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The fundamentals of sales and use taxes; states are turning to sales and use taxes to meet growing revenue needs.

For many years, sales and use taxes were the poor country cousins of the federal income tax. The taxes seemed simple enough; even the forms appeared relatively unsophisticated--no run-on sentences or allusions to obscure code sections. And if the taxpayer made a mistake, the dollar amounts were never material.

In the last decade, business exposure to sales and use taxes has exploded as a consequence of changes in technology, national marketing, purchasing and transportation pattern. Today, even small and midsized businesses find themselves exposed to increasingly confusing and complicated sales and use tax regulations.

For business owners, this means the city or state government has joined Uncle Sam as a business partner. For CPAs, it means more work, more opportunities for planning and--perhaps most important--a chance to expand into an area for which there is a growing demand. One common planning opportunity is the location of manufacturing facilities. Some states and localities offer sales tax exemption on purchases of equipment used in manufacturing.

This article reviews

* The basics of sales and use taxes.

* The transactions subject to tax.

* How the tax base is defined.

* Who pays the tax.

* Some prominent exemptions.


Sales and use taxes complement each other, but each is distinct and has its own grounding in constitutional and tax theory. Nevertheless, both are excise taxes, largely on tangible personal property and certain specified services. Briefly, sales tax is a transaction tax on some services and the exchange of personal property; use tax is a levy on the storage, use or consumption of any items that have escaped sales tax.

Here's a simple example. A company buys to filing cabinets from a local office supply store. If the cabinets cost $300 and the state sales tax rate is 3%, the total price is $309. (In all likelihood there also will be a city and perhaps a county sales tax.) However, if the company buys the same cabinets from an out-of-state supplier that does not have a location (nexus) in that company's state, the purchase likely will escape sales tax. The compoany instead will owe use tax (usually at the same rate as the sales tax) on the storage, use or consumption of the cabinets to the state in which it is located.

The theory behind this scenario is quite simple.

* States refuse to lose revenue simply because an otherwise taxable purchase was made out of state.

* In-state retailers believe a use tax creates an even playing field between them and out-of-state retailers.


In general, taxes commonly apply to exchanges of tangible personal property; specific services such as room rentals, meals, telephone and telegraph services; and sales of utility services such as gas and electricity. Usually the term "tangible personal property" is unhelpfully defined as anything other than real property. Excluding real property such as buildings and intangible property such as contracts, stocks and bonds, personal property includes almost all other tangible, movable objects, including cars, trucsk, furniture, clothes, computers, books, magazines, food, drinks, supplies and machinery and equipment.

The biggest problem is determining if a particular sale is one of tangible personal property, real property or services--or a combination. Making these distinctions can be critical for some businesses.

Building contractors. A plumbing contractor may be required to pay sales tax on all purchases of plumbing supplies when working on real property contract jobs. In many states, the contractor is deemed the final consumer of any tangible personal property used in a real property contract and thus is required to pay sales tax or accrue use tax on al purchases. When the job is completed, the tangible personal property disappears, becoming part of the real property.

On the other hand, if the contractor also has a retail store, he or she may be allowed to buy all materials tax-fre, charging sales tax to retail customers and accruing use tax on the inventory used in real property contracts. Finally, the plumber may have house calls or other noncontract work for which billing is done on a time-and-materials basis. In this instance, tax may be charged only on the sale of parts, not on labor. Here again, the plumber would buy supplies tax-free and charge sales tax on parts' sales.

Contractors who work on local, state or federal government jobs face another problem. Are purchases of materials used in building a post office, for example, exempt from sales tax since it's government contract? Generally not, unless the contractor officially represents the government as purchaser. But again, state laws vary; some states offer exemptions on real property contracts for government entities.

Computer software. Questions about the definition of tangible personal property are particularly evident in the way states handle the taxation of computer software. Is a software purchase a sale of property or an intangible? Does it make a difference that the buyer could have purchased the software by downloading it over a modem?

Most states have confronted the software taxation problem by taxing canned or off-the-shelf software but exempting custom-made software as a service sale. While this certainly makes it easy for the purveyor of off-the-shelf video games, it leaves a gray area as to how much service is required before the sale is tax exempt.

True object test. One of the most useful tools in determining the type of sale is the "true object" test. If the true object of the transaction is the tangible personal property rather than the service per se, the transaction is taxable. For example, an enormous amount of labor goes into assembling a new car, but even if the labor cost far exceeds the material cost, it's clear the consumer wants the car, not the labor. Thus, the sale of the car is subject to sales tax. This contrasts with a tax return prepared by a CPA or a will drafted by a lawyer; the true object of the transaction is the service, and the paper is merely the means of conveying that service.

