Disclaimer: I’m not an accountant or tax attorney, and I am not licensed to give you official legal advice. Everything that follows is based on my experience from running ecommerce brands and consulting with legal experts.
In this section we will dive into the taxes side of accounting. Tax accounting is comprised of two different areas: income tax and sales tax. Tax accounting is in general a little difficult to write about, because it varies to much based on where you live, and where you are selling products. Each country has their own rules regarding both sales taxes, and income taxes.
Sales Tax
Let’s start with sales taxes, since pretty much everyone is familiar with this one. Sales tax is that percentage you pay extra above the advertised retail price when you buy something (at least in North America). If you live in North America and go to the local convenience store to buy a bag of chips for $1, but the amount the cashier actually charges you could be $1.15. In this example you were charged a 15% sales tax. That 15% (or $0.15) is not actually kept by the convenance store. They are simply collecting the sales tax on behalf of their government. This is why sales tax in North America is known as a pass-through tax, meaning that you charge your customers sales tax when they buy your items, and then that sales tax money passes through you and goes to the government.
At the end of the year (or end of every quarter or month, depending on the size of the business) the convenience store owner will send that sales tax moneys they collected to the government. A sort of civil duty if you will. We are collecting moneys on the governments behalf, because it’s the law.
In Europe sales taxes work a little differently where they are baked into the retail cost of the goods, so companies need to bake in sales taxes expenses into their retail prices. From my perspective this almost sounds worse than the North American rules. Since at least we can show a lower retail sticker price, without having to bake in sales taxes into our sticker price. But that’s just my take on it.
One interesting thing about sales taxes, at least in the US, is that it’s not governed at the federal level like income tax. It is governed at the state level, and each state makes its own unique rules about how much they want to collect. This can make it a bit of a nightmare in terms of compliance because as a business owner we need to be familiar with every states individual rules, plus keep an accurate accounting on how much we sell in each state. Not to mention charge our customers from each state the correct amount based on that’s states rules. You can start to see why sales taxes collection and remittance can become a headache very quickly.
Remember, collecting sales taxes puts nothing extra in your pocket as the business owner. It’s actually just another expense for you, as you will likely have to hire accountants, or buy fancy software to help you file them. But you are only collecting and remitting them on the government’s behalf. As the business owner you keep none of the sales taxes you charge your customers.
So the big question becomes: do we have to collect sales taxes, and if so, where?
I feel like a broken record, but I want to re-iterate at this point that I am not an accountant. The information below are the rules to the best of my knowledge at the time of writing this. However, when it comes to sales taxes, it’s one of those things that is complicated and subject to change. So, talk to an accountant when the time comes. But I will try and lay out the basics to give you an idea of what you are in for.
Here in Canada (where I live) the rules for sales tax are pretty easy. If you are doing over 30k annual revenue, you are required to register for sales tax. Practically speaking that means you will register with the CRA, and they will give you a tax ID number which will be your business identity when it comes to sales tax collection and remittance. And once you register for sales tax and get your ID, that’s it, you need to collect them forever. No turning back.
In the US, sales tax laws are more tricky. The US states you need to collect sales tax in comes down to whether or not you have significant businesses ties to the state (again, this is to the best of my knowledge – talk to you accountant for specifics). If you have significant business ties to a state than you will be required to collect sales tax in that state. This is where the concept of NEXUS comes into play.
The definition of nexus is: “A presence/connection in a state that’s significant enough for you to be required to comply with their sales tax law” (TaxJar 2018). The following things can qualify you to have nexus in a given state:
- You live in the state
- You have an office in the state
- You have a retail store in a state
- You have employees in a state
- You sell at a temporary event in a state like a fair
- You have inventory in the state. This is where it gets tricky for Amazon sellers. Amazon has warehouses all over the place so if you use their FBA program you never know what state your inventory will end up in.
Any state where you do not have nexus is known as a “remote state”.
