Charging Sales Tax on Services
Rules of the road
Sales tax is one of the largest sources of state revenue and is crucial to basic government operations. Governments are struggling to fill post-recession revenue gaps, and are increasing the types of goods and services that are subject to sales tax.
As more states expand taxability on services and tangible goods, the potential for sales tax calculation errors and audit risk rises. This paper gives some “rules of the road” in the new world of greater sales tax liabilities for companies of all sizes.
These challenges may apply to the following businesses:
Businesses selling taxable services, such as debt collection, financial services, professional services, and credit reporting services, construction contractors, and maintenance services.
Taxation of Service Contracts
North Carolina recently passed a law requiring taxation of contracts servicing tangible personal property. Examples include:
In-ground pool warranty contracts, HVAC service contracts, extended warranties for airplanes, and laptop repair contracts.
Rule #1: Watch out for potholes.
States fill revenue holes with sales tax
Many companies assume that services delivered in conjunction with goods sold (e.g., swimming pool and pool cleaning, computers and maintenance, construction materials and installation) aren’t taxable—an erroneous assumption. States like Delaware, Hawaii, New Mexico, South Dakota, and Washington tax most services. Still others, like Texas and Minnesota, are actively expanding service taxability.
Your business must determine which services require sales tax collection, and capture variations in inter- and intra-state transactions. As states zero in on sales tax, companies are on notice: inaccuracies in calculation can cost audit fines and penalties.
In a recent publication, the Texas Controller detailed the types of services subject to sales tax. Taxable services include:
Data processingCredit reportingInternet accessParking and Storage
Rule #2: Lost? Look for the signs.
Know when, what, and how much sales tax to charge customers
Failing to correctly apply the right sales tax rates and rules to the correct product and service is a hazardous and potentially costly error. States regularly change product and service taxability rules, with the onus of tracking the changes on the business.
Service providers cannot make assumptions about the taxability of services they provide, nor can they assume which rate to charge. This is particularly true for multi-jurisdiction sellers. Given that sales tax management isn’t the focus of most service-based companies, error risk is high. Whether a service is taxable or not is hardly an open and shut case. The universe of taxable services continues to expand while the universe of exempt services continues to contract.
The historical trend in the services realm has been a slow crawl towards universal taxability.
Knowing which rate to charge and which sales tax rules apply is especially complex for companies providing both goods and services, particularly those along the supply chain. Rates, rules, and boundaries change constantly and defy the best efforts to track manually. Many customers don’t expect to pay sales tax on services and are displeased when they see the charge on the invoice, not realizing the rate charged is determined by the taxing jurisdiction rather than the company.
Rule #3: Follow traffic laws, even when you think they don’t apply to you.
Product and service taxability and location of the seller
Given the variations in rates and rules that apply to product taxability, it’s important to know which jurisdictions require sales tax collection. Yet knowing where your company has nexus (the connection that triggers a sales tax collection obligation) is more difficult than it seems. Nexus can be triggered even for sellers without a significant physical presence in a state, such as online sellers. Other nexus-creating activities range from traveling sales people to attendance at trade shows to the use of a drop shipper. Deciphering nexus is only the first step in the complicated process of identifying the product taxability challenges ahead.
The following services are a sample of taxable services (Minnesota Department of Revenue publication):
Admissions fees to exercise facilities and places of amusementBuilding cleaning and maintenanceDelivery of aggregate materialDetective and security servicesFabrication labor
Source: Minnesota Department of Revenue
Rule #4: Don’t crash at the intersection of goods and services.
When a service is taxable based on an associated product
Many service-based businesses that provide customer support, installation, or warranty services in conjunction with the sale of a physical good could keep an army of accountants busy for a year trying to determine exactly what is taxable. If you run service contracts on goods sold, or if you service tangible goods as part of your sales to customers, you may be liable to collect sales tax.
For instance, in Hawaii, New Mexico and South Dakota, a sales tax is imposed on all services provided. In other states, lawmakers have taken a piecemeal approach and tax some types of services while leaving others exempt.
Determine whether the state in which you have nexus, defines certain services as taxable. In Texas, for example, janitorial services are taxable. Generally, tax is due on the entire amount charged for a taxable service, including items such as labor, materials and mileage charges, even if separately stated.
Texas Takes Tax
A company providing a taxable service in Texas is required to obtain a sales tax permit and to collect state and local sales and use tax. Taxable services in Texas include:
Data processing servicesConstruction related servicesInformation technology servicesDebt collection servicesShoe shining repairAppliance repairFurniture refurbishing or upholsteringJewelry repair or cleaningDog groomingAn additional list of services listed here.
Depending on the states where you sell, you may have to pay sales tax on the services provided in conjunction with physical goods sold. Home Rule states (Alabama, Alaska, Arizona, Colorado, Illinois, and Louisiana) allow local jurisdictions to apply sales tax rates, rules and boundaries to products and services, making the job of determining sales tax that much more difficult.
Rule #5: Objects in the mirror may appear tax-free.
Using the True Object Test to determine taxability
In many states, services can be provided without a sales tax requirement, which could be due to a host of circumstances including:
Status of purchaserIntended use of the good or serviceSales tax holiday
Many states use a True Object test to determine whether the product or the service is taxable. The True Object Test applies to the physical items included in the price of the service sold. However, if the main purpose of the transaction (the true object) is the purchase of property or equipment, and only secondarily the services provided to support those goods, the entire transaction is subject to sales tax, as determined in some cases by The True Object Test.
What is the True Object Test?
When you provide a physical good along with a service e.g., (diabetes treatment along with insulin monitor), but the good is secondary to the service, taxability is based on the real object of the transaction: the service provided.
In order to comply with the sales tax laws of your state, determine the intended use of the good or service. Is the service you’re providing secondary in importance (“incidental”) to the installation of the equipment?
To help make the determination, a number of state taxing authorities developed an analysis called the “true object test” which they apply to the total transaction. Using the true object test, you can get a better idea of whether a transaction will be taxable by determining whether the service provided or the property acquired is the main purpose–or the true object–of the transaction. To apply the true object test, look up the rules of the state in which you’re conducting business.
What’s responsible for audit flags and potential penalties? Tax obligations service-based businesses don’t think they have. For companies servicing installation contracts, technical support, or other business services, sales tax can become a problem if not addressed promptly. Similar at-risk businesses include construction services, manufacturers that provide services along with products, and many other service-based businesses along the supply chain. As ecommerce shrinks the time between order and delivery, the sales tax risk for supply chain providers grows.
Hawaii, New Mexico, South Dakota and West Virginia tax warehousing services. Mississippi, which also taxes warehousing services, allows an exemption for “perishable goods and for goods to be shipped outside of the state.”
Outsourcing the sales tax compliance function can help manage the complex world of goods and services taxability. Avalara is a certified provider of the Streamlined Sales Tax Project: Avalara clients are protected from penalties and interest if any mistakes in sales tax remittances occur.
No system is foolproof, but with a detailed process in place, an auditor is more likely to give your company a clean bill of health. Learn more about when to charge sales tax on services in this webinar.(877) 780-4848