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Tax Risks in Consumer Goods and Services

Avalara

Sellers of consumer goods frequently assume they have very few, if any, sales or use tax obligations. The truth is, they often do. Even small errors in rate calculations, exemption certificate management, nexus determinations, or product taxability decisions can result in costly audit fines and penalties. This is particularly true of businesses selling a wide-range of products and services to customers in multiple states, those with a large number of tax-exempt transactions, or those unaccustomed to worrying about tax obligations in general.  For retailers, distributors, wholesalers, manufacturers and the like, an effective sales tax management process will protect against audit fines and penalties.

Understanding and taking action to mitigate risk in the following four areas is critical in 2014:

Product and service taxability
Requirements for remote and out-of-state sellers
Exemption certificate management
Use tax responsibilities

Manufacturers, distributors, wholesalers and retailers face risk at each point in the order entry process, and the smart ones know that integrating their various financial systems saves time and money in the long run. These points of risk include selling to retailers (resellers), inputting product and service taxability into the database, drop shipping on behalf of another business, and providing installation and repair services along with products. At every step in the process, your business can get hung up, and hung out to dry by an unexpected audit.

1. Product and Service Taxability

RISK: Product and service taxability variations among states can make it nearly impossible for manufacturers, distributors, wholesalers, and retailers to keep up. Integrating sales tax rates, rules, and boundaries, and being able to track processes into fulfillment and order systems is crucial. 

With states looking for ways to bridge substantial budget shortfalls, they are broadening and deepening the definitions of tangible consumer goods (also known as tangible personal property, or TPP). Furthermore, with the continuing disappearance of high-paying manufacturing jobs in the U.S., our gross domestic product is increasingly driven by services, and states are starting to collect tax on both goods and services.

These rules and rates vary dramatically within Home Rule states such as Texas, where cities and towns are empowered to set taxability rules. As a result, transactions like leases, rentals, deliveries, or personal services are subject to sales and use taxation in more states than five years ago. Manufacturers, distributors, and wholesalers are some of the highest risk industries.

Finally, inaccurate sales tax charged on consumer goods and services impacts customer satisfaction. Imagine the hit to reputation caused by asking for additional sales tax after a sale, due to a mistake made during the sales transaction.

What you can do:

Read: How Sales Tax Affects Your Business
Read: Sales and Use Tax Challenges Facing Manufacturers and Distributors 
Investigate: Product taxability management resources like Avalara’s UPC MatrixMaster

What some states are doing:

New York requires sellers to collect sales tax on third-party drop shipments and considers that in some cases to be a nexus-creating activity
Maine grocery retailers are required to collect sales tax on groceries based on the first ingredient of the item.

2. Requirements for remote and out-of-state sellers

Risk: Expanding sales tax requirements for remote and out-of-state sellers impact many manufacturers, distributors, retailers, and wholesalers that deliver from warehouse locations to out-of-state locations. Depending on sourcing rules of the states into which the goods are delivered, the applicable tax rates will apply to the ship-to or ship-from location.

Broadening nexus requirements for out-of-state sellers, sometimes called “Amazon laws” or “Internet sales tax,” are exposing many businesses to an increased risk of audit. These so-called Amazon laws are intended to capture uncollected sales tax from out-of-state Internet, catalog, or phone sales businesses. The nexus (or connection between a business and a state that triggers sales tax obligations) relationships that can create sales tax obligations include affiliate advertising, a remote sales force, drop shipping, direct sales from out-of-state locations, and many more. Thus far, 20 states have broadened definitions of nexus to include sales made online or from remote locations, and many more are considering similar rules.

Nexus rules are established by individual states and every state defines them differently. Manufacturers, distributors, retailers, and wholesalers selling across state lines who are not aware of and on top of these variations can find that their approach to sales tax is extremely error-prone. Using Department of Revenue look-ups and spreadsheets to manage the ever-changing sales tax requirements of each jurisdiction into which you sell can actually lead to significant problems down the road, because even DOR staff may be unaware of the complexity of individual jurisdictions in their state.

What you can do:

Read: How Nexus Confusion Affects Your Business
Watch: Do I Have to Collect Online Sales Tax Now?

What some states are doing:

Online and remote manufacturers, distributors, retailers, and wholesalers with nexus-creating relationships via affiliates, contract agents, drop-shippers, retailers, and such, are now required to collect sales tax in the following 20 states:

Remote seller or out-of-state nexus:

Arizona
California
Connecticut
Georgia
Indiana
Massachusetts
Nevada
New Jersey
New York
North Carolina
Pennsylvania
Tennessee
Texas
Virginia
West Virginia
Wisconsin

Traditional nexus:

Kansas
Kentucky
North Dakota
Washington

3. Exemption certificate management

Risk: Invalid, inaccurate, or missing exemption certificates are one of the top reasons companies are audited for sales tax compliance. For manufacturers, distributors, retailers, or wholesalers with a large number of sales tax exempt transactions, managing certificates can be a huge job, and mistakes are easily made. Many products can be sales tax exempt depending on the time of year, rules of the state in question, and many other factors.

The identification and tracking of sales tax exempt goods and services poses a particular challenge to manufacturers, distributors, and wholesalers. For example, the purchase of the same product (machinery) is taxable in one state and tax-exempt in another.. Depending on the state, durable goods such as machinery may not be considered part of the manufacturing process.

Rules regarding the use of Direct Pay Permits (which allow some manufacturers to make purchases tax-free) vary between states. And tracking which piece of equipment or inventory is specifically tax-free can be burdensome and error-prone.

What you can do:

Read: Automating the exemption certificate lifecycle

What some states are doing:

California exempts certain equipment used in manufacturing from sales tax.
Arizona’s governor recently called for the elimination of the sales tax on electricity used by manufacturers in the state.

4. Use tax responsibilities

Risk: Ignorance of use tax notification rules. Manufacturers, distributors, and wholesalers face unique use tax challenges. For each transaction requiring use tax, there is a concomitant exempt-transaction process (see #2). Whenever there is a sales tax-exempt transaction between two businesses, the purchaser is required to pay consumer use tax for the storage, use, or consumption of tangible personal property (TPP).

Like sales tax rules, consumer use tax rules vary by state and apply not only to sales between businesses, but also between consumers and sellers. Use tax is also required whenever one company is charged less tax than would normally be charged because incorrect rates or rules. In this case, the buyer, or consumer of the goods, is ultimately responsible for paying the difference.

In states that don’t impose sales tax on out-of-state sales, for example, the retailer purchasing goods from a wholesaler would be required to pay consumer use tax.

Furthermore, any errors in use tax computations must be reported to the appropriate jurisdiction and treated as an open liability on your company’s balance sheet. The balance owed must be remitted as part of the next tax return.

What you can do:

Read: The Challenges of Use Tax Compliance
Watch: Will’s Whiteboard Consumer Use Tax versus Sales Tax 

What some states are doing:

California tracks consumer non-compliance with use tax requirements, and the businesses associated with related transactions.
New York considers “co-vendor” relationships (such as wholesalers that use independent distributors) significant enough to require sales tax collection.

What now?

In conclusion, sales and use tax requirements for manufacturers, distributors, wholesalers, and retailers are changing fast. Sales tax management can seem straightforward at first glance, but this belies the complexity of doing sales tax correctly. And the audit fines, penalties, and charges associated with doing it wrong, costs more than hiring experts to handle it for you.
 

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