How to Calculate Sales Tax

What is sales tax?

Sales tax is a type of tax that's charged at the time an item or service is sold. The buyer pays the tax to you, and you remit the tax to the relevant government tax collection body.

The taxes that are collected by each agency are then sent to various departments at the local, county, and state levels to ensure their ongoing operations and functions.

What is the purpose of sales tax?

Sales tax is used to fund a host of municipal and state needs that range from infrastructure to community needs.

All states use sales taxes in various ways, but the intent behind their collection is to maintain or improve the quality of life for the residents of a given municipality and the overall state. Some of the ways sales taxes are used include:

• Road construction and maintenance
• Law enforcement
• Construction of community amenities
• Schools
• Fire departments
• General funds

The state sets a base sales tax rate, and local governments are free to add their own tax to the rate. For example, the state sets its rate at 3.25%, the county adds another 1.25%, and the local government adds another .50%. That's three taxing bodies collecting sales tax on purchases for a total of 5%. You, as a seller, are required to split up these taxes and remit them to their respective taxing bodies.

However, if you're selling online, you may or may not have to remit sales tax to the state, or you may have to charge the base tax rate to the state and nothing further.

Some handy accounting tips to help you track your sales taxes include recording everything in accounting software, separating the collected sales tax into a separate bank account, retaining all of your receipts, and reconciling your books at least once a month to make sure you've collected and put aside the right amount of sales tax.

How do you calculate sales tax?

Learning how to calculate sales tax is easy. It consists of converting the sales tax percentage to a decimal number, then multiplying the cost of the item by the decimal number to get the amount of sales tax you collect.

Sometimes, a sales tax percentage is easy to calculate, such as a 10% tax rate. For example, 10% of $12.00 is $1.20. Add the numbers together, and you get a final sales price of $13.20 with tax. You may still prefer to use the formula when the item amount is harder to calculate, such as $13.52, or when the sales tax percentage has quarter points in the rate, such as 9.75%.

What is the sales tax formula?

The formula for sales tax is a simple algebra equation that involves converting a percentage to a decimal, then using the decimal as a multiplier on the cost of the item to get the final sales tax amount.

When written out, the equation looks like this:

• Sales tax rate = Sales tax percent / 100
• Sales tax = List price x Sales tax rate

In the event the tax rate is a percentage, you drop the percentage sign and divide the tax amount by 100 to get the decimal numbers for the tax rate. Or you can move the decimal point two places to the left, which puts a 0 in front of the sales tax percentage. A 10.00% sales tax becomes .010. Multiply the price of the item with the decimal tax number to get the tax amount. Add the sales tax number to the price of the goods for the final price.

Example of a sales tax calculation

Understanding how to apply the sales tax formula to your actual sales is essential for accurate pricing. Local sales tax rates can vary significantly, so it's important to be comfortable with this calculation regardless of where you're selling.

Here's a look at the sales tax formula in action with an item that costs $50 and a sales tax rate of 5%:

• $50 x .05 = $2.50 for a total of $52.50.
• The 5% got turned into the decimal number of .05 and was multiplied against $50, resulting in a sales tax amount of $2.50.
• Let's look at how it works with a sales tax of 9.25%.
• $50 x .0925 = 4.63 for a total of $54.63.

Who collects sales tax?

In general, you're responsible for collecting sales tax as the vendor or retailer and remitting it to your state's department of revenue.

In the event you're selling at a physical location in another state, you have to collect sales taxes for that state and remit them to that state's department of revenue. Always check state rules and regulations prior to collecting and remitting sales tax prior to making your first sale in order to be in compliance.

If you're selling online through a major website, you usually don't have to do anything towards the collection of sales taxes. The sites are designed to charge sales tax according to the state the buyer lives in on your behalf.

It's good practice to look at the sales tax collection requirements for your home state and any state you plan to sell in, especially when you're starting a business.

What states don't charge sales tax?

Five states in the U.S. don't charge sales tax at the state level. Instead, they charge sales taxes through different avenues.

• Delaware: Delaware doesn't charge a state sales tax, but it does have a gross seller's tax. This tax is paid by the seller, and it's based on the amount of total sales of goods and services.
• Alaska: Alaska has no state sales tax, but its counties, or boroughs, can charge sales taxes. For example, the Yukon-Koyukuk Census Area charges a 4% sales tax.
• Montana: Montana doesn't have a sales tax, but it enables popular tourist destinations to charge sales taxes at the municipal level.
• New Hampshire: There are no sales taxes anywhere in the state of New Hampshire. The state makes up for its lack of sales tax collection by having the highest property tax rates anywhere in the country.
• Oregon: Oregon also bars the collection of sales taxes at all levels but generates income through a very high personal income tax rate and a higher-than-average property tax rate.

What is nexus?

The use of the word nexus in the context of sales taxes refers to the state that you primarily sell from and your connection to the state. For example, you sell your products from a real space that's located in Illinois. You have a physical connection to the state in the form of an office and a location from where you store and ship your products from.

Prior to 2018, the meaning of the word nexus had a different definition than it does now. A case known as S. Dakota vs. Wayfair made its way to the Supreme Court.

