What are sales tax exemptions? How can your small business stay on top of them?
As small businesses grow and sell in more states, learning the process of collecting and filing sales tax can be a significant challenge. Interestingly, it can be just as challenging to learn the process of not collecting sales tax — because every state has its own rules (and certificates!) for tax exemptions.
Exemptions can be based on the product, the intended use of the product, or the status of the buyer. Here are the three main types:
Product-based exemptions. In some states, for example, grocery items are exempt from sales tax.It gets tricky because these exemptions can then have rules within rules: Prepared foods, such as a ready-to-eat rotisserie chicken purchased from the deli, may be taxable; at the same time, a package of chicken breasts the buyer will cook at home might be exempt.
Use-based exemptions. Products that are intended to be resold are frequently exempted from sales tax. Typically, this is because the reseller will charge sales tax when these items are purchased by the end user.
Buyer-based exemptions. Nonprofit organizations or government agencies often are not required to pay sales tax (states cannot charge sales tax on items purchased by the federal government, and often this exemption is extended to state agencies as well). Also, buyers from states without a sales tax can sometimes be exempted from paying tax when purchasing products in other states.
How exemption certificates work
If a tax exemption applies to everyone in a given tax jurisdiction — such as in the groceries example above — sellers do not need to collect an exemption certificate for those particular sales. However, when an exemption is more narrow, a buyer must provide an exemption certificate in order to prove to the seller that tax should not be charged.
Entity-based certificates are for organizations that are exempt because of their standing as a government agency, nonprofit, or some other qualifying status. These certificates allow organizations to purchase items without paying tax, regardless of how they’ll be used.
Usage-based certificates allow for the purchase of items only if they’re to be used for a qualifying purpose — for example, if they’ll be resold. An organization with an exemption for resellers (often called a “reseller permit” or “resale certificate”) can only avoid paying sales tax on items it will resell; it would have to pay sales tax on products the organization would use for other purposes, such as office supplies.
Individuals from non-sales-tax states who purchase items in a state that does charge sales tax typically need to prove their residency to avoid paying tax. (That is, if the state in question allows this. Washington is one state that does; however, the state leaves it up to the seller whether to charge tax, and there are a host of qualifying factors.)
Do you really have to keep track of all these certificates?
Yes. Not only do buyers use exemption certificates to prove to sellers they don’t need to pay sales tax, sellers must keep the certificates on file to prove to taxing authorities they didn’t need to collect the tax.
Fortunately, Streamlined Sales Tax (SST) makes the process easier — whether you’re selling to tax-exempt organizations or you need an exemption for your own business. The Streamlined Tax Exemption Certificate is valid in 44 member states and the District of Columbia, and it can be used for a single purchase or as a blanket certificate in multiple states.
However, sellers still must know which exemptions apply in each state. Buyers can be charged criminally for misusing exemption certificates, and sellers can run into trouble as well if they don’t collect tax correctly.
There’s a lot at risk here — especially because auditors have been paying greater attention to exemption certificates. In fact, a high rate of exempt sales is one of the top reasons businesses are selected for a sales tax audit.
Some states, even SST member states, require companies to register to use the form. And some non-SST states don’t accept out-of-state certificates. So it’s important to check with each state to verify the rules and how to validate a certificate there.
Even if you think you’ve got exemption management under control, there are three things you should do regularly:
Learn about exempt services and goods in each state where you collect tax.
Keep track of changes to exemptions on Department of Revenue websites.
Monitor legislation to stay aware of changes on the horizon.
There’s also a fourth thing we recommend: Automate your exemption management with Avalara CertCapture. We can help you collect, validate, and store all of your certificates and other documentation, giving you instant access and accountability. Along with our other solutions for companies like yours, it’s a great way to minimize your audit risk — and maximize the time you can devote to growing your small business.
The 2021 sales tax changes report: midyear update
Your guide to navigating the complicated world of tax compliance and preparing for the future
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