waving

As I’m going about the process of due diligence with this concept — determining whether or not this opportunity makes business sense — a big potential red flag has become apparent. This year or next, there might very well be a massive headache with respect to collecting online sales tax from out-of-state customers.

Since the inception of ecommerce on the Web, online sales have been exempt from state sales tax — with the exception of the state(s) in which you have had a physical presence. It is believed that this respite from the burden of having to comply with the varying taxing laws of hundreds (thousands) of different taxing authorities helped skyrocket the success of the Web as a business platform.

But if various state governors get their way and manage to persuade the US Congress to implement an out-of-state sales tax, it could be curtains for online retailing — at least the startups and small to medium sized etailers. Why?

If some form of this legislation gets signed into law, online ecommerce sites would be required to determine the proper sales tax owed by each customer based on the geographic location in which they reside and then collect and remit taxes to each of those taxing jurisdictions. Since there are literally thousands of different taxing authorities in the United States, that would be a hellish burden. Remember, this is compared to an in-state, Brick-and-mortar retailer who collects at just one state and one local sales tax rate.

Benefits Derived Versus Payment For Nothing

In theory, both online and brick-and-mortar businesses receive some benefit from state and local government services and programs. However, that is only if they are physically located in the jurisdictions of those governmental entities. What kind of relevant, realistic benefits and services would an online business receive from the hundreds or thousands of out-of-state taxing authorities to whom they may soon be forced to remit sales tax payments?

Let’s look at this from the standpoint of a brick-and-mortar store (B&M) being required to charge a sales tax based on the state and county of each of their customers. Although most customers of B&Ms are likely in-state, local citizens, many B&Ms have customers from different counties within the state, and different states. What if these B&M retailers had to ask each customer their home address and then make sure they charged the proper state and local sales taxes for that customer? They would then have to remit the sales tax to each state and local authority.

How many small mom and pop shops would be able to comply with that requirement? How many people would decide not to open up a new business, or expand into a new physical location in another state, if they were under the same onerous taxing rules?

Legally-legislated Enforcement Money?

Requiring online etailers to monitor, collect, and remit out-of-state sales tax is tantamount to the days of gangs and mobs charging local shop owners enforcement money. If the shops kept paying the money, the mobs would not hurt the owners nor shut down their businesses. Other than those benefits, they did not truly derive any useful services in return for monies paid.

Yet that is exactly what this legislation will amount to for tens of thousands of small- to medium-sized etailers. They will be forced to collect and remit payments with no benefits received in return — other than the promise of not being fined, sued, or shutdown.

The threat of a nightmarish onslaught of paper work may very well make me decide not to pursue this startup concept. The regulatory overburden might cause other ecommerce startups to fail, or not even get out of the starting blocks. It could be the end of ecommerce startups.

How Likely Is This Threat?

There is proposed legislation in the US Congress by Senator Mike Enzi (R-WY) that would reverse the legal precedent set by the Supreme Court that exempts online and catalog businesses from having to collect out-of-state sales tax. According to this resource, in past rulings that dealt with the issue of out-of-state collection of sales tax, the Supreme Court has basically stated that:

…the interstate commerce clause of the Constitution bars a state from compelling an out-of-state retailer from collecting taxes on sales to its residents…that collection is a burden on interstate commerce…[and] that taxes must be fair and nondiscriminatory, that there must be substantial nexus with the jurisdiction and a relationship between the tax and any state-provided services.

Requiring out-of-state businesses to manage the collection and remittance of in-state sales tax would cause an undue burden on the etailer — a burden that would not come with any viable, tangible, or reciprocal benefits.

If passed, this law would make etailers cringe each time they obtained a new customer that came from a state or locale to which they had previously not sold anything. With each new geographic location served, additional paperwork, sales tax remittance checks mailed, and compliance monitoring would be required.

In an attempt to provide a simplified method for collecting sales tax, some legislators have proposed what they call a Streamlined Sales Tax Agreement (SSTA). Would this make it easier for out-of-state retailers to comply with this new law? Not really.

Also from the above linked-to resource:

To start with, mandatory tax collection under the SSTA would cause thousands of merchants throughout the United States to be confronted with the entirely new obligation of collecting tax for over 7,500 local tax jurisdictions (including school districts, transportation districts, sanitation districts, sports arena districts, etc.)  This will create an enormous increase in the complexity of doing business for interstate marketers –certainly not a move towards simplification.
  
To make matters worse, the drafters of the SSTA failed in their original mission to reduce the number of tax jurisdictions.  Under the terms of the SSTA, the number of tax rates could actually increase to over 15,000 (each tax jurisdiction is permitted to have two rates).