The true object test, however, suffesr serious deficiencies when the purchase is a mixed sale and service transaction. Some mixed transactions are easily handled. Auto repair, for example, is usually billed separately as parts and labor with sales tax on the parts. But what of the wedding photographer? In years past, wedding photographers would photograph a wedding and in some states charge sales tax on the pictures. Now they film weddings on video-tape. Does this make a difference? Should there still be sales tax on the video? What if the photographer uses two cameras and does some minor editing? Or adds music? Examples such as this make it clear the true object test falters when the buyer's true object is both the service and the tangible personal property.

Many states are adding to their list of taxable services or, in some cases, simply moving toward taxing all services. Economists have argued taxing tangible personal property but not services is discriminatory. State legislatures, pressed for cash, are more sympathetic to the idea that as the economy becomes more service oriented, tax laws should change accordingly. Most taxpayers would benefit from skillful guidance in this area; CPAs would do well to develop the necessary expertise.


Closely related to problems of defining property and services is the question of the amount subject to tax, or the tax base. Generally defined as the sales or purchase price, it will always be spelled out in some detail in local statutes. For example, the definition of purchase price usually allows for trade-in allowances. Thus, if a consumer buys a new car for $15,000 and gets a trade-in allowance of $4,000, sales tax is due on the adjusted sale price of $11,000.

Discounts and cash rebates offered by a retailer usually reduce the sales tax base. However, the same discount, coupon or rebate offered by a manufacturer may not. The reason given for this distinction is the retailer is not reimbursed, and so the discount is a true reduction in the sale price. With manufacturer coupons, the manufacturer reimburses the retailer.

Bad debts, installment sales, repossessions and shipping charges are four more items often affecting the tax base. Unfortunately, the variety of state responses is staggering and individual state statutes must be consulted. For example, bad-debt treatment varies depending on whether sales tax is on a accrual or cash basis or a combination and depending on the federal income tax treatment.

Shipping and other transportation charges often are considered part of the purchase price and thus subject to tax. Since sales tax is a tax on a specific transaction, when and where title passes can be crucial. Attention must be paid to whether the sale is free on board (FOB) shipping point, FOB destination or even who bears risk of loss. Unnecessary tax liabilities can accrue to clients who misstep in these areas. Proper review and planning are crucial. For example, a company may be able to avoid including freight charges in the taxable price by separately stating them and providing that all sales be FOB shipping point.


Whether the tax is a sales tax or a use tax, most states require the purchaser to pay and the retailer to collect the tax. Generally, retailers are obligated to collect tax from a purchaser unless the buyer has a so-called resale or exempt number. Failure to collect the tax usually means the retailer will be held responsible for it. Getting a resale number may not be enough to relieve liability; it must be accepted in good faith. Unfortunately, "good faith" is not generally defined by the statutes. In one clear violation, a store was held liable for sales tax on weed killer sold to a mortuary. The court thought it ludicrous the seller believed the weed killer was for resale.

Whether a state can require a retailer to collect its sales and use tax depends on whether the retailer has nexus with that state. In the words of the U.S. Supreme Court, "The simple but controlling question is whether the state has given anything for which it can ask return."

Traditionally, nexus has been defined as a physical presence, such as an office or salespeople, in the state. In 1967, the Supreme Court ruled National Bellas Hess, a Missouri company having only mail-order sales with deliveries by U.S. mail or common carrier, lacked sufficient contact with the state of Illinois for it to be required to collect its tax. Even if deliveries are made in company trucks, no nexus may result.

Given changes in communications technology--computers, fax machines, cellular telephones--many states are arguing for a revised definition of nexus. They say physical presence is an obsolete definition; economic presence is what really counts. Many states are calling for mail-order companies to be required to collect their use tax. Federal legislation repeatedly has been introduced to approve this; none has passed.

States are advancing their cause through multistate agreements, aggressive tax enforcement and increased litigation. Questions have been raised about the constitutional differences between a sales and a use tax, the commerce clause (the consitutional provision that gives Congress the power to regulate commerce between the states), due process and, more generally, the evolution of tax law in light of dramatic changes in communications, transportation and other technologies.

At least 31 states have passed legislation overrulin the traditional definition as stasted in National Bellas Hess. Already, cases about some of these expanded definitions are heading toward the Supreme Court. For example, the Court has been asked to review Quill v. North Dakota. There, the North Dakota Supreme Court held Quill, a Delaware mail-order company, had nexus with North Dakota due to its substantial economic presence in the state. This presence included almost $1 million in sales, 230,000 pieces of mail and various software licensing agreements. Whether the Supreme Court will accept these and other technological changes as sufficient to create nexus remains to be seen.


