Sales tax and use tax for manufacturers and distributors
In interviews with manufacturers, the following challenges were cited as the biggest struggles they face regarding tax compliance:
- Tracking thousands of SKU numbers that cross taxability rules or vary in taxability based on state
- Getting the rates right and filing the reports correctly
- Surviving an audit (which in this business is inevitable)
- Keeping track of all the smaller jurisdictions and their special districts
- Ensuring a seamless process that is audit-able
- Figuring out what is taxable and what isn’t
- Tracking use tax
As any good manufacturer knows, having a repeatable, consistent process enables greater quality control. And quality control helps ensure compliance. Let’s review the following areas where sales tax can pose specific challenges to manufacturers and distributors and how they would benefit from a quality control process that reduces cost and risk and improves performance:
- Selling to Retailers (Resellers)
- Selling Direct to Consumers
- Input Item Taxability, Use Tax, and Direct Pay Permits
- Drop Shipping on Behalf of a Distributor or Retailer by a Manufacturer
- Installation, Repairs, and Nexus
Sales tax implications of selling to retailers (resellers)
Both manufacturers and distributors make direct sales to retailers or other distributors. Sales that are intended to be resold to consumers can be exempted from sales tax collection under a resale exemption. Since sales taxes are required to be paid only once, the theory behind a resale exemption is simple: the customer (consumer or end user) will pay sales tax on the full retail price so when the reseller purchases from the manufacturer or distributor, they can be exempt from paying sales tax on that transaction.
Resellers who want the benefit of the exemption must present manufacturers and distributors with current and effective proof of their resale intentions. The most common form of this proof is the Exemption Certificate. In order for exempt purchases to be documented properly, a manufacturer or distributor must maintain exemption certificate information for each state or locality where the reseller receives product. The same rules apply for sales made by a manufacturer to a distributor or forwarder who intends to either collect tax on their own direct sales, or who intends to sell the products to another reseller.
For many manufacturers, this may mean less than 50 certificates if they only sell to large distributors or wholesalers who receive shipments in only a few locations. However, distributors with multiple resale customers must maintain and continually update exemption documentation for all their resellers and any associated ship-to locations in order to ensure the asserted resale sales tax exemption is valid and properly documented.
Distributors must also ensure their own tax-exempt status is maintained and exemption certificate information is provided to each manufacturer or supplier they work with. After all, in the eyes of a manufacturer or supplier, they are considered a reseller.
Sales tax implications of selling direct to consumers
Some manufacturers sell their final product direct to consumer. Often though, spare parts, updates, replacement wear items, or even repairs are more common sources of a manufacturer’s consumer-direct sales. Direct sales to consumers, even if they do not include large amounts of money or whole items, typically incur an obligation for you to properly collect and remit sales taxes.
Consumer sales are usually transacted by phone or online, via a web interface or ecommerce store. A necessary element of selling direct to consumers in today’s world is a functional and accurate online interface to sell your parts and products over the Internet. Easy integration of sales tax rules and laws is critical to making the online checkout process smooth and trouble-free for consumers. It is your obligation to ensure that accurate and current rates, taxability rules and boundaries are applied for each taxable sale. However, not all products, services or parts are created equal.
Manufacturers and distributors who are under pressure to manage costs generally seek technology that can automate their processes, thus reducing costs and generally improving quality control. Selecting an automated sales tax solution that integrates with your online shopping cart to deliver instantaneous and accurate sales tax calculations is critical to customer satisfaction. Adjusting the sales tax after the shopping cart experience delivers a final cost can cause heartburn with your customers when they see that the online statement does not match their credit card amount.
Input items taxability, use tax, and direct pay permits
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.
The taxation of manufacturing equipment
In most states, manufacturing equipment is exempt from sales tax. As with all things tax, however, there are notable exceptions.
As a manufacturer of goods in any state, you must be knowledgeable of what inputs (equipment, raw materials, parts, etc.) are taxable and under which situations.