Even with the proposed Streamlined Sales Tax Agreement, etailers would have a massive tangle of red tape and paperwork to figure out and stay up to date on. It would essentially be an overly costly, impossible task.

To Etail Or Not Etail?

As I was going through my startup due diligence checklist, the issue of taxes came up. After a little research, I learned that the promise land of the etailing space might soon be corralled by the myopic acts of local, state, and federal legislators.

If you are concerned about the very-real possibility of this narrow-minded legislation, please contact your local, state, and federal officials and express your support for a fair across-the-board sales tax policy for all retailers. If etailers have to collect out-of-state sales tax from their customers, then so should brick-and-mortar retailers.

Better yet, let’s keep innovation on the InterWebs alive and well by siding with the Supreme Court on this issue. Taxes should only be collected and remitted in return for direct, tangible benefits from local and state government.

Other Resources

Tax Break Nears End for Online Shoppers

What You Should Know About Potential Federal Tax Law Changes

What You Need to Know About Online Sales Tax

Thanks to this resource for the copyright and royalty free piggy bank image used as the foundation of the above graphic.

Article Comments

  1. Wow. I would agree with your analysis if it were true. Rather than argue your many points in this post asynchronously, could we set up a call? My direct email is dcampbell@fedtax.net and I would be happy to answer any questions you or your readers may have.

    • Jeff Sayre says:

      David, thanks for the comment. As I prefer to provide my readers with the benefits of discussion and information sharing, instead of calling you, I will continue the discussion on this post where it belongs.

      First of all, my analysis is fine. Just because you have a startup which is trying to offer one solution does not make my analysis faulty. What you offer is a potential (partial) solution to the problems presented in my post.

      Second, when you say in your video that the out-of-state sales tax is nothing new because consumers are already required to pay a use tax for products they receive from out-of-state vendors, that is conflating one tax with another and calling them equal. A use tax is not the same things as a sales tax. Use tax is an excise tax levied within the United States. It is not the same thing as sales tax.

      The proposed legislation would be a new form of tax that places the burden on the vendor and removes the burden of reporting and remitting a use tax from the consumer. Instead of levying an excise tax on individuals who purchase products from an out-of-state vendor, the new law would levy a business cost on out-of-state vendors.

      States and local municipalities are interested in this new taxing angle as the efficacy of use taxes has been proven ineffective — they are almost impossible to enforce. As you mention in your video, and as is well known, the vast majority of consumers fail to remit the required use tax for their out-of-state vendor purchases.

      Third, I agree that technology can be leveraged as one part of the solution. I ran a custom database software solution company for almost ten years. We dealt with all manner of point of sale and financial reporting scenarios. It is not difficult to calculate the appropriate sales tax for a given customer by using their bill-to or ship-to zip code and then looking up the appropriate taxing authorities’ sales tax rates in a properly populated database — one that would have to have, under this new legislation, 7500 plus unique taxing authority zones. However, there is more to this complex issue than simply the collection and remittance of sales tax. Thus “software solutions” addresses only one part of the overall problem and burden.

      The issue that arises is the burden of remitting quarterly payments to hundreds of different taxing authorities and then having to report those on (most likely) separate forms on your annual corporate tax return — state and federal. I have two corporations and I know how much of a pain it already is to manage the over 30 to 40 forms that we have to include with our corporate returns each year. It is already too much. I can’t imagine how much more difficult financial reporting compliance requirements will become if this or similar legislation gets signed into law. Will my 60 pages of corporate tax return turn into several hundred pages? The time and costs added just to the corporate-tax-return-filing process could be significant.

      Yes, “software solutions” sound like the panacea to this issue as well, but in this case, the data management and reporting must eventually be done by a person — yourself and / or your account. Adding more forms and paperwork — as a result of out-of-state sales tax compliance and reporting laws — just takes more time away from building the business and adds more costs that do not provide a return on activity. The quarterly filing and reporting to each tax authority is easy to automate, but financial accountants will need to compile their own reports and fill out new forms that get incorporated into the annual tax return. That costs more time and thus money. Whereas this is a marginal inconvenience for a business that has grown to the point where it has at least one full-time employee that deals with financial management and reporting, it is a big deal to a small startup.

      Fourth, because of these issues, the reality is that an ecommerce startup — read small as in staff and small as in budget — will be burdened by having to devote staff time and resources into managing and complying with the numerous collection, remitting, and reporting requirements of the myriad different taxing authorities.

