What Is Online Sales Tax and How Does It Work?

Sales tax is a consumption tax imposed by state and local governments on the sale of goods and services. Its primary purpose is to generate revenue, which funds various public services like infrastructure, education, and public safety. Traditionally, sales tax was straightforward to apply because transactions occurred at a physical location.

However, the rapid expansion of online commerce introduced complexities to this established system. As consumers shifted purchasing habits online, traditional rules relying on a seller’s physical presence became less clear. This necessitated new regulations to ensure online sales contributed equitably to state and local revenues, leading to the concept of “online sales tax.”

Foundations of Sales Tax

Sales tax is a consumption tax levied on goods and services purchased by the end consumer. Sellers collect this tax at the point of sale and remit it to the appropriate taxing authorities. This revenue is a significant funding source for state and local government programs.

Historically, sales tax application was tied to a seller’s physical presence within a state. If a business had a store, office, warehouse, or even employees in a state, it was generally obligated to collect sales tax from customers there. This “physical presence” rule, established by Supreme Court decisions like National Bellas Hess, Inc. v. Department of Revenue of Illinois and Quill Corp. v. North Dakota, meant out-of-state mail-order businesses without a physical footprint were not required to collect sales tax.

This framework worked well when most retail transactions occurred in brick-and-mortar stores. However, as online shopping grew, many remote sellers lacked a physical presence in every state where they sold goods. This led to untaxed online purchases, creating a competitive disadvantage for local businesses and substantial revenue losses for states.

Determining Online Sales Tax Obligations

The concept of “nexus” is central to determining a business’s online sales tax obligations. Nexus refers to a sufficient connection or presence a business has with a state, obligating that business to collect and remit sales tax. Historically, this connection was primarily defined by physical presence, such as having a store, office, warehouse, or employees in a state.

The landscape of sales tax nexus significantly changed with the Supreme Court decision in South Dakota v. Wayfair, Inc. This ruling overturned the long-standing physical presence rule. It allowed states to require remote sellers to collect sales tax even without a physical presence, provided they meet certain economic thresholds. This new standard is known as “economic nexus.”

Economic nexus thresholds typically involve a certain dollar amount of sales or a specific number of transactions into a state within a defined period. For example, a common threshold many states adopt is $100,000 in gross sales or 200 separate transactions into the state. Some states may use only a sales revenue threshold, like California’s $500,000, while others might combine both criteria. Once a business meets or exceeds these thresholds, it establishes economic nexus and must register with that state’s tax authority to begin collecting sales tax.

Navigating Online Sales Tax Collection

Once a business determines it has a sales tax obligation due to economic nexus, the practicalities of collecting online sales tax become important. Sales tax rates vary widely by state and local jurisdiction. This means a business must apply different rates depending on the buyer’s location.

Determining the correct sales tax rate is complex due to “sourcing” rules, which dictate where a sale is considered to take place. Some states are “origin-based,” meaning the sales tax rate is determined by the seller’s location within that state. Most states, however, are “destination-based,” meaning the sales tax rate is determined by the buyer’s location. For remote sellers shipping into a destination-based state, the sales tax rate applies at the customer’s location. This requires businesses to accurately track tax rates for numerous jurisdictions.

Certain goods, services, or purchasers may be exempt from sales tax. Common exemptions include groceries, prescription medications, certain services, or sales to qualifying non-profit organizations or for resale purposes. Businesses must understand these exemptions to avoid over-collecting or under-collecting tax.

A significant development in online sales tax collection is the role of marketplace facilitators. A marketplace facilitator is a platform, such as Amazon, Etsy, or eBay, that facilitates sales for third-party sellers. Nearly all states require these facilitators to collect and remit sales tax on behalf of their third-party sellers when sales are made through their platforms. This shifts the sales tax collection burden from individual sellers to a single, larger entity, simplifying compliance for many small businesses.

Key Considerations for Consumers and Businesses

For consumers, the primary change from online sales tax regulations is the increased likelihood of sales tax applied to online purchases, even from out-of-state sellers. Before the Wayfair decision, many remote purchases were not taxed at the point of sale, leaving consumers responsible for remitting “use tax” directly to their state, though this was rarely enforced. Now, online retailers are generally required to collect sales tax upfront if they meet economic nexus thresholds in the consumer’s state.

Businesses, particularly those selling across multiple states, face considerable complexity in managing sales tax compliance. The varying economic nexus thresholds, diverse sales tax rates across thousands of jurisdictions, and different sourcing rules create an intricate web of obligations. Keeping track of these evolving requirements and accurately calculating the correct tax for each transaction can be challenging.

Many businesses utilize sales tax calculation software or services to navigate these complexities. These tools automate determining nexus, applying correct tax rates based on customer locations, and managing exemptions. While marketplace facilitators simplify collection for sales made through their platforms, businesses making direct sales must still independently manage their sales tax obligations.