Why sourcing rules matter

Sourcing rules determine whether a sale is taxed at the seller’s location, the buyer’s location, or somewhere in between. For businesses that sell across state lines or to customers in multiple localities, sourcing affects:

  • How much tax you charge customers at the point of sale.
  • Which state and local tax returns you must file.
  • Your pricing strategy and profit margins.
  • Audit exposure and potential liability for uncollected tax.

Getting sourcing wrong is costly. After the Supreme Court’s 2018 decision in South Dakota v. Wayfair (138 S. Ct. 2080), many states expanded their reach via economic nexus rules, so even businesses without a physical location in a state can be required to collect tax (see the Wayfair opinion: https://www.supremecourt.gov/opinions/17pdf/17-494_2b3j.pdf).

Key sourcing approaches (simple comparisons)

  • Origin-based sourcing: Tax is calculated using the seller’s address (city/county). States that primarily use origin-based sourcing tax at the seller’s location for local rates; the applicable state tax may still vary. Example states include Texas (see Texas Comptroller guidance: https://comptroller.texas.gov/taxes/sales/).

  • Destination-based sourcing: Tax is calculated using the customer’s delivery or billing address (where goods are received or services consumed). Most states follow destination rules for remote sales; California is a commonly cited destination-based state (see California Department of Tax and Fee Administration: https://www.cdtfa.ca.gov/taxes-and-fees/sales-use-tax.htm).

  • Mixed or special rules: Some states apply different sourcing rules depending on the product or service type (e.g., telecommunications, digital goods, software, or transportation of goods). States may also have special sourcing rules for nontaxable items, exempt sales, and sales for resale.

Economic nexus and why Wayfair changed the game

Before Wayfair, the rule from Quill required a physical presence for sales tax collection obligations. Wayfair overturned that bright-line physical presence rule and allowed states to require out-of-state sellers to collect sales tax if they meet a state’s economic nexus thresholds. Most states that adopted economic-nexus rules set thresholds like $100,000 in sales or 200 transactions in the state, but thresholds vary by state and can change (check state Department of Revenue sites for current rules).

Because of economic nexus, sourcing rules now interact with nexus thresholds: once you meet a state’s nexus standard, you must determine the sourcing rule for that state to calculate which local rates apply.

Marketplace facilitators and third-party sellers

Since Wayfair, many states enacted marketplace facilitator laws that shift the sales tax collection obligation from individual sellers to marketplaces (e.g., Amazon, Etsy). If a marketplace is required to collect tax, a third-party seller may not need to register or collect tax in that state for marketplace sales — but they may still need to register for other business or reporting obligations. Always check the state’s marketplace facilitator guidance.

Practical examples (real-world scenarios)

  • Scenario A — Destination-based sale: A Colorado software vendor sells a cloud subscription to a customer who lives in New Jersey. New Jersey’s sourcing rules and local rates apply because the service is consumed there. The seller must collect New Jersey sales tax if it has nexus there.

  • Scenario B — Origin-based sale: A retail shop in Louisiana makes a sale to a walk-in customer. Louisiana uses origin-based rules for local rates, so the local tax at the store’s location applies.

  • Scenario C — Marketplace sale: A craft seller lists goods on a marketplace. The marketplace collects and remits sales tax in the buyer’s state; the seller should obtain records from the marketplace documenting tax collection for its own records.

These examples reflect common outcomes, but state rules differ for specific product categories (timber, utilities, digital products, and certain services often have bespoke sourcing rules).

Compliance checklist: step-by-step actions for businesses

  1. Confirm where you have nexus
  • Review physical presence: employees, offices, inventory stored in third-party warehouses, or salespeople.
  • Review economic thresholds: look up each state’s current threshold (commonly $100,000 or 200 transactions but not universal).
  • Useful internal link: review our guide on state sales tax nexus for remote sellers for practical registration steps (State Sales Tax Nexus for Remote Sellers).
  1. Determine the state’s sourcing rule
  • Check the state Department of Revenue or tax agency for that state’s sourcing rules and specializations (e.g., CA CDTFA, TX Comptroller).
  1. Classify the product or service
  • Is it a taxable tangible good, exempt item, digital good, or a taxable service? Different sourcing rules often depend on product classification.
  1. Choose the right point-of-sale calculation logic
  • For destination-based states, calculate tax using the customer’s delivery address. For origin-based states, use your location or point of sale.
  1. Automate and document
  • Use sales tax software that applies correct sourcing logic, updates rates, and generates filing-ready reports.
  • Keep records: invoices, proof of delivery, exemption certificates, and marketplace transaction records for at least the state’s statute of limitations period (commonly 3–4 years).
  1. Monitor marketplace facilitator rules
  • If you sell through marketplaces, check whether the marketplace collects taxes on behalf of sellers and whether you still need a seller permit for reporting.

Common pitfalls and how to avoid them

  • Relying on a single state rule: Don’t assume one rule fits all states. States differ on destination vs origin and have special rules for digital goods and services.

  • Failing to track changing nexus thresholds: States update laws; automated monitoring or a tax professional can help.

  • Poor documentation of customer location: Without clear delivery or billing records, you may be unable to substantiate the tax applied during an audit.

  • Ignoring marketplace sales: Marketplaces often collect tax, but sellers still need to maintain records and may owe taxes for non-marketplace channels.

Technology and vendor guidance

Modern sales tax engines from major providers (e.g., Avalara, TaxJar, Vertex) support sourcing rules, local tax calculation, and nexus monitoring. In my practice, automating the tax calculation and filing processes typically reduces errors and audit risk — but automation does not replace policy review. You should:

  • Verify vendor rules and the logic they apply for origin vs destination sourcing.
  • Periodically reconcile automated tax calculations with native state guidance.

Audit exposure and best practices for audits

If a state auditor questions your tax collection, they’ll review nexus, sourcing methods, exemption certificates, and delivery records. Best practices:

  • Keep complete records of invoices, shipping/delivery confirmations, exemption certificates, and marketplace reports.
  • Maintain a written sourcing policy describing how you determine the taxing jurisdiction.
  • If you discover past under-collection, consult a tax professional immediately; many states offer voluntary disclosure programs or limited lookback periods that can reduce penalties.

Special topics: exempt sales, resale certificates, and drop shipping

  • Resale certificates: Collect and retain resale certificates when customers claim an exemption for resale. States vary on certificate format and retention requirements.

  • Drop shipping: Sourcing for drop-shipped goods can be complex because the seller, drop shipper, and customer may be in different locations. States adopt different rules on whether the supplier or retailer must collect tax.

  • Digital products and SaaS: Some states tax digital goods and software; others do not. Sourcing often follows where the customer receives or uses the product, but state definitions differ.

Where to find authoritative, up-to-date guidance

Additionally, our guide on navigating nexus for remote small businesses discusses economic nexus and practical compliance steps: Navigating State Tax Nexus for Remote Small Businesses.

Final recommendations

  • Start by mapping where you have nexus and what product categories you sell.
  • Use a reliable tax engine and keep detailed, auditable records of sourcing decisions and delivery evidence.
  • Treat marketplace sales separately and confirm facilitator collection rules.
  • When in doubt, consult a state tax specialist — this article is educational and not a substitute for personalized legal or tax advice.

Professional disclaimer

This article is for educational purposes only and does not constitute legal, tax, or accounting advice. For decisions that affect tax collection or filing obligations, consult a licensed tax professional or the relevant state tax agency.

Authoritative sources and further reading