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Santa’s Rejects: A Plan for Managing Taxes On Returns

In 2014, Americans returned $68.8 billion worth of holiday goods, which amounted to 11.2 percent of all holiday sales. If the trend repeats itself this year, retailers can expect roughly one out of every ten gifts to be returned. Yes, processing and restocking those goods is a giant hassle. Perhaps even worse, Santa’s (and Hanukkah Harry’s) rejects can unwittingly create a giant sales-tax snafu. Unless you happen to be an audit aficionado, it’s time to develop a plan for managing returns and sales tax.

Truthfully, there is just one bomb-proof solution to this challenge: don’t take any returns. Since that will make it rather hard to sell merchandise, let’s paint a more realistic scenario and talk through what you should do in each contingency.

Let’s pretend that you have a CE store in Cleveland, Ohio. On Black Friday, a man comes in and buys a $100 tablet for his 10-year-old son. On Christmas Day, the son opens his gift and hates it; he wanted an iPad. The family leaves for a ski vacation on December 26, comes back after the New Year, and the father returns the tablet on January 4. You apply the taxes you paid in December as a tax credit in your next filing. No harm, no foul.

Now instead, let’s imagine that as of January 1, 2016, Cuyahoga County decides to move its sales tax rate from 8 to 16 percent. In November, the father paid $8 in sales tax on the tablet. Tax returns are based on the tax rate of the period in which you file. So calculating the tax credit in January 2016 on the $100 sale will result in the state owing you $16 instead of the $8 you originally paid. That’s a fantastic business model, but one that will get you into deep trouble. The solution is to instead file an amended return for November. Simply apply for a refund of the $8 that you paid.

Retailers hate filing amended returns because a) It means filing an extra return, and b) The states do not like writing a refund check. They will create barriers to avoid doing so, starting from requiring you to submit a separate document specifically requesting the refund, through taking an inordinate amount of time to process the refund – potentially five to seven months. As long as the tax rate doesn’t change, most retailers apply a tax credit to their next filing to avoid this bureaucratic quagmire.

That said, there are two scenarios where you should not apply a credit, even if there is no change in the tax rate. First, let’s say January is such a slow month that you owe $50 in sales taxes but the state owes you $100 in credits due to all the holiday returns. In this scenario, you would have what’s called a “negative tax return.” Most states will not allow a tax payer to file a negative return; their software systems can’t handle it. In this situation, you should either file the amended return or forward the tax credit to a future month with higher sales.

Second, imagine that a lot of kids hate their holiday gifts — they all want to play iPad games instead of Android apps — so 30 percent of your sales are returned. This is a significant chunk of your January revenue. In this case, do not try to apply sales tax credits to your January return.

When tax credits are unusually high relative to sales (and January is typically a slower month), the disparity is a red flag to auditors. Even if you calculated your tax credits correctly, the red flag will draw attention to your account. To be clear: when returns from a past month amount to an unusually high percentage of your monthly transactions, go down the track of filing the amended return. It will attract less attention.

Keep in mind that amended returns, though inconvenient, are always a correct and legal way to manage returns and sales tax. Note too that if you sell online and have nexus in multiple states (via virtual employees, warehouses, etc.) these rules apply in each state and county where you file taxes. Because of the level of vigilance this requires, most companies turn to tax automation software.

While the holidays might be the most lucrative time of year, they can also become the most expensive if returns lead to sales tax errors and trigger an audit. Know what to do in each scenario. Don’t let Santa’s rejected gifts ruin your holiday windfall.

Jonathan Barsade is CEO of Exactor, which offers in-store, catalog and online merchants secure, reliable and accurate tax calculation, record keeping, tax processing, and other sales tax services through its fully automated, cloud-based SaaS sales tax compliance solution.