At Avalara, we talk a lot about helping businesses reduce risk — and for manufacturers, there’s perhaps no greater risk (at least from a tax perspective) than use tax. This self-assessed tax with complex rules can be confusing for any company, but manufacturers have it particularly rough. Here are just a few reasons why:
- A business might owe use tax depending on whether materials become part of a final product or simply play a role in the production process.
- It can be difficult to understand tax risk related to procurement, such as whether things like forklifts and R&D equipment are subject to use tax — because in some jurisdictions items are exempt only if they directly change the product.
- Certain changes can create taxable events without a business realizing it, such as when items are removed from inventory for promotional use or transferred between plants.
Like with most other taxes, the rules for use tax aren’t consistent across jurisdictions, which only adds to the headache — especially if your business has operations, sales, and/or vendors in multiple states. And auditors know this, which is why manufacturers are a prime target for states looking to boost revenue.
So how can you avoid getting burned by manufacturing tax errors? A good start is avoiding these five key use tax mistakes.
1. Assuming ‘no sales tax’ means ‘tax free’
Use tax can be confusing, even for tax professionals, so it’s important to ensure your team understands what it is and when it could apply for your business. Everyone has a basic idea of what sales tax is, so it’s easy for people to assume if a vendor doesn’t charge it on a particular purchase, that must mean no tax is owed. That’s not always the case.
2. Not understanding state differences
When it comes to state-specific rules, use tax rates are just the tip of the iceberg. Some states follow a “direct-use” approach to taxability, which provides manufacturers with tax exemptions on equipment only if it directly creates a physical or chemical change to a final product for sale. Meanwhile, the “integrated-plant” rule in other states is broader and can apply to things that help in the overall production process.
A forklift provides a good example: Classified as MRO (maintenance, repair, and operations) supplies, it’s likely not tax-exempt equipment in a direct-use state. But in an integrated-plant state, it might be. This can be either a risk or an opportunity — are you taking advantage of all the exemptions you qualify for? Or are you taking exemptions you don’t deserve?
3. Not ‘self-auditing’
No, you don’t have to do everything a state auditor would do, but businesses should absolutely have processes in place to examine and validate the tax impacts of purchases, items that move into and out of inventory, and other points that can lead to problems. Let’s say you purchase materials without knowing for sure how they’ll be used. Do you have a tax accrual process for these situations? If not, you might end up under- or overpaying.
You also need to watch your vendor transactions closely. If vendors aren’t correctly applying your exemptions based on the items you’re purchasing (and how and where those items will be used), you could be overpaying. Or you could be underpaying — and remember, even if it’s a vendor making the error, that doesn’t mean you’re off the hook.
4. Thinking the state will offer up a refund
If you underpay sales or use tax, the tax authorities are definitely going to let you know. Wouldn’t it be great if the same held true for overpayments? Unfortunately, it doesn’t work that way. That’s why it’s so important to stay on top of your obligations; just as you don’t want to underpay and face potential fines and penalties in an audit, you also don’t want to overpay and provide the state or other jurisdiction with what amounts to an interest-free loan. It’s on you to manage (and to request a refund if you find out one is warranted).
5. Trying to manage it all on your own
This might be one of the biggest mistakes of all. If you’re trying to manually track all of this across various jurisdictions (let alone across many different SKUs and pieces of equipment), you might be in for an unpleasant surprise, especially if your business is growing and expanding operations.
