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States crack down on tax-free online purchases

Attention online shoppers: If you favor Web retailers who do not collect sales taxes, you've become inadvertent, yet budget-savvy, tax cheats.

With household budgets under increasing pressure, the virtual mall that is the Internet appears to offer quick financial relief for consumers — shop at the right e-tailer and the transaction occurs free of state and local sales taxes. For shoppers in cities like Chicago which now has the dubious distinction of having the highest sales tax of any major U.S. city, that ensures every day can be a 10 percent-plus discount day online.

Or so it would seem.

With the exception of five states — Alaska, Delaware, Montana, New Hampshire and Oregon — all states assess sales tax as do many local municipalities. However, they consider it assessed whether it was collected from the taxpayer or not, as in the case of online or catalog purchases from out-of-state retailers.

In other words, taxpayers are legally obligated to report the amount of any sales tax they did notpay on either their annual state income tax forms or by filing a separate "use tax" form. (Use tax is what states call the sales tax when it is not collected by the retailer.)

If  this comes as news, then welcome to the "Twilight Zone" of the tax code where consumers who favor retailers who do not collect sales taxes to save money on their purchases become inadvertent, yet budget-savvy, tax cheats.

With state budgets as stressed as consumers’, there is growing interest in collecting these "unpaid" sales taxes. In California, for instance, an attempt was recently made to assess sales tax on online music downloads. The sponsoring assemblyman argued that if consumers have to pay a tax when they physically buy a CD at their local store, they should have to pay the same tax when downloading the digital version of that same album. The measure failed, but the general discussion rages on.

"Sales taxes (on Internet purchases) are not new taxes," stresses Scott Peterson, executive director of the Streamlined Sales Tax Governing Board, Inc. located in Nashville, Tenn. The Board’s members consist of the state revenue departments looking to collect their due from shoppers by making it mandatory for retailers — local or remote — to collect the appropriate sales tax from each customer. And quite a bit of unpaid taxes are due thanks to the growth in Internet shopping. Peterson estimates the shortfall to state revenue coffers in the billions. (The distinction between ‘new’ taxes and existing taxes is key. There is an existing Congressional moratorium on assessing any new taxes online.)

States cannot legally require out-of-state retailers to act as their collectors. They can only pressure them to do so. It has to do with a 1992 Supreme Court ruling pertaining to remote merchants, which the states are hoping to eventually convince Congress to alter. Until then, they can only exude pressure, mainly on those retailers who have some sort of physical presence in their state — be it a warehouse or visiting salesmen with a booth at a convention. But, while this ruling excuses, for example, from having to collect state sales taxes, it does not prevent the states from going after consumers for the taxes the retailer did not ask them to pay.

Generally, the States only choose to do so for large purchases. This is because big ticket items — like manufacturer-direct living room sets shipped across state lines — tend to leave a paper trail and are easier to trace to a specific consumer than an online shopping spree.

“Many states have data sharing agreements. They share it because they all have the same sales tax collection problem. There is also data sharing going on between the states and the IRS,” adds Peterson.

Who Knew?
Despite the heightened interest in sales tax collection, the states generally do a poor job of clueing consumers in on their obligation Only about 25 states even put a line on their state income tax returns to prompt taxpayers to pay, according to TurboTax, the tax preparation company. The rest expect consumers to know they need to file a separate ‘use’ tax form.

"Even if consumers do know, they often fail to comply because they assume no one else does,"” says Bob Meighan CPA, a vice president with tax-software firm TurboTax.

They are right.  Compliance according to all the involved parties is very low except perhaps among tax attorneys.  But compliance is also hard. It is not just a matter of keeping track of when one is not being charged sales tax, but also having to calculate how much they should have been charged.  That is not a straightforward calculation due to overlapping local assessments and the different rates for different types of items.

For otherwise law-abiding consumers, this whole issue creates an ethical dilemma especially given the historically low probability of getting caught.

"No state tax authority (can absorb) to the administrative expense of processing (sales) tax returns filed by someone who placed a $50 order with an out-of-state merchant,” says Pete Sepp, vice president for policy and communications with the National Taxpayers Union in Alexandria, Va., explaining the conundrum for the states. After all, that would net the state maybe $2.50, an amount unlikely to offset the expense of processing the form. Nor does that amount offset the expense of pursuing payment from a shopper who failed to file such a form.

That is why even though the burden of payment rests legally on the shoulders of consumers, many states’ collection efforts are focused instead on pressuring retailers to just collect the taxes voluntarily. It seems to be working, as online shoppers may have noticed during the past holiday season that tax-free purchases are becoming rarer, though purely online operations, such as, have remained tax-free zones. But even is not in the clear. Disgraced former New York governor Eliot Spitzer had been revving up a full assault on to address his state budget problems this year. It is an effort which is expected to continue without him.

As annoying as it is to see sales tax tacked on to purchases, for some shoppers there is a silver lining. Sales tax can be deductible at tax time. At least this tax time — the measure allowing for the deduction on federal income tax returns expired and will have to be extended by Congress for future tax years.

But for this tax season, 2007 federal income tax filers still have the option of either claiming the amount of sales taxes they paid in 2007 or the amount of state and local income taxes paid, whichever is larger.

“However, most working taxpayers are going to be better off taking the deduction for their state and local income taxes,” says Meighan.  “That is, unless the taxpayer has purchased something of high value during the year, like a car, where the sales tax would have been significant,” he adds.

For taxpayers in states where the income tax is low but the sales tax is high, it will also be worth determining which would offer the bigger benefit. And obviously in those states where there is no state income tax but consumers do pay sales tax — such as Texas, Florida, Washington, Nevada, Wyoming and South Dakota — then being able to deduct sales tax is going to be highly beneficial. 

To do so, taxpayers can use the IRS-provided table which determines the deductible amount based on income levels. If major purchases were made during the year, such as a car or heirloom jewelry, these amounts may be added to the amount from the table, according to IRS instructions.

For those concerned the IRS might underestimate just how good a consumer they have been, an alternative calculation can be made.  But it requires a shopping bag full of 2007’s receipts, a calculator and a lot of time. 

When it comes down to it, as unfair as it is, making all retailers—online or otherwise—collect taxes may be the best option for taxpayers, regardless of how overtaxed they already are. Having to account for the prior financial year is hard enough at tax time without having to calculate and report the amount of taxes that were never paid in the first place, even if that amount is deductible.