5 Steps to Avoid Sales Tax Risk with M&A
As part of the financial terms of any potential transaction, you’re likely looking at the ratio of...
In most states, the performance of personal and professional services is not a taxable event. New Mexico, Hawaii, and South Dakota tax a variety of services. If the service you perform includes data processing, information analysis, communications, or the interstate movement of data you may be performing a service that is taxable in a number of states.
If your service involves the construction of real property or the installation of property, there are a variety of issues you must concern yourself with. Contractors owe tax on all the items of material they purchase. They are generally not permitted to purchase materials for resale. As with all rules, there some very limited exceptions to this rule.
Providers of non-taxable services have the obligation to pay tax on all the property they purchase to perform the service. For example, a contractor must pay the tax on all the construction materials they purchase. As a service provider, it is very important that the invoice submitted to your customer indicate what service is provided and that there is no segregation of property and labor on the invoice. Anytime items of property and serve are separated on the invoice it could appear that the property was resold and that tax should have been collected.
Construction services are generally non-taxable when billed to the customer
It would be difficult to provide an exhaustive list of the services that are taxable. Some of the uncommon services taxed by several states include:
Detective and investigatory services
Credit reporting and bad check lists
Pre-employment background checks and resume verification
Car storage charges
Armored car services
Criminal background checks
Even though most states don't tax services, it is still a prudent effort to verify that your service is not taxable before you start offering it.
Most states have both a "sales" and a "use" tax. When states refer to a "sales tax", they usually mean the tax charged to the customer by an in-state retailer at the time a taxable transaction occurs. Sales taxes can either be a "privilege tax" or an "excise tax." As a privilege tax, the tax is imposed on retailer for the privilege of doing business in the state. In these situations, if the retailer does not charge the sales tax, the retailer is usually the only party who can be held liable for failure to charge the tax (see Missouri sales tax law). As an excise tax, the tax is imposed on the property being sold. If the retailer does not charge the tax, the states can usually pursue either the purchaser or the retailer for the unpaid tax. (See Georgia sales tax law). In both situations, the retailer has the ability to collect the tax from the customer to cover their liability.
"Use tax" is a complementary tax to sales tax and is due whenever a taxable transaction takes place but the retailer failed to charge the sales tax. In most situations, we speak of use tax being due on purchases made from out-of-state vendors when they have failed to charge the tax on the sale. Use tax may be accrued and paid by the purchaser or it can be collected by the vendor. Many states consider the tax that is collected by a non-resident retailer to be "vendor use tax" rather than sales tax because the retailer does not have a regular place of business in the state. Other states consider use tax to be only the tax that is paid directly by the purchaser when the retailer does not charge the tax.
Use tax is one of the most misunderstood areas of multistate taxation and one area where state tax auditors generally make significant collections each year from unsuspecting taxpayers. In most cases, the rates of tax for sales and use tax are the same. In some states, the use tax may not include certain local taxes. In no situation, though, may the "use" tax rate of tax exceed the "sales" tax rate of tax.
For purposes of these FAQs, a multistate business is one that derives revenue from customers located in more than one state or buys inventory, supplies, and equipment from vendors located in more than one state. Under this definition, most businesses in the U.S. are multistate in nature. But just because you have a multistate business does not mean that you necessarily have a multistate sales tax responsibility.
If your client's company derives revenue only from in-state customers, but it purchases inventory, supplies, and equipment from vendors throughout the country, then your issue is going to be limited to determining the use tax liability on any taxable purchases made on which no tax was charged. Even though your client may not have customers in states, they may still have a significant use tax liability if non-taxed purchases of supplies, equipment, furniture, and other non-inventory items are purchases. As CPAs, we have the obligation to assist our clients in these matters.
In many cases, the answer to this question is "yes". If your client does not have sufficient physical presence in a particular state that would require them to collect and remit the tax, then the customer has the obligation to accrue and pay the use tax in the state where the property is used. If the property being sold is for resale to other customers, then your client should obtain and retain valid resale exemption certificates from their customers.
If, on the other hand, your client has sufficient physical connections with another state ("nexus") then that state can legally require your client to collect and remit the sales or use tax due on the transaction. There is really no way for your client to shift the tax remittance responsibility to their customer. In most states, the legal burden for use tax rests equally with the retailer (where they have nexus) and with the purchaser. Unfortunately, in many states the party that gets assessed for unpaid use tax is the party that is audited first by the state.
One of the few ways vendors can avoid being assess for failing to collect use tax is to obtain a valid resale exemption certificate or some other type of "direct payment" exemption certificate. Absent these documents, the vendor and the customer are on equal footing with regard to having a liability for the tax due on taxable sales and purchases.