Some people break the nexus requirements up into having “hard” and “soft” nexus. By hard nexus they are referring to if you live in a state, or have permanent connection to a state like having your own warehouse there. Amazon sellers would be more worried about what is known as “soft” nexus, which includes the condition of having inventory in a state. If you are using the FBA program with Amazon you could potentially have inventory in 20+ states across the US, giving you nexus in all these states. This is why sales tax matters for Amazon FBA sellers is more complex than the average e-commerce seller who typically only have nexus in 1 or 2 states.
Generally speaking, only physical products are subject to sales tax, where as services are typically not. This is changing in some states however, and it is expected that more states are going to charge sales tax on services in the future.
This brings up an interesting question of whether or not shipping costs that we charge customers are taxable. The answer is, it depends. Some states state that the charges for shipping and handling is taxable, where as some states put it as non-taxable. In addition to shipping, some things are taxable in some states and non-taxable in other states, such as groceries and clothing. Each state can have wildly different rules, which is a big part of why collecting sales tax in the US is a pain in the butt.
The last thing I will mention here about sales tax is regarding sales tax in the EU. There was a ruling past a few years ago which states that if you are selling products in the EU, you have to collect sales tax, no matter if you have warehouses/physical presence in the EU or not. This shook things up a bit for dropshippers and other brands selling in the EU who did not historically collect taxes there. So, it just goes to show how the landscape for sales taxes is constantly changing. If there is any lesson to pull from this, it’s definitely consultant an accountant when it comes to sales taxes. It’s not one of those things you want to try and figure out on your own. Your time is better spent on other parts of the business.
Income Tax
Income taxes is the other side of tax accounting. In short: businesses are taxed on the income (ie. Profits) they make in any given tax period.
All the expenses that a company incurs to produce their profits are deducted on their return, and the company only pays income taxes on the difference between their profits (ie. revenue minus expenses).
Such expenses that companies typically incur are the costs of inventory, the cost of renting office space, the cost of any software subscriptions, etc. So, the only way to accurately calculate your companies tax liability is to accurately keep track of your companies total revenue, and total expenses, which requires good bookkeeping practice. Accurate income tax accounting is not possible without diligent and on-going bookkeeping. You must track, categorize and log all transactions and expenses so you know exactly how much to pay the tax man at the end of the year.
Corporate vs Personal Income Tax
In the ‘Sole Proprietorship vs Corporation’ section we talked about how a corporation is legally a separate entity from the person (or people) that own the business. This carries over into the world of taxes. Legally, a corporation is a separate entity, and therefore is taxed separately from it’s owners personal taxes.
For businesses that are incorporated, the profits you make from your corporation will first be taxed by the government. Then, when you eventually pull money out of the corporation to pay yourself, it will get taxed again on your personal tax return. So technically the money get’s taxed twice before it reaches your personal bank account. This is why it’s typically beneficial to leave profits inside your corporation instead of taking profits out, as to defer tax payments as much as possible. Notice the word ‘defer’ here. We are deferring, not eliminating the need to pay personal taxes on our profits. We will eventually have to pay personal taxes on whatever money we withdraw from our companies, but we can defer those tax payments for as long as possible with clever tax planning.
When filing personal tax returns you will typically a bunch of slips from your employer, and you enter that information into your personal tax form to create your return. When it comes to filing corporate tax returns you get no slips. The real work behind doing a corporate tax return is in the bookkeeping and preparing of financial statements for your business. In this way corporate tax is not a thing you do at the end of the year (like personal tax typically is). Instead, corporate tax is a yearlong process that involves constantly logging and updating your books. Filling out the tax return can actually be a pretty quick and easy process once you have your books completed and financial statements prepared.
Corporate Income Tax Rates
The rate (or percentage) of income tax you pay on your business’s profits will depend on what country and state/province your business is incorporated in. It varies greatly, so you should carefully look at the pros and cons of different areas before deciding where to incorporate.
Some countries or states/provinces can carry significant tax advantages over others. For example, in Canada, the federal government offers something called the Small Business Deduction, which is a reduced tax rate for small businesses on their first $500k in profit on a yearly basis. This can be hugely beneficial for small business owners in Canada.
Remember, talk to your accountant country, state, or province specific tax and liability laws before deciding where to incorporate.