Special Report: How COVID-19 is changing business sales tax obligations and enhancing risk [Part 11]
Manufacturers and Other Nonretail Businesses Face Heightened Sales and Use Tax Compliance Risks
COVID-19 is changing the way we do business, the way we buy, the way we sell and how all of this affects businesses of all sizes and industries as well as their customers.
Greetings from my home office in NYC. It’s my Week 11 covering COVID-19 changing the way you and I literally live our lives. I’m sincerely hopeful you and your families are safe and well. In this week’s installment of my special report covers how this crisis is impacting businesses, buyers and the tax landscape. You can see more COVID-19 related blogs here.
Nonretail businesses are facing increased sales and use tax registration and exemption certificate management requirements resulting from Wayfair economic nexus and pandemic.
In this report, I look at how these nonretail businesses are facing more stringent registration and exemption management requirements.
The Supreme Court’s decision in Wayfair two years ago greatly expanded the ability of state and local governments to impose sales and use tax obligations on remote businesses. It did so by replacing the physical presence nexus standard with “economic presence” — the amount of economic activity occurring in the state. Every state that imposes a general sales tax, with the exceptions of Florida and Missouri (43 out of 45), has adopted the Wayfair economic nexus standard. The impact of Wayfair on remote retail businesses has been getting most of the attention, particularly as online purchasing surges as a result of COVID-19. However, the sales and use tax impact on companies in key nonretail industries should not be overlooked by businesses in those industries and their tax advisors. Many of these businesses likely need to register in more states than ever before and comply with a whole new set of different state-determined exemption rules.
Importance of Exemptions to Nonretailers
In most states, sales and use taxes are imposed on the sale of all tangible personal property and certain specified services unless specifically exempt from this tax under state law. Full and partial exemptions from sales and use taxes may be available and can be especially important to qualified manufacturers, wholesalers, and distributors.
Types of Exemptions
Exemptions to sales and use taxes are expressed in several ways: (1) explicitly, e.g., items considered a part of the manufacturing process; (2) as exceptions to the definition of a taxable sale or tangible personal property; or (3) as exclusions from a taxable category of transactions. Exemptions may be granted based on the nature of the product (such as food), the type of transaction (such as a resale), or the nature of the entity selling or buying the product (such as a charitable organization). Examples include:
- Resellers exemption
- Manufacturing exemptions
- Raw materials
- Industrial supplies
- Industrial tools
- Entity exemptions
- Product/service exemptions
- Tax holidays
- Enterprise zones
- Special Incentives
Sales tax in general is imposed on the final consumer. So, sales for resale are generally exempt from sales or use tax. The sales tax applies only to retail sales generally defined as a sale for any purpose other than resale in the regular course of business, while the use tax is generally imposed on the storage, use, or other consumption in the state of tangible personal property purchased from a retailer.
Drop shipment transactions are more complex than typical two-party transactions because they involve three parties — the seller of the product, the drop-shipper supplier and the customer — in potentially three different states with three different sets of sales and use tax rules. Before Wayfair, it was relatively safe for drop shippers to accept out-of-state resale certificates from companies that did not have physical presence nexus in the customer’s state. Now, companies selling products through drop shippers may create a “less-visible” filing requirement in many additional states because of economic nexus.
Drop-shipping is a retail fulfillment method where the seller doesn’t keep the products it sells in stock. Instead, when a seller sells a product, it purchases the item from a third-party and has it shipped directly to the customer. As a result, the merchant never sees or handles the product.
The manufacturing exemption presents many challenges to sales and use tax professionals. This is so because each state defines the manufacturing process differently for purposes of a machinery and equipment exemption and must be researched separately.
Several states offer a use-based exemption from tax (or a reduced rate) for machinery and equipment used in the manufacturing process. Every state is different, but these exemptions often require certain “tests” to qualify:
- Percentage of Usage — qualifying items must be used in manufacturing for a statutorily-determined amount of time that varies by state.
- New and Expanding Operations — some states limit use-based exemptions to items part of a “new manufacturing operation” or that “expand the existing manufacturing process.” Under this requirement, machinery/equipment for repairs would not qualify under some states’ provisions.
- Partial Exemptions – Many states provide partial exemptions.
- Minimum Dollar Amount/Minimum Useful Life — some states establish a minimum dollar amount, and/or useful economic lifespan.
These qualifying tests are often complex, and the regulations vary across states. Because of this, manufacturers must understand:
- What is tax exempt in all relevant taxing jurisdictions.
- How the equipment/machinery must be used to make it tax exempt.
Other Exemptions: types of entities, products, services and certain special incentives
States provide exemptions for certain types of (1) entities, e.g. tax-exempt organizations, (2) products, e.g., food, (3) services, e.g., health care, and (4) special incentives, e.g., tax holidays and enterprise zones. Each state has different rules and must be researched.
Keeping Track of Exemption Rules
Keep in mind that the burden of proving that a purchase qualifies for exemption rests with the purchaser. It is the responsibility of the purchaser to:
- Understand all qualifications before claiming any exemption;
- Provide the appropriate exemption certificates to suppliers; and
- Keep complete and adequate records.
If there is a dispute, a purchaser must substantiate its qualifications to the tax authorities. In an audit, tax authority generally need not prove that a purchase does not qualify for exemption; the purchaser must prove it does. A purchaser who issues a false or fraudulent exemption certificate will be held liable for payment of tax, penalties, and interest and may also be subject to both civil and criminal penalties.
Next Steps for Nonretailers
Since nonretail businesses now have nexus in more states because of Wayfair and increasing remote business, these businesses will be required to register in those states. This means that manufacturers, wholesalers and distributors may have to register as well where the volume of business or number of transactions exceeds the minimum thresholds created by the economic nexus laws in each state. And although sometimes these businesses will be eligible for various resale and manufacturer’s exemptions and will owe no tax, they may still have to file what are called “zero-tax” state tax returns. Bottom line is that all nonretail businesses will have to have systems and expert support in place to manage all the various exemption requirements of the states. This will be key when the taxing authorities come knocking at the door.