Case Study: How Local Taxes Can Impact Small Businesses

At the Sales Tax Institute, we receive questions about sales tax from small business owners every day. And virtually every question we get pertains to sales and use tax at the state level. People want to know if they’re complying with the sales tax laws of a state that they’re selling in, they want to know if they have sales tax nexus in a state, etc.

But there is another crucially important topic when it comes to sales tax compliance that most don’t properly consider: local sales and use tax.

Local Taxes are Misunderstood

There is a lot of misunderstanding about local taxes and they simply aren’t treated as a priority by many small businesses. There are a number of reasons for this:

1. Local taxes frequently comprise a small percent of the taxes that a business has to account for, so they just don’t make the radar.
2. It can be very difficult to track sales and purchase data with the level of detail that is needed to administer local taxes properly.
3. Tracking local tax rate changes can be very difficult and time-consuming, especially for a small staff dealing with multiple local municipalities.

But here’s the thing: local sales and use taxes absolutely should be taken seriously. Why? Local tax laws and procedures can differ from state-level sales and use tax laws and procedures – especially for specialty taxes. Some local jurisdictions have exemptions, tax bases and forms that are different from those at the state level.

So you have to ask yourself: Are you sure that your company is in compliance with local sales and use tax laws? If not, you may be making a very costly mistakes and have unknown tax liabilities on your hands.

To understand how local tax rules can create tax liabilities for a company, we’ll look at a case study with some state-specific rules. This will help illustrate the impact local taxes can have on your operations and why you need to be managing your local tax obligations correctly.

Local Tax Case Studies – 3 Examples in Illinois

Illinois has local Retailer’s Occupation Tax (sales tax) but not local use taxes. Since Illinois is an origin state, it has special rules regarding the sourcing of local Retailer’s Occupation Tax. The special rules look at the composite of the selling activities that comprise a retailer’s business in order to determine the jurisdiction in which the retailer must collect local Retailer’s Occupation Tax. If the composite of the selling activities occur within Illinois then the Retailer’s Occupation Tax will apply, which includes the appropriate local taxes.

Per the rules, there are 5 primary selling activities. If the retailer conducts at least 3 of these activities in the same location, then that location is where the transaction will be sourced. If within Illinois, then this is the location for determining the local tax under the Retailer’s Occupation Tax. If outside of Illinois, then the Use Tax will apply and local tax will not apply. The 5 primary activities are:

1. Location of sales personnel exercising discretion and authority to solicit customers on behalf of a seller and to bind the seller to the sale;
2. Location where the seller takes action that binds it to the sale, which may be acceptance of purchase orders, submission of offers subject to unilateral acceptance by the buyer, or other actions that bind the seller to that sale;
3. The location where payment is tendered and received, or from which invoices are issued with respect to each sale;
4. Location of inventory if tangible personal property that is sold is in the retailer’s inventory at the time of its sale or delivery; and
5. The location of the retailer’s headquarters, which is the principal place from which the business of selling tangible personal property is directed or managed. In general, this is the place at which the offices of the principal executives are located. When executive authority is located in multiple jurisdictions, the place of daily operational decision making is the headquarters.

Note that if a retailer performs 2 or less of the above primary activities in the same location, then 6 secondary rules come into play.  And as you might expect there are exceptions and special sourcing rules for some types of businesses including internet sellers.

So what impact can these rules have on your business? Let’s look at 3 examples:

#1: A Retailer Located in Illinois Making Sales in and Headquartered Chicago.

Let’s say you are a retailer located in Illinois making sales in Chicago. Since you are located in Illinois, if you conduct at least 3 of the above 5 activities in Chicago, then you are required to charge Retailer’s Occupation Tax for Chicago at the rate of 10.25% on the sales regardless of where in Illinois you might ship the product..

#2: A Retailer Located in Illinois Making Sales in Chicago.

Now let’s say that you are a retailer located in Springfield, Illinois making sales to a customer in Chicago but you are conducting less than 3 of the above activities in Chicago. In this case, you would not charge the 10.25% Retailer’s Occupation Tax for Chicago. Instead, you would charge use tax at the lower rate of 6.25% that applies in Springfield.

#3: A Retailer Located Outside of Illinois Making Sales in Chicago

Let’s say that you’re a retailer located outside of Illinois making sales to customers in  Chicago. You have a sales person in Illinois but all other sales activities are taking place outside the state. Per the Illinois rules, local Retailer’s Occupation Tax would not apply. Rather, use tax would apply. So you would charge use tax at the lower rate of 6.25%.

It’s plain to see how you could easily get tripped up when trying to determine the correct rate of tax to apply to your sales. If you weren’t aware of the specific rules for Illinois and erroneously charged the 10.25% tax, you could be overcharging your customers a whopping 4% in tax.

That adds up quick! And you don’t want to make a tax determination error like this come audit time. Not to mention, your customers might be a little angry that you were overcharging them 4% sales tax!

For these reasons, it is crucial that you are aware of local tax rules among the different jurisdictions where you operate. These sorts of special rules and idiosyncrasies abound throughout local jurisdictions. And as always, ignorance of the rules is no excuse if your company gets audited.

Next Steps for Understanding Local Taxes

This is just one example of how local sales and use taxes can impact the rate you charge.  There are a myriad of local taxes that can apply to different industries and situations. Increasing your knowledge of how local taxes work can hugely benefit  your company and customers. Know about and stay on top of your local tax responsibilities to avoid mistakes on tax liabilities that you may not be aware of.