Manufacturers are generally located in a single state or perhaps two states, so their risk is a bit lower when it comes to product taxability, right? This might be true for sales tax obligations but not necessarily true for use tax obligations. The manufacturer must ensure accuracy for their own use tax burden on products consumed or services purchased.
Product taxability affects items you purchase to use in your manufacturing process. Items related to shipping or even a part in a final product. Based on the state, some products are not taxable if used to build manufacturing equipment but the same product might be taxable when used to repair the manufacturing equipment. If that product is a small bolt, for example, how do you handle taxability if some of its uses are taxable and some are not? Do you purchase everything and pay sales tax up front? You would then need to track, calculate, and request a refund of the unnecessarily paid tax on items that were used for an exempt purpose.
The accurate and early identification of use tax liability, properly exempted items and properly taxed items is a special challenge for manufacturers. According to the Connecticut State Department of Revenue, “…a determination of the proper rate of tax is dependent on the type of item purchased and how and where the manufacturer will use it.” Again, using bolts as an example, they may be used in the manufacturing process on equipment, but also on a conveyor. Depending on the state, conveyors may not be considered part of the manufacturing process. The conveyor may be considered as part of the inventory movement process because it is used to convey the product to a final location or to shipping, which may or may not be taxable in a given state.
As an alternative, many states allow manufacturers to use “Direct Pay Permits” to allow a manufacturer to make purchases without paying sales tax. When a part purchased using a Direct Pay Permit is pulled from inventory, the part must be tracked for how it is used and tax accrued if it is used in a taxable manner, or usage tracked if used in an exempt manner.
Another struggle manufacturers face is when they make bulk purchases that are then shared among multiple internal plants or facilities. If plant A runs out of bolts, they are shipped from a central inventory instead of direct from a vendor. The central inventory must track where each item goes and for what purpose in order to establish taxability of that item. In the example above, a bolt for a repair to a conveyor system might be taxable in one state, but exempt in another. The manufacturer has to know:
- the inventory item used was a bolt
- which state it was shipped to
- the purpose of the bolt
- the taxable nature of that purpose
It is a lot to track and execute accurately in order to ensure sales and use tax compliance.
Once the identification of use and taxability is determined and documented, then you must ensure the correct amount of use tax is accrued for each item and file a use tax return in a timely manner. In some states, there may be several different possible tax rates depending on the item and how and where it is used. Each state will have their own specific qualifications for a manufacturer in regards to whether or not you can use Direct Pay Permits. You must apply and be approved and also understand clearly what you can purchase sales tax-free using the Direct Pay Permit. However, there is a general stipulation that the manufacturer will have a system that clearly tracks and shows the amount of sales and use tax owed.