Exemptions to sales and use taxes usually fall under one of two categories: those exempt by definition or by specific legislative enactment. An example of the former is a wholesaler and of the latter, foor or clothing. Since most states require sales tax only on retail sales, wholesale transactions are exempt by definition. Food and clothing often are exempt by legislative grace to make the tax less regressive. In either case, any exemption claimed must be specifically authorized or implied by the statutes.

In addition to relieving the regressive nature of the tax, legislatures often pass exemptions to encourage busienss investment (machinery and equipment exemptions), to discharge constitutional prohibitions (sales to the federal government), to promote tax equity among taxpayers and to satisfy special interest groups. Agricultural states, for example, usually exempt seed, manufacturing states exempt machinery and so on. Finally, some exemptions exist simply because they are akin to motherhood, home and apple pie. The most prominent are sales tax exemptions for purchases by churches and other nonprofit charitable groups. However, sales by these groups usually are subject to sales tax like any other retailers.

Perhaps because of the number and variety of exemptions, many small businesses remain ignorant of the exemptions to which they are entitled. CPAs should regularly review client operations in light of not just state but local sales and use tax exemptions. Many small businesses, for example, are unaware of manufacturing and machinery exemptions. Most states allow a manufacturing exemption for sales of personal property that become an ingredient of tangible property that itself will be sold. Generally, the personal property both must be completely consumed in the manufacturing process and must become a physical part of the product. The theory is the ingredient items were actually purchased for resale and thus should be exempt.

A chemical used both as a catalyst and an ingredient in manufacturing probably will be exempt from tax only to the extent it is an ingredient. Some states, however, look at the ingredient's primary purpose, and if that purpose is to become a part of the product for sale, the chemical will be exempt from tax. Thus, ice used to keep sausage meat cold is taxable while ice used to provide the meat's water content would be exempt.

In addition to the manufacturing exemption, some states exempt machinery used in processing, manufacturing or mining on the theories

* It encourages further investment and expansion.

* It attracts manufacturers to the state.

* Failure to do so will result in a cascading or pyramiding of the sales tax. (Pyramiding of sales tax occurs when tax is paid on each ingredient of a final product, which is itself subject to sales tax.)

Machinery exemptions often are restricted to machines that act directly on a manufactured product. Machines that test the product or move it along the assembly line may not be eligible for exemption. The primary recurring controversy in both the manufacturing and the machinery exemptions is in distinguishing between operations taking place before or after manufacturing and the manufacturing process itself. Many states also exempt the consumption of electricity, fuel, gas or other energy consumed directly in a manufacturing or production process.

In all these areas--manufacturing, machinery or energy--careful attention must be paid to the precise meaning of manufacturing, processing and refining because the exemption eligibility often rests on a proper definition of the activity. CPAs should review the statute application to processing and manufacturing clients.

This discussion of exemptions has been necessarily brief and serves only as an introduction. The wide variety of exemptions is beyond the scope of this article. Exemptions often exist for tobacco sales subject to separate excise taxes, containers and labels, prescription drugs and prosthetic devices, water sales, livestock raised for breeding, animal feed and orchard trees, among others.

A host of smaller exemptions and possible pitfalls varies from state to state and can result in either large refunds or assessments for unkowing taxpayers. Most states, for example, tax magazine subscriptions and exempt packing material. Subscriptions probably are not significant for the usual Mom-and-Pop outfit, but heavy assessments can result for small high-tech companies that maintain large libraries. On the other side, refunds may await small manufacturers that mistakenly have been paying sales tax on labels, tags and other packing materials.


Businesses' growing exposure to state sales and use taxes coupled with states' growing financial needs has created both planning opportunities and dangers for taxpayers and their CPAs. Sales and use taxes have become a "growth industry," and smart CPAs will position themselves accordingly, not only to better serve their clients but also to better market themselves in a growing and complex area of tax law.

BRUCE M. NELSON, CPA, is a revenue agent with the Colorado Department of Revenue in Fort Collins. He is a member of the American Institute of CPAs, the Colorado Society of CPAs and the Academy of Accounting Historians.

Mr. Nelson is an employee of the Colorado Department of Revenue. His opinions, as expressed in this article, are his own and do not necessarily reflect those of the department.
COPYRIGHT 1991 American Institute of CPA's
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1991, Gale Group. All rights reserved. Gale Group is a Thomson Corporation Company.

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Author:Nelson, Bruce M.
Publication:Journal of Accountancy
Date:Dec 1, 1991
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