Many businesses are exposed to use tax for the first time while under audit, which can lead to a costly lesson in compliance.
What do sales tax and use tax have in common?
Sales and use tax share a lot of similarities. Both are transaction taxes that may be imposed when something that is purchased is taxable. Taxability rules are often the same for each tax type.
However, use tax only comes into play when sales tax has not been collected by the vendor on a taxable purchase, which explains why sales and use tax are referred to as “complementary” taxes.
What happens when a vendor does not collect sales tax?
In some situations, the vendor does not collect tax on a transaction because they don’t have nexus in the state of the purchaser, or perhaps the item is taxable in the purchaser’s state but not in the vendor’s state. In many cases where tax is not collected, the vendor is simply not aware that they have a duty to collect tax on a given transaction.
When this happens, the purchaser will need to accrue and remit use tax to the appropriate state or local taxing jurisdiction(s) for that purchase, and this is true for both individuals and businesses. Use tax is not only a business tax, and some states have even added a use tax line to their individual income tax returns to encourage individual use tax compliance.
What is the difference between sales tax and use tax?
Sales and use tax can be difficult to differentiate. The main difference is that the responsibility of use tax falls on the purchaser rather than the vendor.
From a business perspective, the invoice for the purchase will usually be routed to the accounts payable group of the purchaser. This is likely one invoice of many invoices received by the accounts payable group, who is usually under pressure to process as many invoices as quickly as possible. On other occasions, the purchase may be charged directly to a business owner’s credit card.
Regardless of how the transaction is paid for by a business, it is important to review the invoices for sales tax. Often, the vendor will charge their own tax rate rather than the tax rate for the “ship to” location on the invoice. In this case, the purchaser may be paying correct taxes in the seller’s jurisdiction, but not in their own jurisdiction. A worst-case scenario is that this can potentially double the tax paid on that purchase. This makes it important to flag and review the higher valued taxable purchases, such as furniture and fixtures, for sales or use tax.
Reviewing these transactions is relatively simple. The purchaser should review each invoice to compare what tax was paid to the tax that should have been paid and remit any shortages found.
Despite the relatively straightforward process of reporting use tax, we are not currently aware of any automated systems that can do this accurately without effort. It is not a “set it and forget it” type of process. Calculating and remitting use tax is largely manual.
Are there any special considerations with respect to use tax?
Some purchasers may have high value items such as equipment shipped to a state that does not impose sales tax, such as Montana or Delaware, then later the purchaser will ship those items to a taxing state where the items will actually be used.
This is not a legal way to avoid tax. The purchasing business or individual owes tax to the jurisdiction where the equipment is being used. While the purchaser may not have to pay sales tax in Montana or Delaware, they will still need to accrue and remit use tax in the states where the equipment will ultimately be used, if not in the tax-free states.
Another complication to consider is that some jurisdictions do not have a temporary storage exemption. This means that if the purchaser is moving or storing the taxable item in a particular taxing jurisdiction, that equipment is not exempt just because of the short period of time it was in that location. The result may be that the business or individual will owe use tax in the temporary storage states as well.
Many jurisdictions will allow credit for taxes paid if they were legally imposed by another jurisdiction. As a result, use tax isn’t “accumulated” as the purchase is moved from place to place in the shipping process. In this case, the purchaser would reduce any taxes paid to the destination state by the amount legally imposed by and paid to the other state(s).
This process can prove to be an administrative nightmare. If a purchaser fails to track sales or use taxes correctly throughout the shipping process, then the tax credit may be skewed and the purchaser could be paying the wrong amount to the wrong jurisdiction(s).
How to remediate use tax?
Taxpayers who have not addressed use tax in the past can remediate the situation by first evaluating the jurisdiction(s) where use tax may be owed, then reviewing the amount of time in which use tax may have accrued as well as the amount of tax owed to each jurisdiction where they have a filing obligation.
This is easier said than done.
Some purchasers may opt to register to pay use tax prospectively and take the risk that an audit could go all the way back to the beginning of the time when the use tax was owed to the jurisdiction, usually in addition to penalties and interest on any taxes owing.
In most jurisdictions and under certain circumstances, purchasers can enter into a voluntary disclosure agreement (VDA) with the jurisdiction. This is a method whereby the purchaser contractually agrees to “catch up” on prior period taxes while agreeing to stay in compliance with the jurisdiction in the future.
A VDA lookback period is typically 36 months for use tax. After reviewing all purchases and calculating taxable sales and the total amount owed, penalties are usually waived, so the purchaser would pay only the tax and interest and go forward with compliance from there.
Some states group sales and use tax together and imply that if a taxpayer is registered for sales taxes, then they should also understand their responsibility to pay use tax. These states present a higher risk of audit, and in some cases the state may not allow a VDA because registration in the state precludes a taxpayer from being able to assert that they were unaware of use taxes.
The most important part of filing use tax is understanding which jurisdiction(s) that the purchaser is in, and that the purchaser is making efforts toward staying in compliance with those jurisdictions. Compliance with the jurisdictions can include remitting previously owed tax under a VDA and/or registering and filing prospectively to remain in compliance.
For more guidance, reach out to the tax professionals at taxops.com.