One of the principle tenants of multistate sales tax is that all sales of tangible personal property are presumed to be taxable unless a specific exemption or exclusion from the sales tax exists in law. To further compound the issue, even though exemptions may exist, the burden to claim the exemption rests with the customer.
A sales tax "exemption" is a provision of law that specifically states that an otherwise taxable transaction is "not taxable" if certain conditions are met and if the vendor receives the appropriate exemption certificate from the purchaser. The most common exemption is the "resale" exemption that allows items of resale inventory to be purchased without tax. Without providing the vendor with a valid resale exemption certificate, though, the vendor is obligated to charge the customer sales tax.
Exemptions can exist at both the product level and the entity level. The resale exemption is an example of a "product" exemption. "Entity level" exemptions may include sales to the federal government, certain charitable organizations, state government agencies, and sales destined for
A sales tax "exclusion" is a transaction that has never been subject to tax. For example, many states exclude from sales tax any transfer incident to the formation or reorganization of a business entity. In most states, sales of services are excluded from tax unless specifically listed as taxable in the law.
Most states do not require that certificates be exchanged by the parties when a transaction that is "excluded" by law is entered into. In most cases, these transactions are generally recognized as being non-taxable by operation of law and do not require an affirmative claim by the purchaser.
If a transaction is not excluded by law, it is deemed to be taxable. As a taxable transaction, the only way a purchaser can obtain relief from either the sales or use tax that will be due is to provide the retailer with a valid exemption certificate that is specific to that transaction. In most cases, absent a valid exemption certificate, sales tax will be charged by vendors even though they may know the item is not taxable. Because the tax burden is on the retailer if they fail to collect the tax, their only obligation is to collect that tax or collect the exemption certificate.
This is a very common question and it also reflects an attitude that has cost businesses millions of dollars in taxes over the years. As stated earlier, all sales of property are deemed to be taxable unless valid exemption certificates have been received. If a resale certificate is issued to the seller and the purchaser uses the materials ways that are inconsistent with the resale certificate, then only the purchaser has a liability for the use tax due when the inventory was converted to a taxable use.
If no exemption certificate is issued to the seller, and an audit is conducted on the seller, the sale will be deemed to be taxable until a valid resale certificate has been received. In most states, it is permissible for retailers to obtain certificates for historical sales. Other states, though, only allow certificates to be valid from the date of issue forward. If a retailer fails to obtain a resale certificate and the customer to whom the property was sold is unable or unwilling to provide a resale certificate to the retailer after the sale, the retailer can (and will) be assessed sales or use tax on the transaction. In addition to the tax, interest and penalties will likely be assessed.
Assessments like this happen with great regularity. Many wholesalers have been assessed tax on transactions that everyone agreed were "resale" transactions, but since the wholesaler could not get a resale certificate from their customer, they were assessed the tax, interest, and penalties as if the transaction had not been for resale. This problem occurs most when customers go out of business after the sale or stop using the supplier. As mentioned earlier, the presumption of state sales tax is that every sale is taxable until a valid exemption certificate is issued.
Even though your client may only sell property in "resale" transactions, they should still implement a strict policy of obtaining and retaining resale exemption certificates from their customers. Collecting exemption certificates is vital for limiting liability even if they do not file returns in the state where the sale is made.
As mentioned earlier, all sales of tangible personal property are deemed to be taxable unless specific statutory exemptions are available for either the property being sold or for the purchaser of the property. Depending on state law, retailers either have the exclusive liability for uncollected sales tax or they share the liability equally with the purchaser. Unless the law specifically permits otherwise, in those states where nexus exists, any non-taxed sales must be supported by a properly executed exemption certificate. The variety of certificates and the exemptions available will vary by state law. The most common exemptions may include the resale exemption, exemptions for certain items of manufacturing or processing equipment, exemptions for repair parts, exemptions for certain types of medical devices, and exemptions for sales to certain non-profit organizations.
Because all sales of tangible personal property are deemed to be taxable, the failure of the retailer to obtain and retain exemption certificates to support sales which are not taxed can have a significant detrimental impact on the retailer. One of the most common audit finding and reason for assessment of tax, penalty, and interest is the failure of the retailer to have the appropriate exemption certificate. In most cases, it makes no difference if everyone agrees that the transaction is not taxable, the only legal way to support the failure to charge tax is to have the appropriate exemption certificate.
In many cases, state law permits retailers to obtain certificates after the fact from customers. Under audit, though, a company may only have a limited time to obtain the certificates. If a customer is out of business or is not on speaking terms with the retailer, the odds of obtaining a certificate is very low. All non-taxable sales which are unsupported by a proper certificate are deemed taxable. As such, the retailer is held responsible for the tax that should have been collected.
