If you’ve been in business for awhile, this post isn’t for you, so feel free to skip ahead. (Maybe you want to get into the nitty gritty of whether storing items in an Amazon FBA warehouse gives you sales tax nexus?)
But one thing we’ve noticed from beginner sellers is a little confusion between sales tax and income tax. And hey, that comes with the territory. Most people see the word “tax” and immediately cringe. To take the time to look further into it, means you’re serious about your business. We applaud you. So this post will go into the very basics of sales tax and income tax and get you started dealing with both.
Income Tax 101
Income tax is a direct tax that you pay on your income. This is the tax that we’ve all been dealing with since we started working. The United States has a federal income tax, which is handled by the IRS. Forty-three states and the District of Columbia also have an income tax, so unless you’re lucky enough to live in Alaska, Florida, Nevada, South Dakota, Texas, Washington or Wyoming, then you have to file a state income tax return, too.
The government is very interested in you paying your income taxes. According to this infographic from the Congressional Budget Office, individual income taxes are far and away the government’s top source of revenue.
As a newly self-employed person, dealing with income taxes can be a struggle. First of all, there’s self-employment tax, which – you guessed it – is unique to self-employed people. There are also quarterly estimated tax payments. Since you no longer work for an employer who takes money out of your check every pay period, it’s your responsibility to pay-as-you-go your income tax four times per year. Does all this sound confusing? It can be, which is why it pays to consult with an accountant or other tax pro who is familiar with eCommerce. Here’s a list of tax pros to get you started.
One common misconception we see is that online sellers don’t have to file income tax unless they make above a certain amount of money per year, or unless they receive form 1099-K. While there can be gray areas here (no tax is ever simple!), for the most states and the federal government want you to pay tax on every penny of income you receive. Many online sellers see their activities as a hobby, but the IRS has specific rules for determining whether you actually have a hobby or a business. One of the big downsides to treating your business is a hobby is that you can’t deduct expenses in the same manner as you would with a business.
Sales Tax 101
Sales tax, on the other hand, is what we live and breathe here at TaxJar. Sales tax is the tax on the sale or lease of goods, and is what is known as a “pass-through tax.”
Unlike income tax, sales taxes is decided and administered by state governments only. Merchants are required to collect sales tax from their customers and remit it back to the state, essentially acting as tax collectors.
Along with income tax, sales tax is a major source of revenue for states, so they are very invested in making sure that merchants comply with sales tax laws. That said, states can only enforce sales tax collection on merchants who have sales tax nexus in their state. Nexus includes:
- Having an office
- Having an employee
- Having a warehouse
- Having economic nexus (i.e. your sales or transactions into the state mean you are subject to the state’s economic nexus rule)
- Having an affiliate
- Storing inventory
- Drop shipping from a 3rd party provider
- Temporarily doing physical business in a state for a limited amount of time, such as at a trade show or craft fair
For example, if you live and operate your business in Indiana, then you have sales tax nexus and must register for a sales tax permit and collect sales tax from customers there. But if you live in Indiana and do not have any sales tax nexus (no office, employees, affiliates, goods in a warehouse, etc.) in Illinois, then you don’t need to collect sales tax from your customers in Illinois.
The amount of sales tax you collect varies from state to state and location to location as well. Each state sets a sales tax rate – for example, California’s is the highest in the nation at 7.5%. Then counties, cities, other localities and even special taxing districts can set their own rates. For example, the sales tax rate in the Beverly Hills 90210 zip code is a combined 6.25% California sales tax, 1% Los Angeles County sales tax, and a 1.5% district sales tax rate, for a total of 8.75%.
The Differences Between Income Tax and Sales Tax in a Nutshell
- Income tax is a direct tax paid by individuals on their income, sales tax is a pass-through tax charged on a sale
- Individuals pay federal and (unless you’re lucky enough to live in a state without it) state income tax. Sales tax is administered at a state level only, and consumers who live in states with a sales tax pay it to merchants at the point of sale. Merchants, in turn, remit sales tax collected to the state
- Essentially all income-earning individuals have to deal with income tax; only product sellers or people who sell certain services have to deal with collecting and remitting sales tax back to the state
Do you have questions about sales tax? We go into this much more in-depth in our free Sales Tax 101 for Online Sellers guide. Download it today!
Other comments or questions about the difference between sales tax and income tax? Start the conversation in the comments.