Most states obtain the bulk of their revenue from sales taxes, not income taxes. Therefore they are very jealous of sales tax revenue. Some states (such as Florida) even tax services, not just tangible items.

While the concept of sales taxes seems simple - the ultimate flat tax - in reality sales taxes can be very complex. In some states, food or clothing is taxed at reduced or tax exempt rates. Certain types of transactions can qualify for reduced levels of taxes, such as sales to manufacturers, or if your shop is located in a special zone. A growing number of states have also enacted sales tax exemptions or reductions to spur business in impoverished areas, as well as instituting "tax holidays" such as the weekend before school starts each Fall. To make this more complicated, quite a number of states collect sales taxes for their counties as well. In some states the county rates can vary, so you must keep records of sales in each county as well as each state in which you do business.

The general rule in almost every state is that sales made within the state are taxable; the burden is on the business owner to prove that you qualify for an exemption. The most common problem is where the business owner fails to obtain a tax exemption certificate (usually for a merchant who is buying items for resale to the general public). If your customer failed to give you a valid exemption certificate, then YOU are liable for the sales tax, not your customer. So you should routinely request proof of exemption from everyone who asks for it, and keep that proof on file in case of audit.

A related problem area is interstate purchases and sales. Some states such as California are extremely aggressive in attempting to collect taxes from businesses that don't even have an office in the state. The ability to collect from out-of-state businesses depends on whether your business has "nexus." Nexus is a legal term which means connection to the state. Different state and federal courts have inconsistent definitions of what it means to have sufficient connection to the state to be subject to tax. Internet commerce in particular is a highly volatile area of sales tax law that is temporarily on hold, but which is still undecided.

Also, note that if you purchase items or equipment via interstate commerce you may still be subject to tax in your state. Almost every state has imposed a use tax on out-of-state purchases by their in-state businesses (and consumers too), equal to the sales tax that would have been paid. In a sales tax audit, you would be found liable for use tax on items you bought from out-of-state firms.

The most problematic area of sales tax audits is the definition of tangible items subject to sales tax. For example, one sound recording studio sells engineering time (billed by the hour) to make master recordings of music or commercial information. The studio also offers to duplicate that master recording onto thousands of CDs or cassettes. Most people would say that it is common sense that the engineering time would be an intangible that is tax exempt, while the CDs or cassettes are subject to sales tax. However, the state Department of Revenue ruled that all of the $15,000 engineering time was simply an enhancement of the $80 master tape, so the entire engineering time was subject to sales tax, even though intangible services are exempt from taxes in that state. You can see from this example that even "cut and dried" flat tax issues like sales tax are subject to wild interpretations, so it pays to build a strong argument for your interpretation and site any previous state rulings in your support before the audit is completed.