Many customers try to pass exemption certificates that are not signed, not dated, or have the FEIN shown rather than the proper state registration number. In most cases, these certificates will be rejected by the auditors.
Vendors are required to assume that all sales are taxable until the customer provides a valid exemption certificate. The only way to have the vendor stop charging tax is to provide them a valid exemption certificate.
In most cases, exemption certificates do not expire. Other states, (i.e. Florida) require that exemption certificates be updated annually. As a matter of business practice, exemption certificates should be updated no less frequently than every 5 years. In addition to keeping retaining the new certificate, you should also retain the certificate that is being replaced. If you have the space, you may want to recommend that clients keep certificates to cover 10 years worth of sales transactions. In most cases, this period is beyond the period that most states would audit. In some cases, the use of an automated services may be a cost beneficial alternative to managing the certificates manually.
As mentioned in Section 1, nexus is the term most frequently used to indicate that a company has established a sufficient connection with a destination state which allows that state to require the company to register, collect, and pay the sales or use tax in the destination state. In fact, once a company has established nexus, the state can compel it legally to collect and remit the tax.
A complete analysis of all the nexus creating factors is well beyond the scope of this material. When all the court cases, rulings, and regulations are distilled into a few salient points, it seems clear that for a company to have nexus with a state it must have some type of physical connection with the state. This connection can be made by owning or renting property in the state, sending salesmen and other company employees to the state to transact business, and having agents represent your company in the state.
One of the most common misunderstandings about nexus is the belief that some type of permanent presence is necessary before an out-of-state retailer has an obligation to collect and remit sales tax. Not the case. In many cases, the presence of salesmen, repair personnel, or other business executives in the state for two, three, or four times during a year will create the nexus needed for the destination state to require this company to register.
Nexus is also created at the "entity" level and not the "transaction" level. That is, a company may have multiple divisions or multiple lines of business all under the same legal entity. If any one of those divisions or lines of business creates nexus in a state, all the other divisions and operations will also have nexus in the state.
Eventually, yes. Once nexus is established, states usually require that the registered company collect and remit the sales tax for at least 2 years. Most of these decisions have been informally developed and are not found in statute. Requiring a company to collect sales tax and file returns after nexus is terminated is recognition by the states that the market development activities created in the states when nexus existed has a residual affect that will last for some period of time. From personal experience, it can be somewhat difficult to cancel a registration with a state once a company is registered. In most cases, once nexus is established and business is established in a particular state, there is a greater chance that business will expand in that state and not decrease.
Yes. There could be a variety of reasons that would allow a state to require a company to register for, collect, and remit sales tax in a particular state. In most cases, the reasons for a state being able to exert this type of requirement may have nothing to do with nexus. For example, several states require companies who desire to obtain a contract with the state government that all related entities must register with the state and agree to collect and remit sales tax on sales made in that state.
Another way states require non-resident companies to become compliant with the state's sales tax laws is in the area of drop-shipments. A standard drop shipment involves the retailer's supplier shipping materials directly to the customer of the retailer. If this shipment takes place in a state where neither the supplier nor the retailer have nexus, the customer may be the only party the destination state could hold liable for the tax. If, however, the supplier has nexus in the destination state, the supplier will be required to charge the retailer sales tax on the sale unless the retailer can present the suppler a "resale exemption certificate" for the sale. In most cases, the retailer does not want to pay the supplier tax since the tax charged would be on the wholesale price and would increase its cost of sales.
To avoid being charged the tax, the retailer will likely be required to provide the supplier a resale certificate with a registration number issued from the state where the shipment is being made. To obtain such a number, the retailer will need to register with the state. Once registered, most states will require that company to collect the tax on its taxable sales to the customer. Therefore, even though the retailer does not have nexus, for it to avoid being taxed on its wholesale price of the goods delivered, it is likely that the state will require it to register and collect the tax.
This is a frequent occurrence for resellers of telecommunications services. In these cases, the transaction is an electronic drop shipment of communications services versus a physical drop shipment.
The first step in analyzing this situation is to carefully evaluate whether nexus existed between the retailer and the state where the sale took place. If nexus did exist, carefully examine the transaction to determine what is, in fact, taxable. If you have concluded that nexus exists and that the transaction is taxable, the next step may be to contact major customers to determine if they paid use tax on those transactions. In most interstate transactions, the purchaser and the retailer have an equal responsibility for the payment of tax on the transaction.
