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Working with sales and use taxes - some problem areas.

State governments' ability to raise tax rates or impose new taxes for additional revenue is decreasing. At the same time, their need for additional revenue is increasing. To close this gap, states are attempting to collect unpaid tax through the audit process. One area many states have targeted is the sales and use tax.


The terms "sales tax" and use tax" are often used in the same context but are mutually exclusive. These taxes are similar because under both the tax is assessed and paid on the purchase price of merchandise. These taxes are often known under different names in different states ("retailer's occupation tax" in Illinois; "business license tax" in California; "gross receipts tax" in Indiana). The only difference between the two taxes is who collects and remits the tax: A seller or merchant collects the sales tax from a purchaser and remits the tax to the state; a purchaser must self-assess the use tax and remit it to the state.

Transactions that may be subject to use tax include:

[ ] Items purchased from an out-of-state mail order house.

[ ] A purchase from an out-of-state seller.

[ ] An item taken out of resale inventory for personal use.

[ ] Property brought into a state for use within that state without paying out-of-state sales taxes. This can occur even if the property is in that state for only a moment. This creates exposure to the use tax in multiple states.

State audit programs typically focus on sellers. Sellers may become liable for any uncollected tax, even if the purchaser was technically required to remit it. Practically speaking, it is important to collect the tax at the time of the sale, as it is very difficult to collect the tax later from a purchaser. This makes it incumbent on practitioners to advise clients of their exposure to sales tax. If they did not know that the tax affected certain sales and thus did not collect, they may find it impossible to collect after the state audits and assesses them.

Problem areas

While the concept of sales/use tax seems simple, problems arise as to what sales or purchases are exempt within a state and when a company is deemed to be doing business within a state. If a company is deemed to have a "nexus," it then becomes liable to collect a tax from its customers in that state unless

- it can show that the purchaser is exempt from the tax;

- the purchaser gives the seller a resale certificate indicating that it is purchasing the item for resale; or

- the purchaser gives the seller an exemption certificate that states that it intends to self-assess the tax.

States are increasing their attempts to create nexus for sellers, as it is much simpler for the state to collect the tax from one seller rather than from numerous purchasers. Some minimal activities within a state that have created nexus for a seller include:

[ ] Owning or leasing real estate or tangible personal property (even if it is raw land held by an individual).

[ ] Maintaining a business location for inventory.

[ ] Having resident or nonresident employees work in the state, regardless of how frequently.

[ ] Having company-owned trucks and personnel make deliveries into the state on a regular basis.

[ ] Having company employees attend a trade show in the state.

[ ] Having company-owned inventory molds or patterns in a state to be processed.

Each state has different rules as to what creates nexus. Some states take the position that nexus can be created through a subsidiary. This typically occurs when there is some common or shared management, such as:

[ ] Centralized parent/subsidiary purchasing.

[ ] Centralized parent/subsidiary financial departments.

[ ] Centralized parent/subsidiary advertising departments.

[ ] A common board of directors.

[ ] Intercompany sales or purchases.

One tax planning strategy that national retail chains are using is to set up mail order subsidiaries to avoid collecting the sales tax on the mail order sales. These subsidiaries might be set up in the lowest sales tax state or where almost all sales are to be out of state. Certainly, the subsidiary should be set up in a state in which the parent already has nexus or the subsidiary should avoid the five traits mentioned previously.

As states attempt to bring more companies under their jurisdiction, they become more creative as to what constitutes nexus. Some states have attempted to create an economic nexus for companies that regularly solicit sales into their market via catalog or other "junk mail" mailings. The theory behind this nexus is that these catalogs and junk mailings end up in landfills, thereby causing an economic burden on the state.

Some states have even gone so far as to create nexus teams to investigate the extent to which companies are doing business in their state. A point to keep in mind is that nexus for sales tax is created at a much lower level of activity than for income tax.

Another problem area is substantiation of those sales when the seller is not required to collect the tax, for example, a sale for resale. Keep in mind that a sales or use tax is imposed only on the end user of merchandise and is only payable once. So if a company is selling to a customer that will resell the item, no tax need be collected on the first sale. The tax will either be collectible or payable when it is sold to the end user or the end consumer. However, the fact that this sale is for resale and is not a taxable transaction has to be substantiated to the state in which the sale is made; otherwise the state assumes it is taxable. The normal verification for this type of sale is a resale exemption certificate. Each state has its own requirements as to what information must be included in such a certificate, but all states require that the purchaser's state registration number be included. Many also require the name and address of the buyer, date of certificate and/or signature on the certificate. The state generally will not investigate whether the item was purchased for resale or whether the purchaser paid the tax to the state. If the seller cannot show that the sale was exempt, he is liable. Therefore, it is the seller's responsibility to have the necessary documentation in order to prove exempt sales. A particular problem in this area is drop shipments.

Example: Illinois dealer D purchases an item for resale from New Jersey vendor V. The merchandise is drop shipped by V to D's customer in Wisconsin. D does not have nexus in Wisconsin, while V does. V would have to have a valid Wisconsin resale certificate from D or V would be assessed the tax by the Wisconsin Department of Revenue.

The problem is that D cannot provide a valid Wisconsin exemption certificate, as it does not have a Wisconsin resale number, which is required. To obtain a resale number, V needs to register with Wisconsin. This would normally also require V to file sales tax returns in Wisconsin, even though it does not collect tax or owe use tax, as it does not have a nexus in Wisconsin. There are a number of states that will allow D to present V with its Illinois resale number. However, there are a number of states that will not allow the vendor to accept any number except that state's number. These states (known as absolute requirement states) include the District of Columbia, Kansas, Michigan, New York, Oklahoma, Pennsylvania, Tennessee, Utah, Washington, Wisconsin and Wyoming. Most states allow the seller to get a statement from the buyer and some allow statements from the seller's salesmen.

One additional area of significant concern is the assessment of a sales tax on services. Some states subject maintenance contracts, repair services, data processing and management services to tax.

In most states, exemptions from the sales and use tax exist for sales to governments, charities, intercompany transactions, isolated sales and some special manufacturing machinery and equipment. As noted with drop-ship situations, sales in interstate commerce may be exempt.

Caution: States are holding "responsible officers" personally liable for these taxes in the same way in which the IRS does for payroll taxes.
COPYRIGHT 1993 American Institute of CPA's
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Copyright 1993, Gale Group. All rights reserved. Gale Group is a Thomson Corporation Company.

Article Details
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Author:Preston, Richard W.
Publication:The Tax Adviser
Date:Oct 1, 1993
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