The Impact of State Sales Tax Law on Federal Income Tax Returns for Businesses

By Joel M. Busch, CPA, JD, MST

For a retailer with stores and customers throughout the United States, sales tax reporting plays a large part in its tax compliance responsibilities. They may prepare the various required sales tax returns in-house or may hire an outside firm to take care of it for them.

Regardless of who prepares sales tax returns and otherwise plans for sales tax related matters (including audits), CPA firms and corporate tax departments that handle income tax returns need to have a detailed level of understanding of each state’s sales tax liability rules, as activities in multiple states can have a dramatic impact on their federal income tax returns based on the state sales tax rules they are subject to.

This article will cover the core, detailed rules as they relate to how state sales taxes imposed on intrastate sales can greatly impact major areas of a client’s federal income tax return. It will also provide practical guidance on making sure sales tax related items are not overlooked on the federal income tax side to prevent major audit vulnerabilities with the IRS and how to potentially plan to take advantage of pro-taxpayer options on the federal income tax return.

Income Tax Return Gross Receipts – Does it Include Sales Tax Collections from Customers?

In a nutshell, the answer is: it depends. For federal income tax purposes, the amount of reportable gross receipts of a business for the year can have impacts on a wide variety of items for the taxpayer. Some of the major impact items based on reported gross receipts for the year include whether the business can use the cash method (versus having to use the accrual basis), whether it is subject to the IRC §163(j) interest expense deduction limitations, and if it is required to capitalize certain overhead expenses to inventory under the UNICAP rules.

For the 2024 tax year, for most C corporations and partnerships with a C corporation partner, if they have average gross receipts for the prior three tax years of $30M or less¹ they normally can use the cash method,² are exempt from the §163(j) interest expense deduction limitations³ and are not subject to the UNICAP inventory rules.⁴

The Definition of Gross Receipts for Federal Income Taxes

Under Temp. Treas. Reg. §1.448-1T(f)(2)(iv)(A), gross receipts are defined as follows:

“[G]ross receipts of the taxable year in which such receipts are properly recognized under the taxpayer's accounting method used in that taxable year (determined without regard to this section) for federal income tax purposes. For this purpose, gross receipts include total sales (net of returns and allowances) and all amounts received for services. In addition, gross receipts include any income from investments, and from incidental or outside sources. … [G]ross receipts do not include the repayment of a loan or similar instrument (e.g., a repayment of the principal amount of a loan held by a commercial lender).

Finally, gross receipts do not include amounts received by the taxpayer with respect to sales tax or other similar state and local taxes if, under the applicable state or local law, the tax is legally imposed on the purchaser of the good or service, and the taxpayer merely collects and remits the tax to the taxing authority. If, in contrast, the tax is imposed on the taxpayer under the applicable law, then gross receipts shall include the amounts received that are allocable to the payment of such tax [emphasis added].”

As such, a tax practitioner needs to know which states impose their sales tax directly on the seller (i.e., a seller-based regime) and which states impose sales tax on the buyer (i.e., a buyer-based regime, with the seller merely acting as a collection agent of the state).

Accounting for the Differing State Tax Treatment of Sales Tax for Federal Income Tax Purposes

If a sale is subject to sales tax in a state with a seller-liability regime, where the tax is imposed directly on the retailer, when the retailer collects the applicable sales tax from the buyer, the sales tax collection from its customers will need to be accounted for as taxable gross income on the retailer’s federal tax return, with a corresponding income tax deduction in the year paid to the applicable state tax agency (or when accrued at the time of the sale, as applicable).

On the other hand, if a sale is subject to sales tax in a state with a buyer-based liability regime, the sales tax collection from the buyer is neither included as taxable gross receipts nor reported as an income tax deduction on the federal income tax return.

