U.S. sales tax: When is a transaction exempt?
If you understand which transactions are exempt from U.S. sales tax, you’ll be able to process those transactions more smoothly and keep your customers happy. Having a solid understanding of U.S. sales tax exemptions also makes it easier for you to stay tax compliant. This information is especially important when it comes to audits, since reviewing exemption certificates is a big part of U.S. audits.
In this article, we’ll help you answer important compliance questions, such as:
- How do I identify tax-exempt products and transactions?
- What is a U.S. sales tax exemption certificate and why is it important?
- How can I streamline the tax-exempt transaction process?
Please note that as with any element of U.S. tax law, exemption rules vary from state to state, so performing state-specific research is important.
How can I identify a tax-exempt transaction?
U.S. sales tax exemptions are based on one of three factors:
- What type of product is being sold
- Who is purchasing the product
- How the product will be used
Just as EU countries apply a 0% VAT rate to essentials (like food, water, and medicine), all U.S. states recognise that some products are required for basic survival. As such, most states offer product-specific exemptions for items such as food, clothing, prescription medicines, and medical devices.
However, this doesn’t mean these items are exempt nationwide. For example, there are 13 states that don't provide a complete exemption for food purchased in a supermarket, 10 of which impose a lower tax rate on them. The three U.S. states that apply full sales tax rates to groceries are Alabama, Mississippi, and South Dakota.
The taxability of medicines and medical devices also varies among states. In most cases, the differences are based on the definition of a medical device and whether or not a prescription is required. Every state aside from Illinois applies a tax exemption of some kind.
Nonprofit organisation tax exemptions are common across different states. In the Internal Revenue Service (the national U.S. tax authority, also known as the IRS) tax code, nonprofits are referred to as 501(c) organisations. There are 29 kinds of nonprofit organisation tax exemptions, including:
- 501(c)(5): Labor, agricultural, and horticultural organizations
- 501(c)(11): Teachers' retirement fund associations
- 501(c)(19): Organization of past or present members of the armed forces
The most common designation is 501(c)(3), which covers everything from religious, scientific, and educational institutions as well as cruelty prevention charities.
Nonprofits are not the only tax-exempt purchasers. In a rare example of a tax law that applies nationwide, states cannot apply tax to sales made to the federal government or its agencies. Many states (including Florida, Indiana, and Texas) have similar rules that apply to state governments and their agencies.
The way a product will be used also affects its taxability. Products that will be employed to support certain industries (such as agriculture, manufacturing, or industrial processing) or to encourage certain activities for the public good (such as industrial development or expansion or pollution control) are usually tax-exempt.
These kinds of exemptions often align with the primary industry of a state. For example, in Texas, there are a large number of sales tax exemptions on products used for agricultural purposes (publication 94-101). Similarly, in California (home of digital megacorporations such as Apple, Google, and Meta) sales of digital products generally aren’t taxed.
What is a U.S. sales tax exemption certificate?
A U.S. sales tax exemption certificate (also called a resale certificate, a sales tax certificate, or a reseller permit) is an official document, issued by a state tax authority, that exempts the holder from having to pay sales tax.
The exact format of the certificate differs depending on the state, but they will often specify the reason for the exemption. Sellers accepting certificates should also look for the name of the holder (as this will need to match the name on any invoices) and the expiration date of the certificate.
A buyer needs to present an exemption certificate if they have an exemption because of the use of the product or the nature of their organisation, but not if they’re buying tax-exempt products.
While most U.S. sales tax exemption certificates are state specific, you should also be aware of multijurisdictional exemption certificates (which are valid in 36 different states) and the simplified Streamlined Certificate of Exemption (valid in 24 states).
What are my responsibilities during a tax-exempt transaction?
Both buyers and sellers have different responsibilities during a tax-exempt transaction. Understanding these responsibilities allows each party to comply with their legal obligations and therefore avoid financial or legal penalties.
The buyer’s responsibilities
- Determining exemptions: It’s up to the buyer to inform the seller if a transaction is tax-exempt, but only if the buyer is a sales tax-exempt organisation or if the product will be used in a way that makes it sales tax-exempt. Product-based exemptions are handled by the seller.
- Providing exemption certificates: Once an exemption is determined, it’s the buyer's responsibility to provide a valid exemption certificate. If an exemption certificate is not presented by the buyer, sales tax must be charged.
The seller’s responsibilities
- Validating certificates: It’s a business's responsibility to ensure any certificates they receive are valid. For instance, it must not be expired, it must list the correct reason for exemption, and the holder listed on the certificate must match the buyer making the purchase.
- Retaining certificates: Businesses need to keep any certificates they receive, as failing to present relevant certificates during an audit means that a business will be responsible for paying back any sales tax that was not collected.
How can I save time on managing and verifying exemption certificates?
Managing certificates can become complicated, and having a manual filing system makes presenting them during an audit cumbersome and complicated. To keep things simple, and to make compliance easier, try using a digital solution.
Avalara Exemption Certificate Management provides an automated option for businesses struggling to request, verify, archive, and manage exemption certificates in an efficient way. It’s particularly useful for European businesses that may find U.S. exemption rules complicated and are looking for assistance.
If you’re looking for additional information on managing exemption certificates, you can also check out our latest webinar: Managing tax-exempt sales 101.
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