Special Report: How COVID-19 is changing business sales tax obligations and enhancing risk [Part 14]
Manufacturers and Distributors Sales and Use Tax Risk and Complexity Have Soared: Wayfair and the Pandemic Impact
COVID-19 is changing the way we do business, the way we buy, the way we sell — this series follows how all of this affects businesses of all sizes and in most industries as well as their customers and their tax advisors.
Greetings from my home office in NYC. I have covered how COVID-19 is changing the way you and I live our lives since early March. I sincerely hope you and your families are safe and well. In this week’s installment of my special report, I discuss how SCOTUS’ decision in Wayfair changing the standard for states and municipalities to impose sales and use tax compliance obligations from physical to economic nexus, and the explosion in online and remote selling caused by COVID-19 lockdowns, closures and restrictions on reopening has impacted manufacturers and distributors. You can see more COVID-19 related blogs here.
Manufacturers and distributors are facing substantially increased sales and use tax compliance and audit risks that include the obligation to register, collect and remit sales and use taxes in many more states and municipalities. In addition, they face many more exemption certificate management requirements resulting from Wayfair economic nexus and the COVID-19 pandemic.
Wayfair and the Pandemic: The Perfect Storm
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 and remote purchasing surges as a result of the pandemic. However, the sales and use tax impact on companies in key nonretail industries, e.g., manufacturers and distributors, 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. As state Departments of Revenue get back into full gear, manufacturers and distributors are likely to be sales and use tax enforcement targets.
Manufacturers and Distributors
Manufacturing is typically defined as an operation of producing a new product, article or commodity that is different, and that has a distinctive name, character or use from raw material and that is intended to be sold either as a finished product or a component of a future finished product.
Not all manufacturers use raw materials in their processes, of course. Some, like automobile manufacturers, buy parts or components from suppliers and then manufacture, machine, or fabricate those parts into a new, complete product. These companies still operate as “manufacturers” as defined by tax authorities.
Note: Certain industries that do manufacture goods, such as pharmaceuticals, tech and construction, often fall under tax law specific to their industries and will not be covered in depth in this white paper.
Distributors, for tax and legal purposes, are often defined as “any individual, partnership, corporation, association or other legal relationship that stands between the manufacturer and the retail seller in purchases, consignments or contracts for sale of consumer goods.”
Importance of Exemptions to Manufacturers and Distributors
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 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).
- 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 Sales — 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 sale 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 many companies and 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.
States also 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, the state tax auditor 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.
Protect Your Business from Sales and Use Tax Risk
Failure to accurately manage sales and use tax compliance is likely to have serious consequences for manufacturers and wholesalers, particularly in this post-Wayfair and COVID-19 environment where states and municipalities are facing dire financial circumstances. Heightened enforcement will include comprehensive audits with costly, often unanticipated sales and use tax bills.
Next Steps for Manufacturers and Wholesalers
- Understand how your business and sales and use tax risk has changed in light of Wayfair economic nexus, the pandemic, heightened enforcement and audits;
- Establish and reinforce a people, process and technology approach
- Assess the benefits of working with a third-party provider to help navigate sales tax nexus, registrations, changes in exemption compliance management requirements and tax base changes
- Understand role of automation to ensure accuracy; integrating tax data and documentation; and keeping your company in compliance
- Consider cloud-based technology that integrates directly with ERPs
- Get a nexus study to understand in which states and localities where to focus your attention
For more detail on the significant sales and use tax audit and compliance risks manufacturers and distributors face and what you can do to best manage these risks, read our white paper.