States with a Seller-Based or Buyer-Based Sales Tax Liability System

Of the 46 states (including Washington, D.C.⁵) with a state-based sales tax (or the equivalent of a state sales tax⁶), 18 states impose the sales tax directly on the seller. These states are Alabama; Arkansas; Arizona; California; Washington, D.C.; Hawaii; Illinois; Florida; Kentucky; Michigan; Mississippi; New Mexico; Nevada; South Carolina; South Dakota; Tennessee; Virginia; and Wisconsin.⁷

The following 28 states have a buyer-liability based sales tax system, with the seller generally acting as an agent of the state: Colorado; Connecticut; Georgia; Iowa; Idaho; Indiana; Kansas; Louisiana; Massachusetts; Maryland; Maine; Minnesota; Missouri; North Carolina; North Dakota; Nebraska; New Jersey; New York; Ohio; Oklahoma; Pennsylvania; Rhode Island; Texas; Utah; Vermont; Washington; West Virginia; and Wyoming. (Please see the TXCPA website for the citations for the related state tax statutes and regulations.)

Texas is a state that has a buyer-liability based sales tax system.

The Proper Flow of Sales Tax Collections to the Federal Income Tax Return

Now that we have down the general federal income tax rules on sales tax collections, as well as the details of which states have a seller-based or buyer-based sales tax liability regime, the following are examples of what it takes to properly report the sales tax component of a sale for federal income tax purposes.

Example #1. Acme Corporation, a calendar-year C corporation, sells a widget to a customer in its home state of California for $100. (To focus on the sales tax component on the sale, we will ignore the impact of cost of goods sold, which will be a reduction in gross income for tax purposes and an expense for book purposes.) The applicable sales tax on the sale is $9. Because California is a seller-based sales tax liability state, for federal income tax purposes the retailer would need to report the sale as $109 in gross receipts and then take a $9 deduction on its income tax return when the sales tax is paid to the state or accrued at the time of the sale.

If, for financial accounting purposes, Acme reports the same sale above as $109 in revenue with a corresponding $9 expense on the sale, no M-1/M-3 adjustment is needed on the corporate income tax return and the federal income tax return gross receipts and deduction would match the revenues and expenses on the books.

However, if only $100 is reported as revenue for book purposes, with the $9 sales tax reimbursement reported only on the balance sheet, the retailer would now have to report the $9 in sales taxes collected from the customer on Schedule M-1 or M-3 of the 1120 twice: first as $9 of gross income for tax purposes in excess of revenues per book and then $9 of tax deductions in excess of that expensed per books. The $9 M-1/M-3 difference will also show up in the gross income and deductions sections of the income tax return.

Example #2. Beta Corporation, another calendar-year C corporation, sells a gadget to a customer in its home state of Indiana for $200. Again, to focus on the sales tax component on the sale, we will ignore the impact of cost of goods sold. The applicable sales tax on the sale is $14. Because Indiana is a buyer-based sales tax liability state, with the retailer merely acting as an agent for the state to collect the tax on their behalf, for federal income tax purposes the corporation would simply report the sale as $200 in gross receipts on the 1120 return with no corresponding reporting in either gross income or in the deductions section for the $14 received from the customer for the sales tax.

For financial accounting purposes, if the sale is reported simply as $200 in revenues, with the $14 showing up purely on the balance sheet, no M-1 or M-3 would be needed on the federal tax return. On the other hand, if for book purposes they include the $14 of sales tax collected from the customer in revenues as well as an expense item, then a M-1 or M-3 adjustment would be required on the federal income tax return, with a reduction of both gross income and deductions (as compared to book revenues and expenses) by the same $14.

After going through these two examples, one may think that it is no big deal if $9 or $14 shows up as gross receipts with a corresponding deduction on the federal income tax return or it is simply left off the taxable income calculation altogether. After all, in either event, the taxable income from each sale will always be the same pre-sales tax price (before any cost of goods deduction). Well, to help illustrate the potential significant federal income tax impact to a taxpayer, let’s take the example to a fuller level.