If customers have not accrued the tax, you may consider billing your customer for the tax that was not charged. This strategy is almost never used for taxes more than a few months delinquent since the loss of a customer of such an issue could be far more damaging to the business than the payment of tax directly by the company.
Under audit, non-registered businesses can be assessed tax for many years of the past due taxes. A few states limit the look-back to seven years but other states will go back much further if they suspect fraud or some willful negligence. In addition to the tax, states will impose interest which averages 12% a year and penalties which can be 25% of the tax due. To avoid such and economic hit, many states allow unregistered taxpayers to come forward under a "voluntary disclosure program" that will limit the look-back period to three or four years and usually has a provision to abate the penalty. These are best done through an intermediary such as a CPA who can approach the states anonymously.
If you wish to become registered with the state and you owe taxes from prior periods, DO NOT complete the registration application without doing a voluntary disclosure. On most applications, you have to tell when you started doing business in a state. If you answer correctly, the state will process your application and probably schedule you for audit or send you an assessment for the past due taxes.
If you answer incorrectly and state that you are just now starting to do business in the state, you are committing fraud and could face criminal and civil penalties. If you mail the application, you could be committing mail fraud which is a federal crime.
Failing to respond in some way to a known liability can be a very expensive option to use as a way of addressing the problem. For more detailed information on the voluntary disclosure program, please see the documents on this subject in the SalesTaxHelpCenter.com document library.
Most states have statutes that hold corporate officers or other "responsible parties" personally liable for the sales or use tax that was not collected. In some cases, states impose severe criminal penalties for officers who collect tax but do not remit the tax collected.
This liability attaches to the officer and the liability can be enforced through the lien, levy, and sale of property to satisfy the debt.
Acquiring either the assets of stock (equity) of a company that may have a liability for past due taxes creates what is commonly known as "successor liability". That is, the acquiring company takes on the same risk and liability that the target company had. Acquiring the assets of an entity does not prevent this liability from attaching unless specific statutory procedures are followed. In many states, notices of bulk sales must be filed before a business can be sold. Further, purchasers may be required to withhold certain amounts of the purchase price until an audit has been done of the target company.
It should be noted, that provisions in purchase contracts that attempt to limit the liability of the purchaser for unpaid tax are ineffective and not binding on the state. Any time a business is acquired, careful diligence should be conducted to identify and quantify the sales and use tax risks of the company.
The risks inherent and penalties that your client could be subjected to start with an analysis of whether the company had nexus with a particular state. If nexus did not exist, then the state has no jurisdiction over your client and has no ability to compel your client to pay any type of tax.
On the other hand, if your client had/has nexus with the other state, then that state can use any means at its disposal to enforce the tax liability against your client. This can include assessments against your client, the levy of any property in the destination state, filing collection suits in court, using collection agents to collect the debt, or using the courts in the home state to enforce a valid legal judgment from the courts in the destination state.
If your client is ever contacted by another state, be responsive and pay attention to all the dates and deadlines in the notices. If your client has nexus in the destination state, that sate has the same authority to enforce assessments and judgments against your client as the home state does.
Companies that sell and install software and provide other computer related services have a variety of issues they should be concerned with. First, many of these companies have nexus in many states and do not realize the significance of this connection with the state.
Further, almost all states tax computer software licenses when the software is delivered in a tangible fashion on tape of disk. In addition, more states are taxing software when it is downloaded electronically. For years, the electronic delivery of software was an effective way to minimize the sales tax. In some states, this technique still works.
In addition to states taxing downloaded software, a few states now tax custom software and many of the consulting services that are used to implement the software when sold.
For companies that provide data processing, there are two separate issues they would need to concern themselves with. First, the company must still have nexus with the state where the customer is located before they would have an obligation to collect any taxes that may be due. Second, an analysis should be completed to determine if the service is taxable. There is not an established definition of what constitutes "data processing." States may tax consider these services to also be "information services" or "computer services".
There are less than 15 states that tax data processing, information processing and computer services. There may also be special tax rates for these services or special limited exemptions for these services.
The taxation of software maintenance agreements is more difficult that one would first imagine. A thorough analysis of this subject can be found in the SalesTaxHelpCenter.com document library. In summary, the taxation of these agreements depends on whether the agreement is optional or mandatory, whether the technical assistance is priced separately than any upgrades that may be included with the maintenance agreement, whether the upgrades are delivered electronically or delivered in a tangible form, and whether there is a contractual obligation to deliver the upgrades or whether the upgrades are at the vendors discretion.
Because it is an industry standard to include software upgrades and technical assistance in a single maintenance contract price, a few states have elected to tax these contracts at some reduced tax base. Some states tax the contract at 50% of the price.