By Tram Le, originally published in Tax Notes, Volume 109, July 3, 2023
Tram Le is a member of the SALTovation team at TaxOps and an adjunct professor at the University of Texas at Arlington. She writes about hot topics in state and local tax affecting business operations and growth strategies and can be reached at tle@taxops.com. In this installment of Spreading SALTovation, Le examines sales tax exemptions and other rules, which vary by state. She explains the true object test, classes of property that are often exempt from tax, and offers strategies for limiting risk through robust exemption certificate management.
Sales tax is a consumption-based tax for end-users of goods and some services [1]. When a taxpayer has nexus and is responsible for collecting and remitting sales tax, it must collect the correct amount of tax owed from customers based on what goods and services are taxable, excluded, or exempt. Determining what is taxable or exempt depends on where the goods and services are being consumed and the jurisdiction’s sales tax rules, which frequently differ by state. Multistate taxpayers are particularly at risk in this ever-changing sales tax landscape, where the way a state defines, classifies, and imposes tax today may not be the same tomorrow.
Sales Tax Base
Sales tax is imposed on the retail sale of tangible personal property unless it’s exempt. States generally exclude services from the sales tax base unless enumerated as taxable. Only a handful of states such as Hawaii, New Mexico, South Dakota, and West Virginia, tax most services. In these states, the retail sale of services is taxable unless exempt and the tax base is broad. A broad tax base eliminates problems of determining whether a transaction is taxable in states that tax on broad categories such as data processing or information services.
To properly manage their sales tax obligations, taxpayers selling into multiple states must understand the nature of what they are selling — goods, services, or both — and know the tax treatment where those goods or services are being delivered and provided. If a taxpayer is selling tangible personal property, sales tax generally applies. However, if the nature of the transaction is not considered a sale of tangible personal property or if a taxpayer is only providing a nontaxable service, the sale may not be subject to sales tax.
In determining the taxability of the goods or services, the taxpayer must know what is included in the tax base (goods and services that are subject to sales tax) and what is exempt in each state where the taxpayer has nexus. Significant differences in the sales tax base exist among the states because of the varying nature of exemptions and exclusions from sales tax and the lack of uniformity in how states define some goods and services.
Is It Tangible Personal Property?
In some instances, a transaction may not clearly be a sale of tangible personal property and may be considered a sale of real property, services, or intangible personal property. Tangible personal property is typically defined as personal property that can be seen, weighed, measured, felt, or touched, or is perceptible to the senses in any manner. Personal property is property that is movable. On the other hand, real property is property that cannot be moved, such as land or a building that is attached to land. A key distinction between tangible personal property and real property is whether the item can be moved from one location to another. As for intangible personal property, it includes such items as images, copyright, and patent interests, and is not defined or enumerated as taxable under state sales tax laws.
Items such as furniture and fixtures may be tangible personal property in one type of transaction but not in another. Since furniture and fixtures can be touched, seen, perceived, and moved, it would likely be considered tangible personal property. When the sale of furniture is lumped with the sale of real property, though, the nature of the transaction may not be considered a sale of tangible personal property and would not be subject to sales tax.
The sale of software and related maintenance and cloud computing services is another challenging area, because states take differing positions on the tax treatment and approach to imposing sales tax. Although prewritten or canned software is classified as tangible personal property under the Streamlined Sales and Use Tax Agreement, member states do not consistently tax software. Additionally, software maintenance contracts generally provide services and updates to ensure that the software will be maintained to operate properly, improve the software’s performance, and meet a user’s needs. Maintenance contracts may be a mandatory or optional part of the original sale or added after the initial purchase. The taxability of a maintenance contract may depend on factors such as the taxability of the original software, whether the maintenance contract is mandatory or optional, and whether the updates are provided on a tangible medium, such as a flash drive or CD.
In general, states tax prewritten or canned software regardless of delivery medium and exempt customized software, which may be defined as meeting the needs of one customer. It may include canned software modified for a specific customer. Some states exempt when the prewritten and canned software is delivered or transferred electronically or is considered a license, which is treated as intangible property. Other states may distinguish the tax treatment based on whether the software is “operating” versus “application” software. Still other states tax software as a sale of tangible personal property only if it is transferred in a tangible medium.
In many states, cloud computing is generally considered a service unless the transaction is characterized as a sale or rental of tangible personal property or as a transaction involving the sale of taxable prewritten software. The characterization of cloud computing is not generally dependent on whether cloud services are taxable. Instead, it is taxable if it’s considered data processing or information services in states that have a broader sales tax base and tax these services.