      The collection of sales tax is the easiest of these issues to address. The remittance is a significant burden which your startup seems to be attempting to address. The reporting and compliance monitoring is another hellish burden that would rest squarely on the ecommerce startup and / or his or her accountants.

      Each of these adds new layers of complexity, costs, and time investments that previously had not existed. That makes it a set of new burdens that diverts precious human and financial resources away from making sales and building the business.

      Fifth, also in your video, you mention proposed measures in the legislation that attempt to mitigate the additional burden imposed on vendors who have to collect out-of-state sales tax. The fact that these measures are included in the legislation is testament to the realization on the part of legislators that the new law would place burdens on vendors.

      The $500k out-of-state threshold is ludicrous. My ecommerce startup could easily hit that threshold in its first year with only two employees and fewer than 700 customers. Imagine if those 700 customers represent 500 different taxing authority jurisdictions? That is not only feasible but highly likely. We estimate that 95% of our customers will come from outside of our state of physical presence. That means we would hit the threshold at roughly $530k of gross sales.

      Five-hundred-thousand dollars, or even a million, in out-of-state sales (gross revenue) is a terrible metric to use in triggering out-of-state sales tax collecting requirements. Our costs will be more than half (more like 80%) of gross revenues. Having to divert extremely limited human resources — there initially will only be two employees — into managing an out-of-state sales tax nightmare when we will generate roughly $100k – $200k pre-tax bottom line profit (based on 500k versus 1 million threshold) is absurd. It will force us to spend precious time and resources on doing paperwork rather than building the business and hopefully expanding our employee base.

      Now, if the threshold were $500k or a million of sales to a given state per year, then that might be getting to a reasonable threshold whereby an etailer would have sufficient fulltime staff already focused on financial management and reporting. However, $500k gross revenue across all out-of-state geographic territories is a poorly thought out, terrible target threshold.

      Sixth, in your video you state that your service is free to vendors as you collect a fee from the taxing authority. I’m interested to learn if you already have agreements with all 7500 plus taxing authorities or if there is a national program through the proposed Streamlined Sales Tax Agreement. By the way, I have little faith in the Streamlined Sales Tax Agreement (SSTA) offering anything that is truly streamlined. I believe that the present reality of there being at least 7500 taxing authorities (maybe as many as 15,000) will remain. I have a hard time believing that all of those authorities — or even that each state — will sign on to the SSTA.

      Seventh, I am interested to learn if your solution offers an easily usable API that allows software developers, such as myself and my company, to integrate your service into our platform. To make your solution truly useful and painless to ecommerce startups, there must be a RESTful API to leverage. Also, do you have a plugin for WordPress or a module for Drupal that developers of the various ecommerce solutions for those popular platforms can use?

      For your service to be a real solution regarding the collecting and remitting of out-of-state sales tax, it cannot require manual interaction with an employee. It cannot require scant employee resources being diverted to using an online system. In other words, it must not impose any new burdens on an ecommerce startup. It must be fully automated.

      However, with regard to the final potential burden of this new sales tax legislation — compliance monitoring and reporting on corporate tax returns — I doubt there are any solutions to minimize or mitigate this new burden and cost.

      Eighth, is your service already live? Since there is no federal law that yet mandates on-line vendors collecting out-of-state sales tax, why should an etailer be interested in your service? Are there other services that you offer beyond the simple calculation and remittance of sales tax?

      Finally, the issue of being burdened with tax collecting duties for governmental entities who do not provide any tangible benefits or services to a vendor is an important issue of constitutionality. Whereas the tax is paid by the customer and that customer arguably does receive benefits from their state and local taxing authorities, there is a new cost to the vendor that did not exist before. That cost is the managing of the out-of-state sales tax process — the collecting, remitting, and reporting. That is a type of tax, although it is not one that is collected, rather it is tax on the very limited time and financial resources of the startup.

      This is a cost that did not exist before. This is a cost that is the result of an out-of-state governmental entity — one that offers no benefits or services to the vendor — demanding that the vendor does what they have been incapable of doing. As I stated in my article, my guess is that if this legislation gets passed, it will eventually be struck down by the Supreme Court on grounds that it still is an unfair burden to vendors, vendors who are mandated to incur additional costs from out-of-state governmental entities who do not provide any tangible benefits or services in return.

      I look forward to your answers and learning more about your company’s offering. Perhaps your company will offer part of the solution to this complex issue.
      ___________

      Note: You can watch David’s video about his company’s sales tax collecting service here: http://fedtax.net

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