|State||Specific notes on sales tax for manufacturing equipment||Source|
|Alabama||State manufacturing machinery and equipment tax rate of 1 and 1/2 percent.||Alabama Department of Revenue|
|Hawaii||Manufacturing equipment is taxed at a rate of 0.5 percent.||Hawaii Department of Taxation|
|Kentucky||While manufacturing equipment is taxed, there are exceptions.||Kentucky Legislature|
|Mississippi||Sales of "manufacturing machinery or machine parts" are subject to a 1.5 percent sales tax rate.||MS.gov|
|Nevada||Sales/use tax "is imposed on the sale, transfer, lease, rental, use, or other consumption of tangible personal property for consideration" with no exception for manufacturing equipment.||Nevada Department of Taxation|
|New Mexico||Manufacturing equipment is taxable, but an investment tax credit may apply.||New Mexico Department of Taxation & Revenue|
|North Dakota||Exemptions may exist for manufacturing equipment depending on the situation.||North Dakota Department of Commerce|
|South Dakota||"South Dakota does not exempt Industrial or manufacturing equipment".||South Dakota Department of Revenue|
Sales tax implications of drop shipping by a manufacturer
A distributor or wholesaler will sometimes request the manufacturer to drop ship their product to either their location or to their customer’s location. If you are shipping direct to the distributor, and the product is considered tax-exempt for resale, then no tax is required – only resale documentation. But if you are shipping direct to the consumer on behalf of your customer, the sale is complicated by the possible combinations of nexus that can require collection or documentation.
Knowing what documentation you need to maintain for which states becomes a major challenge—especially as ship-to destinations may vary widely if your customer, the distributor, has you ship to customers in numerous states. As we have seen, whether the product itself is taxable or exempt is not always an easy question. But when a manufacturer drop ships, the freight, handling and/or delivery charges may also be taxable. Every state considers freight costs differently—some only tax a portion of the cost, others tax the whole amount, and some don’t tax it at all.
This research needs to be maintained by your tax department on a regular basis to ensure your business stays up-to-date with changes and new shipping locations as your distribution system grows.
Installation, repairs and sales tax nexus
Installation of finished items or even servicing working models can create sales tax nexus in states where your manufacturing or distribution center is not located. Each state has different determinations on what counts as installation or repair services and whether your service team entering the state and performing the job constitutes nexus and thus sales tax collection or documentation obligations.
To complicate the matter further, if you use a third party vendor to handle the repairs or installation of your products, you may have created a condition that constitutes nexus as well. Which portion of the services and how they are taxed, varies from state to state. Keeping track of this information for each state can readily become a nightmare for many manufacturers.
Knowing whether installation services and repairs constitute nexus and under what circumstances is critical when complying with any potential liability to collect and remit sales and use tax. When entering new states with any type of business activity, it is always wise to include a sales tax nexus study to assure whether or not you will be creating a sales tax responsibility by your activities in that state.
A repeatable, consistent process for sales and use tax compliance
As with other manufacturing processes, having a repeatable, consistent process with sales and use tax compliance means automation. Automating sales and use tax compliance with a solution that ensures that consistent, accurate process means a solution that delivers:
- Accurate sales and use tax calculations for collections that take into account product taxability, location, rules and regulations.
- An exemption certificate management process that enables digital collection and storage of exemption certificates as well as transaction association and timely renewals.
- Flow-through returns processing that provides a liability worksheet for review for each return filed, empowering your company to have oversight and visibility to all your sales and use tax liabilities and remittance.
- Best practices in managing your sales and use tax processes and easy access to all data in case of an audit.
- Up-to-date sales and use tax rates and information.
Using an automated solution for sales and use tax compliance helps manufacturers and distributors stay up-to-date with the latest changes in sales and use tax information. Consistency, repeatability and accuracy help to reduce audit risk and potential negative assessments. Critical features to look for in an automated solution:
- Easy integration with your back-end financial applications and/or inventory management software.
- Ecommerce integration capability.
- Geospatial technology to ensure “to the rooftop” level accuracy for locations.
- Accuracy and speed.
- Accessibility of information—anywhere, anytime.
SaaS sales tax management solutions can be cost-effective
When looking for a solution to help automate your sale tax process, numerous options are available. The options range from lookup tables to dedicated software located on a resident computer to Software-as-a-Service (SaaS) options. The benefits of using a SaaS solution include:
- Accuracy: Real-time, immediate calculations.
- Eliminate Burden on IT: Reduced or eliminated IT support.
- Reporting: Reporting and management of sales and use tax data and exemption certificates in a centralized database.
- Easy Access to Information: Accessibility of information during an audit.
- Cost Reduction: No new hardware or software investment.
In addition to these benefits, some SaaS solutions, such as Avalara’s AvaTax, provide seamless integration with your existing Enterprise Resource Planning (ERP) and financial applications. This capability enables you to associate exemption certificates with customers and transactions and provides ease of processing for your invoices including sales tax and/or exemption status. Having a certificate management system that enables you to have renewals tracked automatically, online collection and storage of certificates and simplified workflow with tax department oversight empowers your company to ensure a quality process. And that quality process will reduce your risk of exposure to audits and failure to file timely.
Avalara’s AvaTax gives you that control to implement a quality workflow process in managing exemption certificates; a method of applying sales tax, when appropriate; and a flow-through process for filling out sales tax returns and remitting any sales and use tax liability.
Contact us at: 877-780-4848