Bundled Transactions
When goods and services are sold together, it can be difficult to distinguish between the two. Many transactions do not fall squarely into one category or another. For example, a hairdresser may transfer goods to the customer in the form of shampoo or coloring agents while providing hairdressing services. When a sale includes both taxable goods and nontaxable services and are combined as one single charge, this is generally referred to as a bundled transaction. States typically apply a true object test to determine whether the transaction is ultimately a transfer of tangible personal property or whether the taxable good is incidental to the nontaxable service.
One potentially controlling factor is whether the taxable good is incidental to the primary purpose of the transaction. If the taxable property is valuable to the customer or is only useful as a component of the service, it is not likely considered incidental to nontaxable services and the transaction would likely be subject to tax. A bundled transaction will not generally be subject to tax if the true object of the transaction is the service itself, the transfer of tangible personal property is inconsequential, and the property can be stated separately from the service.
Exemptions From Sales Tax: Transactions
Sales tax exemptions are narrowly construed, and the application of exemptions may be based on the type of goods or services purchased, how the goods or services are being used, and purchaser’s status. Exemptions are provided for administrative purposes and policy reasons to address the regressive nature of sales tax. A regressive tax is one in which lower-income taxpayers absorb a greater share of the tax than higher-income taxpayers. Sales tax was historically imposed on goods and not services because services were not a significant part of the economy. Additionally, it was difficult to source and track where services were consumed.
When a purchase or transaction is exempt from sales tax, the purchaser must provide a valid exemption certificate to the seller. The seller is responsible for determining whether the certificate is valid. An exemption certificate is generally not required for purchases of goods or services that are not taxable.
Type of Goods or Services
Food and health-related items considered necessities are exempt in whole or part from the sales tax base in most states. For example, food for home consumption is exempt fully while prepared foods or food sold for immediate consumption is taxable in most states. Each state that exempts food for home consumption has its own definition of what that is and its own requirements to qualify for the exemption.
States may exempt food sold for home consumption based on the vendor or retailer’s status. In Arizona, food sold for home consumption must be sold by a retailer, such as a grocery store or convenience store, that is eligible to participate in the federal food stamp programs.1 A few states have limited exemptions, reduced tax rates, or partial exemptions for food or food items. Hawaii generally imposes a sales tax on food but has a limited exemption for purchases made with food stamps or Special Supplemental Nutrition Program for Women, Infants, and Children vouchers.2 Kansas imposes a sales tax on food and food ingredients, but at a reduced rate.3
States exempt some health-related items such as medicines, drugs, and equipment. Generally, drugs and medicines sold to individuals when required by federal law to be sold under prescription are exempt from sales tax. However, states vary in their requirements and definitions of what is considered a prescription drug. In Alabama, a drug includes any medicine prescribed by a physician, filled by a pharmacist, and sold to patients for human consumption.4
In other states, drugs and medicines are exempt from sales tax regardless of whether the drug or medicine is prescribed. In the District of Columbia, the exemption applies when any substance contains at least one recognized medicine, pharmaceutical, or drug intended for cure, mitigation, or prevention of disease.5 Texas exempts drugs that have a required “drug facts” panel in accordance with federal regulations.6
Exemption-Based Use of Goods or Services
How the purchaser will use a product or service also factors into determining whether the transaction is exempt from sales tax. Taxpayers engaged in manufacturing or research and development activities may qualify for some sales tax exemptions.
Manufacturing is exempt from sales tax in most states when the goods or services are used directly in the manufacturing process. This includes items such as machinery, equipment, raw materials, and services including design, utilities, and engineering that are used directly in the manufacturing process. As such, these goods or services cannot be used for any other purpose, such as for general business operations or for personal use.
Activities considered as manufacturing, and thus qualified for a sales tax exemption, vary from state to state. In Colorado, manufacturing is defined as the operation of producing a new product that is different from, and has a distinctive name, character, or use from, raw or prepared materials.7 An exemption is provided for the purchase of machinery and machine parts purchased to be used directly and predominantly in manufacturing.8 Colorado also provides an exemption for the purchase of ingredients and component parts purchased by manufacturers, which through the manufacturing process becomes a part of the manufactured product.9
Many states provide exemptions for purchases of property and equipment directly used in qualified R&D. In North Carolina, there are exemption provisions for the sale of equipment, or an attachment or repair part for equipment, that is sold to a company primarily engaged at the establishment in R&D activities in the physical, engineering, and life sciences; is capitalized by the company for tax purposes; and is used by the company at the establishment in the R&D of tangible personal property.10
In California, there’s a partial R&D and manufacturing sales and use tax exemption on the purchase of qualified machinery or equipment primarily used in some types of business. These include businesses engaged in manufacturing; biotechnology R&D; physical sciences, engineering, and life sciences R&D; and the generation and production, storage, or distribution of electric power. The purchase must be qualified tangible personal property that is used in a qualified manner.
