Bookkeeping – Tracking Sales Tax (Lesson 40)

Lesson 40

Many businesses especially retail have to collect sales tax as a function of their legal mandate from state governments.  In effect the business is a collection agent for the state.  If properly set up, this collection process is automated using modern retail accounting software.  This article explains the legal requirements and accounting procedures for the bookkeeper as a function of their daily operations. 

Legal Requirements 

Just about every state in the Union has a sales tax.  Some states rely on this source of revenue as a major funding component of state governments.  Rates vary from 2% to 8% on consumer purchases.  Each state is different in their regulations.  Some states exempt certain items like food products, baby products or pharmaceuticals.  Sometimes the sales tax rate is different per group of consumer goods.

A question often posed is the taxability of nonprofits.  In general nonprofits are ‘Income Tax’ free and not exempt from other forms of taxation.  So they are technically responsible to collect sales taxes on products sold and transfer this tax to their respective state department of revenue.  Each state is different related to their laws and regulations.  So please go to your respective state department of revenue or taxation to research the specifics.   Most states write the law to state that the last person to buy the product for personal use is responsible to pay the tax, the seller is responsible to collect the tax.

Wholesalers are in an interesting situation especially since they sell to both retailers and final consumers.  For sales to retailers the tax is exempt or carried over to the retailer to collect.  For final consumers, the tax must be collected.

Many states mandate the tax payment within 15 to 20 days after the end of a calendar month for most retailers.  The large retailers like Walmart or grocery chains, the transfer frequency may occur more often like weekly.  For you the key is to calculate the tax correctly and pay the tax as collected by the due date.  In addition most states use a form filed with the tax payment identifying gross sales, exempt sales, taxable sales and the tax obligation.

The collection of sales tax is a legal obligation and often not taken seriously by owners of small business.  Most states assess punitive civil penalties for failure to collect and/or pay these taxes.  Some states have the power to physically lock the doors of businesses for noncompliance.  A few states consider failure to comply a criminal offense.  The individual assigned this responsibility is usually the signor of the sales tax application form (application for a state identification number) or the responsible officer of the company.  As stated in the payroll series, it is not your obligation to sign the tax form; an officer of the company should sign all documents related to governmental authorities. 

Accounting Process

The key to accounting for sales tax is that the business is an agent for the state and is responsible to collect this tax.  This means sales tax is NOT a function of operations, but a legal obligation.  Therefore it is a liability payable to the state.  It never shows up as a cost or expense on the income statement (profit and loss statement).  Even though the formula is a function of sales, it is not reported in any revenue account.

Key Business Principle

SALES TAX COLLECTION IS A LIABILITY TO THE STATE AS IT IS COLLECTED.  SALES TAX NEVER SHOWS UP ON THE INCOME STATEMENT.

For accounting purposes an account in current liabilities is created called ‘Sales Tax Collected’ and represents the amount owed to the state at any given point in time.  It is customarily a sub-account within accrued taxes (parent-child account).  Here is my example:

CURRENT LIABILITIES

  • Accounts Payable
  • Credit Card Payables
  • Accrued Payroll
  • Accrued Taxes
    • Income Taxes
    • Payroll Taxes
    • Sales Tax Collected
    • Meals Tax
  • Accrued Expenses
  • Unearned Revenue
  • Line of Credit

In a typical sales transaction, there are two independent economic transactions.  One is the business sales transaction and the other is the sales tax obligation.  The customer pays for both.  Here is a typical journal entry:

SALES JOURNAL
Date       ID               Ledger                        Description                            DR                   CR
Today    508311       Sales                            Sale of 100 Widgets                                    208.00

.              508311       A/R                              Fritz Invoice #508311          218.40
.              508311       Sales Tax Collected  Fritz #508311                                                 10.40
.                                                                                                                         $218.40       $218.40

Notice the financial obligation, whether on account or paid at exit, is the combined amount for both economic transactions.  In addition the sales tax does not get assigned to any of the three types of income statement accounts (revenue, cost of sales or expenses).

The ledger for sales tax collected ends up being a long list of credits related to the numerous sales transactions throughout the month.  In each 30 day cycle there will exist one debit entry for the payment to the respective department of revenue or taxation.  Remember, a debit decreases liabilities and the customary credit is to a cash account reducing cash.

At times there may be debits for taxes refunded to customers for returns – Lesson 39.

Various Issues

There are some issues with sales tax I need to explain.  I’ve already touched based about wholesalers and nonprofits.  Now I want to explain contract work.

Most states do not asses a sales tax on contract work such as construction, site development, professional consulting and so on.  What does happen is this: the contractor pays the sales tax at the point of final consumption of the materials.  In effect the tax is built into the contract price.  Just about every state uses this form of sales tax collection as the alternative would be an accounting nightmare and political death for any politician advocating sales tax on real estate transactions.

Continuing with construction, there is an issue related to subcontractors.  Often subcontractors like electricians, plumbers, HVAC, painters etc. provide both materials and labor to fulfill their contract.  Technically they are not the final consumer of the materials and therefore purchase the materials from wholesalers and assess the tax to the contractor via their invoices.  Some states require separation of the materials and labor component.  The labor component is nontaxable and the materials is taxed at the regular rate.  For the contractor, the key is to understand how the subcontractor will present their bill.  This allows for proper estimation of the costs for a project.

Another issue with sales tax relates to prepared foods.  Many states exempt sales tax on the basic ingredients; but once combined as a prepared item or meal it becomes taxable.  So if the business is in the food industry please be sure to read up on your state’s respective regulations.

One final comment about sales tax.  I’ve experienced three state tax audits for sales tax.  The state audits one year but uses the defiency calculation and assesses the penalty for three years!  You are allowed to demand a specific audit for the other two years but the cost involved is typically more than the tax assessment.  Anytime the tax deficiency is less than $1,000 pay the tax and call it a good day.  CPA’s charge more than $150 an hour for audit defense work and often their fees will exceed the tax defiency.  So urge your employer to be wise and just pay the tax and save some money.

Summary

Every state that has sales tax requires business owners to act as agents for the revenue department.  Owners are legally obligated to collect the tax at the point of sale.  The customer pays for two distinctly different economic activities, the first is the actual sale of product purchased and the second is the obligation to the state for sales tax.

The tax collected is a liability from the business to the state.  Failure to pay in a timely fashion generates expensive civil penalties and possible criminal charges.  Act on Knowledge.

If you have any comments or questions, e-mail me at dave (insert the usual ‘at’ symbol) businessecon.org.  I would love to hear from you. If interested in my services as an accountant/consultant; click on ‘My Services‘ in the footer of this article.

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About David J Hoare 427 Articles
I spent 12 Years as a Certified Public Accountant, Over 20 Years of Practice in Accounting and Consulting, Controller in Management of Closely Held Operations, Masters of Science in Accounting, Prepared over 1,000 Business Tax Returns and Hundreds of Individual Returns