Sales Tax Demystified: How It Works, Who Pays, and What Small Businesses Need to Know

Sales tax touches nearly every purchase you make but often feels confusing: different rates, exemptions, and rules depending on where you are and what you buy. Whether you’re a consumer trying to understand the price on your receipt or a small-business owner setting up systems to collect and remit tax, understanding the fundamentals of sales tax makes a big difference. This guide explains how sales tax works, what “use tax” means, how online sales are treated since the Wayfair decision, common exemptions, and practical steps to stay compliant.

What Is Sales Tax?

Sales tax is a consumption tax imposed by state and local governments on the sale of goods and certain services. It’s typically calculated as a percentage of the purchase price and collected by the seller at the point of sale. The seller remits the tax to the appropriate tax authority (state or local government).

Who pays sales tax?

Ultimately, the consumer pays sales tax because the tax is added to the purchase price. Businesses act as the collector: they charge the tax to customers, hold it in trust, and then periodically remit it to the state and local tax agencies.

How is sales tax calculated?

Calculation is simple in concept: taxable price × applicable tax rate = sales tax due. What makes it tricky is that the applicable tax rate is often the sum of several rates: state rate + county rate + city rate + any special district rates. For example, if a state rate is 4.0% and the combined local rates add 3.25%, the total rate is 7.25%. On a $100 sale, the sales tax would be $7.25.

Destination vs Origin Sourcing

States use two main methods to determine which jurisdiction’s rate applies: origin and destination sourcing.

Origin-based sourcing

If a state uses origin sourcing, tax is based on the seller’s location. If your shop is in City A, sales you make are taxed using City A’s rate, even if the buyer is in City B.

Destination-based sourcing

Most states use destination sourcing for retail sales: the tax rate is based on the buyer’s delivery address. If you ship an item to a customer in another city, you use the rate for that city. Destination sourcing is more common for remote and online sales because it matches the location of consumption.

Exemptions and Nontaxable Items

Not everything is taxable. States carve out exemptions for certain goods and services, often to promote affordability or policy goals.

Common exemptions

• Groceries and unprepared food (often taxed at a lower rate or exempt)
• Prescription medications
• Some clothing (varies by state)
• Resale purchases (items bought for resale are typically exempt with a resale certificate)
• Manufacturing equipment or raw materials in certain jurisdictions
• Sales to qualifying nonprofit or government entities

Exemption rules vary widely; what’s tax-free in one state may be taxable in another. Businesses must check specific state statutes and maintain appropriate exemption documentation (like resale certificates) to avoid liability.

Use Tax: The Consumer’s Backstop

Use tax complements sales tax. It applies to purchases where no sales tax was collected—often out-of-state or online purchases. Use tax ensures local businesses aren’t disadvantaged when residents buy remotely from sellers who don’t collect local sales tax.

When does use tax apply?

If you buy an item from a seller that doesn’t charge sales tax for your state, you generally owe use tax to your state. Many states provide a line on the income tax form to report use tax for occasional purchases, but frequent online buyers and businesses should report and remit use tax appropriately.

Online Sales, Nexus, and the Wayfair Decision

For years, businesses with only an online presence escaped collecting sales tax in states where they had no physical presence. That changed with the 2018 South Dakota v. Wayfair Supreme Court decision, which allowed states to require remote sellers to collect sales tax based on economic activity rather than physical presence.

Economic nexus

After Wayfair, most states adopted economic nexus rules: if a remote seller exceeds a sales threshold in the state (for example, $100,000 in sales or 200 transactions in a calendar year), the seller must register, collect, and remit sales tax in that state. Thresholds vary by state, so sellers must monitor sales and transactions in each jurisdiction.

Marketplace facilitator laws

Many states have enacted marketplace facilitator rules requiring platforms (like Amazon, Etsy, or eBay) to collect and remit sales tax on behalf of third-party sellers. If you sell through a marketplace, check whether the platform collects sales tax for you—this can simplify compliance but doesn’t eliminate your obligation to verify how the platform reports sales.

What Small Businesses Need to Do

If you sell taxable goods or services, follow these practical steps:

1. Determine nexus

Assess whether you have physical presence or economic nexus in each state where you sell. Consider inventory locations, employees, or marketplace activity.

2. Register where required

If nexus exists, register for a sales tax permit with the state’s revenue department before making taxable sales. Selling without a permit can lead to back taxes and penalties.

3. Collect the right tax

Implement systems to calculate the correct combined rate for the customer’s location—this is particularly important for destination-based states. Automated tools and point-of-sale systems can help.

4. Maintain exemption documentation

Keep resale certificates, exemption letters, and other supporting documents properly stored. States audit these records closely when claims are made.

5. File and remit on time

Sales tax filing frequency (monthly, quarterly, annually) is typically set by the state based on your taxable sales volume. Missing filings triggers interest and penalties.

Filing, Penalties, and Recordkeeping

States expect accurate filing and timely remittance. Common penalties include late-filing fines, late-payment interest, and failure-to-register penalties. In disputes, audits can lead to assessments for back taxes plus interest.

Audit risk and documentation

Audits often focus on exempt sales, resale certificate validity, and use tax compliance. Keep detailed records—sales invoices, exemption certificates, purchase orders, shipping records, and platform reports—typically for at least three to seven years depending on state law.

Shopping Smart: Tips for Consumers

Consumers can take practical steps to avoid surprises:

• Check whether sales tax is added at checkout for online purchases—many sites display tax before you finish.
• Understand that tax holidays (temporary exemptions on school supplies or hurricane preparedness items) may apply in your state.
• Keep receipts to support use tax reporting if you buy from out-of-state sellers who didn’t collect tax.

Practical Examples

Example 1: In-state purchase. You buy a laptop in a city where the combined sales tax rate is 8.5%. On a $1,200 laptop, the sales tax is $102 (1,200 × 0.085).

Example 2: Online purchase. You order furniture online from a retailer headquartered in another state. If the retailer has economic nexus in your state (exceeded thresholds), it must collect your state’s sales tax at checkout. If not collected, you may owe use tax when you file your return.

Special Topics to Watch

Several evolving areas are important for both sellers and buyers:

• Digital goods and services: States differ on whether software downloads, streaming services, and digital subscriptions are taxable.
• Subscription models: Ongoing billing can complicate sourcing and taxability determinations.
• Cross-border sales: International VAT and customs duties are separate from U.S. sales tax rules.

Sales tax may seem mundane, but it shapes pricing, competitiveness, and compliance burdens for businesses while influencing how consumers experience costs. For sellers, the best defense is proactive compliance: know where you have nexus, register early, collect the right tax, keep clean records, and use automated tools to reduce errors. For shoppers, awareness helps avoid surprises at checkout and ensures you meet use tax obligations when necessary. The details differ by state, but the underlying principle is the same: sales tax funds public services and infrastructure, while governments and businesses negotiate the practical mechanics of collection and remittance.