Qualified tangible personal property includes machinery and equipment deemed to have a useful life of one or more years. Qualified uses include items primarily used (50 percent or more) in any stage of the manufacturing, processing, refining, fabricating, or recycling process; in R&D; or to maintain, repair, measure, or test any qualified tangible personal property.11
Lastly, purchasers who intend to resell a good or service are typically carved out from sales tax requirements. This exemption exists to avoid double taxation. Sales tax generally applies to the end-user, who is the person who consumes the good or service. The end user will ultimately pay the sales and use tax on taxable goods and services.
Purchaser’s Status
Sales to nonprofit, religious, and educational organizations and governmental entities are often exempt from sales tax when these entities and organizations meet exemption qualifications. In Colorado a nonprofit that has received tax[1]exempt status under IRC section 501(c)(3) must generally be the buyer of record; apply for a state tax-exempt certificate; and provide appropriate documentation at the point of purchase to substantiate its exempt status. Purchases by U.S., state, and local government agencies are typically exempt from sales tax when made for official purposes. However, qualifications and requirements vary by state. Purchases in California and South Carolina by the federal government are exempt from sales tax, but purchases by state and local governments are generally subject to tax.
Exemption Certificates Management
Once exempt purchasers have been identified, the next step is to manage exemption certificates. This is a critical aspect of sales tax compliance because it determines whether businesses need to collect tax or can claim exemptions. However, exemption certificate management can be burdensome and fraught with risks for taxpayers. It involves more than just the product being sold, because factors such as the purchaser’s identity and the product’s intended use come into play.
To claim a sales tax exemption based on a particular use, the purchaser must provide the seller with a valid exemption certificate. The certificate requirements vary from state to state, but they typically include information such as the vendor and purchaser’s name, address, and the type of goods or services being purchased.
To avoid the costs of noncompliance, vendors must possess proper exemption certificate documentation. Missing, invalid, or expired certificates can quickly escalate the risks for businesses. Small mistakes in obtaining and managing certificates can compound, making it challenging to gauge the extent of the risk. Assessments, penalties, interest, and lookback periods may apply in various states. These penalties aim to encourage voluntary compliance.
Taxpayers that sell to exempt purchasers must keep records of the transactions, including copies of exemption certificates. This includes doing a periodic review of exempt purchasers and ensuring certificates on file are current. Businesses should monitor when certificates expire, because state-specific statutes of limitations determine how long to retain records. If a business is audited, it may be required to produce evidence to support the exempt status of a transaction. This evidence may include a copy of the customer’s current resale certificate and the business’s own files of valid customer resale numbers, if the business is substantially engaged in reselling products like those being purchased. Forms vary by state and by whether an entity is in-state or out-of-state.
An exemption certificate is not required when the goods or services are not taxable in the state. As a seller, where items are not taxable or a statutory carveout of some items exists, like food, clothing and medical supplies, the seller does not need to obtain an exemption certificate. The specific exemptions that apply in a state vary, so it is important to check with the department of revenue.
Conclusion — Minimize Risk
Sales tax administration poses challenges for businesses, particularly when it comes to exemption certificate management. Poor documentation and nuanced laws can increase the risks associated with these activities, leaving taxpayers vulnerable to penalties for noncompliance and other issues. To mitigate these risks, businesses should invest in proper exemption certificate management systems and processes, including staying up to date with state- specific requirements and regularly validating certificates.
By navigating the complexities of exemption certificates, businesses can reduce their exposure to risk and maintain compliance with sales tax regulations. Staying informed about updates in sales tax exemptions, understanding key issues related to resale certificates, and effectively managing retailer documentation are crucial steps toward ensuring sales tax compliance in a constantly evolving tax landscape.
- 1 Ariz. Rev. Stat. section 42-5101(1), (3) and Ariz. Rev. Stat. section 42- 5102(A)(1).
- 2 Haw. Rev. Stat. section 237-24.3.
- 3 Kansas Department of Revenue, Pub. No. KS-1223 (Jan. 2023).
- 4 Ala. Code section 40-23-4.1.
- 5 D.C. Mun. Regs. tit. 9, section 449.
- 6 Tex. Tax Code Ann. section 151.313.
- 7 Colo. Rev. Stat. section 39-26-709(1)(c)(III).
- 8 Colo. Rev. Stat. section 39-26-709(1).
- 9 Colorado Department of Revenue, Taxation Division, Sales & Use Tax Topics: Manufacturing (rev. June 2021).
- 10 N.C. Gen. Stat. section 105-164.13.
- 11 Cal. Rev. & Tax. Code section 6377.1.
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Tram Le can be reached at tle@taxops.com or 720.227.0093.
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