Example #3. Going back to Acme Corporation, let’s assume that its total sales for the year are comprised entirely of those hot-selling widgets and it sells 296,000 widgets, all in California, every year for the past three tax years (2021, 2022 and 2023) – with each widget having a $100 base sale price, $5 cost of goods sold and $9 of applicable sales tax, which is collected from its customers on all of their sales.

If Acme’s tax department is unaware of the applicable sales tax liability system in California, the federal income tax rules on sales tax collections and/or how the sales tax collections have been reported for book purposes, and the sales taxes collected end up not showing up in either the gross receipts or deduction sections of their 1120, the return will show $28,120,000 of both gross income and taxable income each year (296,000 x ($100 sales price - $5 cost of goods sold)).

On the other hand, if the sales tax collections are properly reported as taxable gross receipts on its 1120 return and also deducted on the 1120 for the same year, it will still have $28,120,00 of taxable income for each year. However, with the sales tax properly included in gross receipts, the annual taxable gross receipts on the 1120 for each year will be $30,784,000 (296,000 x ($100 sales price - $5 cost of goods sold + $9 in sales tax reimbursements), which pushes their three-year prior average gross receipts for the 2024 tax year above the $30 million threshold, making Acme subject to, among other requirements, the mandatory use of the accrual method and the §163(j) interest expense deduction limitation.

A Quick Glimpse of Other State-Based Taxes and their Impact on Reporting Gross Receipts

While this article’s main focus is on intrastate state sales taxes, many businesses will likely have a number of other state-based taxes that will impact their federal gross receipts reporting on their federal income tax return.

One of the more commonly faced local taxes of businesses is property tax. For both landlords and equipment lessors, often the property taxes imposed on their property are passed on to their tenant or lessee as additional required rent. For some, this is handled by having the landlord or lessor paying the property tax to the appropriate tax agency (in many states, the local county Tax Collector) and then sending a separate invoice to the tenant or lessee to pay as additional rent (with additional rent defined in the lease agreement as reimbursements for property taxes).

However, the situation that can throw these particular companies off is when the lease agreement calls for the lessee or tenant to pay the property taxes directly to the Tax Collector (sometimes accomplished by simply sending the property tax bills directly to the tenant for them to make the payment directly).

In these cases, since the property tax liability (from the perspective of the government) is a direct liability on the property owner, under the same federal income tax law as mentioned previously in the sale tax discussion above, the lessor or landlord must include the property tax payment made by the lessee or tenant in their taxable gross receipts for federal income tax purposes, with a corresponding deduction for the same amount – even if the tenant makes the payment directly to the Tax Collector.

Important Takeaways

The following are important items for tax practitioners to have down to properly report sales taxes collections on their federal income tax return:

• Keep track of state and local sales tax liability rules on a regular basis – not only for income tax purposes, but also in the event of a sales tax audit in a particular state.
• The federal income tax team needs to work closely with the SALT and financial accounting departments to coordinate reporting matters and make, when necessary, the appropriate M-1 or M-3 adjustments and properly report taxable gross receipts.
• A best practice is to have sales tax collections treated the same way for both financial accounting and federal income tax purposes, to avoid the need for the book-to-tax adjustments on the income tax return.
• For financial accounting purposes, subsidiary ledger accounts should be used for the profit and loss and/or the balance sheet statements if any book-to-tax differences could exist related to sales tax collections from customers.

For example, if the financial reporting team wants to treat all sales in California that are subject to California’s sales tax as a pure balance sheet item, without including it on the profit and loss statement, they can use a subsidiary ledger on the balance sheet liability account for these sales tax liabilities, so the income tax department can more easily track, capture and report this amount to the M-1/M-3 and the gross receipts and deduction section of the federal income tax return.

If the total in this subsidiary account is say $75,000 for the year, the tax department will take this amount and add it to the book revenues to arrive at taxable gross receipts and then take a corresponding $75,000 tax deduction beyond the amount expensed per books.