The Court ruled that the original definition of nexus for the purposes of sales taxes wasn't in keeping with online sales, and that online retailers were to charge sales taxes according to the buyer's location. Prior to this ruling, sellers weren't required to charge sales tax to out-of-state buyers because they weren't in the same state at the time of the sale.

Now, all states have different definitions of a nexus. You, as a seller, may not be required to collect sales taxes because you don't sell enough to reach a sales threshold set by the state. Other states collect taxes no matter how much or little you sell in that state.

What is value-added tax?

Value-added tax, or VAT, is a tax that's added at each stage of the production of an item. A product becomes worth more at each stage of its transformation.

Ingredients and materials are subject to a tax, then as these items are turned from a raw material into a good, more tax is added. Once the good has been completed, packaged, and shipped to market, it's reached its final tax amount. The consumer buys the item with the tax already factored in and pays the face price with no additional taxes charged.

The U.S. is one of the few countries in the world that does not charge VAT. Instead, the decision to charge sales tax is a decision made by each state in the union.

When do you need to calculate sales tax?

Knowing exactly when you must collect sales tax is crucial for running a compliant business. The rules can vary dramatically depending on how and where you sell your products or services.

Different sales channels and customer types come with their own unique requirements that you'll need to understand to avoid potential penalties or audits. Let's explore the key scenarios where sales tax calculations become necessary:

Selling online vs. in person

Sales tax requirements differ significantly between in-person and online sales. For physical store locations, you'll typically collect the local sales tax rate where your business is located.

Online sales are more complex, and you must typically collect sales tax based on the buyer's shipping address rather than your business location. Many e-commerce platforms now include built-in tax calculation tools that can automatically apply the correct rates based on customer location, making compliance easier for online sellers.

Selling across state lines

Interstate sales create additional complexity for sales tax collection. State tax authorities can require out-of-state sellers to collect sales tax even without physical presence in the state. Each state sets its own economic nexus thresholds (typically based on sales volume or transaction numbers) that determine when out-of-state sellers must register and collect tax.

Understanding these thresholds is essential if you sell to customers in multiple states, as compliance requirements can vary dramatically from one state to another.

Selling to tax-exempt organizations

You generally don't need to collect sales tax when selling to tax-exempt organizations like nonprofits, schools, or government agencies. However, these organizations must provide valid exemption certificates that you must keep on file.

The burden of proof for tax-exempt sales falls on you as the seller, so maintaining proper documentation is critical. Some states also have specific forms or digital systems for verifying tax-exempt status, making it important to understand the requirements in each jurisdiction where you operate.

Common mistakes to avoid when calculating sales tax

Even experienced business owners can make errors when dealing with the complexities of sales tax. These mistakes can lead to unexpected tax liabilities, penalties from state tax authorities, or even audits that consume valuable time and resources. Being aware of the most common pitfalls can help you develop systems to ensure accurate sales tax collection and remittance.

Using the wrong rate

Applying incorrect tax rates is one of businesses' most common sales tax errors. Tax rates can change frequently, with many jurisdictions updating rates quarterly or annually.

What makes this even more challenging is that sales tax amounts can vary by state, county, city, and specific districts within the same city. Using outdated rates or neglecting to check for local tax overlays can lead to under-collection (creating liability for your business) or over-collection (potentially angering customers). Automated tax calculation software can help ensure you always use current rates.

Not accounting for shipping

Many sellers overlook the fact that shipping charges may be taxable, depending on the state. Some states consider shipping an inseparable part of the taxable sale, while others exempt shipping charges if they're separately stated on the invoice.

This inconsistency across states can create confusion, especially for e-commerce businesses shipping to multiple states. The safest approach is to research each state's specific rules regarding shipping charges and update your systems accordingly to avoid compliance issues.

Ignoring local tax rules

Beyond state-level requirements, local jurisdictions often have their own sales tax rules that can significantly impact your tax obligations. Special transportation, education, or economic development districts may add additional percentage points to the base rate.

Some localities also have product-specific exemptions or special rates for certain categories like food, clothing, or digital goods. Failing to account for these local nuances can result in incorrect tax collection and potential liability during an audit. Regularly reviewing local tax changes is essential for businesses operating in multiple jurisdictions.

Wrapping up: How to calculate sales tax

The act of calculating sales tax itself is straightforward. All you need is the formula for sales tax to come up with the correct amount of sales tax to charge. It's knowing how to correctly charge sales tax in each state is where you can run into confusion.

You can decide to sell in your state only, which limits your ability to generate profits and earn an income, or you can start an e-commerce business and take advantage of the hosting service's built-in sales tax calculators for each state. You spend less time figuring out how to handle sales taxes and spend more time making sales.

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Key Takeaways

• Sales tax helps fund local and state government operations, including infrastructure, law enforcement, and schools.
• States set a base sales tax rate, and local governments can add additional taxes.
• To calculate sales tax, convert the percentage to a decimal and multiply it by the item price.
• Online sellers must charge sales tax based on the buyer's state and remit collected taxes accordingly.

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