About the Author: Joel M. Busch, CPA, JD, MST, is an Associate Professor at San Jose State University where he teaches tax courses at both the graduate and undergraduate levels at the Lucas College and Graduate School of Business. He may be contacted at joel.busch@sjsu.edu.

Footnotes

1. Rev. Proc. 2023-34, §3.31

2. Treas. Reg. §1.448-2(c)(2)(iv)

3. IRC §163(j)(3)

4. IRC §263A(i)

5. For purposes of this article, we will refer to the District of Columbia as a state.

6. A number of cities and boroughs in Alaska have a locally-based sales tax. This list summary excludes these locally-based sales taxes in Alaska.

7. State tax statutory and regulatory citations:

• A number of cities and boroughs in Alaska have a locally based sales tax. This list summary excludes these locally based sales taxes in Alaska.
• Alabama Code. Sect. 40-23-67
• Arizona Rev. Stat. Ann. Sect. 42-5008(A) and Arizona Admin. Code Sect. R15-5-2002(A)
• Arkansas Reg. GR-79(C)
• California Rev. & Tax. Code Sect. 6051
• Colorado Rev. Stat. Sect. 39-26-106(2)(a) and Colorado Code Regs. Sect. 39-26-104-1(1)
• Connecticut Gen. Stat. Sect. 12-408(2)(A)
• District of Columbia Code Ann. Sect. 47-2002(a)
• Florida Stat. Sect. 212.07(2)
• Georgia Code Ann. Sect. 48-8-30(b)(1)
• Hawaii Rev. Stat. Sect. 237-13
• Idaho Code Sect. 63-3619(b)
• ILCS Sect. 120/2(a)
• Indiana Code. Sect. 6-2.5-2-1(b)
• Iowa Code Sect. 423.2(1)
• Kansas Stat. Ann. Sect. 79-3604
• Kentucky Rev. Stat. Ann. Sect. 139.210(5)
• Louisiana Rev. Stat. Ann. Sect. 47:304(A)
• Maine Rev. Stat. Ann. Sect. 1753
• Maryland Code Ann. Tax-Gen. Sect. 11-403(b) and (c)
• Massachusetts Gen. L. Sect. 3(a)
• Michigan Comp. Laws Ann. Sect. 205.52(1)
• Minnesota Stat. Sect. 297A.77, Subd. 1
• Mississippi Code Ann. Sect. 27-65-31
• Missouri Rev. Stat. Sect. 144.060
• Nebraska Rev. Stat. Sect. 77-2703(1)(a)
• Nevada Rev. Stat. Sect. 372.105
• New Jersey Rev. Stat. Sect. 54:32B-12(a)
• New York CRR Sect. 525.2(a)(4)
• NMSA Sect. 7-9-4(A)
• North Carolina Gen. Stat. Sect. 105-164.7
• North Dakota Cent. Code Sect. 59-39.2-08.2(1)
• Ohio Rev. Code Ann. Sect. 5739.03(A)
• Oklahoma Stat. Sect. 1361(A)(1)
• Pennsylvania Stat. Ann. Sect. 7202(a)
• Rhode Island Gen. Laws Sect. 44-18-19
• South Carolina Code Ann. Sect. 12-36-910(A)
• South Dakota Cod. Laws Sect. 10-45-22
• Tennessee Code Ann. Sect. 67-6-201(1)
• Texas Tax Code Ann. Sect. 151.052(a)
• Utah Code Ann. Sect. 59-12-103(1)
• Vermont Stat. Ann. Sect. 9813(a)
• Virginia Code Ann. Sect. 58.1-603
• Washington Rev. Code Sect. 82.08.050(2)
• West Virginia Code Section 11-15-10
• Wisconsin Stat. Sect. 77.53(5)
• Wyoming Stat. Sect. 39-15-103(b)(ii)

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