Sales and Use Taxes (#229)

In this podcast episode, we discuss sales and use taxes. Key points made are noted below.

Sales Tax Basics

Sales tax is charged when there’s a sale of tangible personal property, which is to say, most anything but real estate. And it can also be imposed on the sale of some services. The seller collects the tax and remits it to the government, which in the United States is usually the applicable state’s Department of Revenue. That much seems simple, but then things get more complicated.

The seller only has to collect sales tax if it has nexus, which means that it has regular and systematic contacts in an area, usually through its employees or property. That means the seller has to collect sales taxes if, for example, it maintains a warehouse in a state, or its salespeople travel to a state to solicit sales, or it uses its own vehicles to transport goods into the other state. If this is not the case, then the seller does not have to collect sales tax. Instead, the buyer has to pay the government the sales tax, except now it’s called use tax. Also, the use tax is paid to the government where the buyer is located, not to the government where the seller is located.

So in other words, some sort of a tax is always paid, except that the name of the tax may change, and the government to which the tax is being paid may also change.

Sales Tax Exemptions

But of course, the situation gets even more complicated. Then we have sales tax exemptions. Each state has its own list of exemptions where you don’t have to pay sales tax. And it’s a long list. I looked up the exemptions list for the State of Colorado, and it’s 20 pages long. For example, no sales tax is due when selling firewood or propane for residential use. Or, alteration services are not taxable, as long as they’re billed separately from the sale of clothing. Or – and I like this one, it nearly defines what a bureaucracy does for a living - water sold through a pipeline is not subject to sales tax, though bulk water sold in tanks is subject to sales tax. Go figure.

The point is, there’re many exemptions from sales tax, so you have to check the rules that apply to wherever you have nexus. And on top of that, some buyers have sales tax exemption certificates.

These certificates authorize a buyer to not pay sales tax, either because of the manner in which it’s using acquired goods, or because of the nature of the business. For example, the purchases made by a farmer are usually tax-exempt, because the purchased goods are then used to grow crops. Or, the raw materials bought by a manufacturer are tax exempt, because they’ll go into finished goods that will then be sold, and the buyer of those goods will pay sales tax. Or, the nature of the business may allow an organization to avoid paying sales tax. This usually means governments, religious institutions, and non-profits.

When the seller receives one of these sales tax exemption certificates from a buyer, the seller needs to keep a copy of the certificate, in case its books get audited by the government and it needs proof that it acted correctly. If the exemption is out of date or was only partially filled in, the auditors can declare the certificate invalid, in which case the seller is now liable for the full amount of the sales tax that it didn’t charge the buyer.

And it gets better. Even when the seller has received an exemption certificate, the seller is not necessarily off the hook for sales tax liability.  The seller has to use his best judgment to see if a sale falls within the restrictions imposed by the exemption certificate. If a buyer tries to buy something that’s outside of the exemption range, the seller is supposed to figure this out and charge sales tax. And that really means that the sales clerks who are taking care of these sales have to be trained in how to deal with exemption certificates – which they probably aren’t. Instead, it’s quite likely that they’re relying on what the customer tells them, which may not be accurate.

Layers of Sales Taxes

But of course, it gets even better. Sales taxes can come in multiple layers. There’s the state-level tax – except for states that don’t have any sales tax – and there’s the county-level tax and the city-level tax, and there’re probably one or two special tax districts inserted in there somewhere, too. An example of a special tax district is one that’s intended to pay for a new sports arena that the taxpayers voted for. Once the bonds are paid off, this type of special district goes away. Other districts, like transportation districts that pay for a subway or light rail line, are more likely to be permanent. In total, there’re about 10,000 government entities in the United that can charge sales tax. The clear champions for tax districts are Texas, with more than 1500 of them, and Missouri, with more than 1200.

Each of these tax districts gets to charge its own tax, which is piled on top of the sales taxes from the other tax districts to create the aggregated sales tax that a person or a company actually pays when making a purchase. If any one of these districts changes its tax rate, that changes the tax rate that the seller charges when it sells goods. As you might expect, tax rates usually go in only one direction, which is – up. Therefore, if the seller doesn’t keep up-to-date on the latest sales tax rates and keeps charging the old rate to its customers, it may find that it’s been under-collecting sales tax. And when this is the case, the seller has to come up with the shortfall.

Overcharged Sales Taxes

In those rare cases where the seller has been over-charging sales tax, it cannot keep the overage. Either it returns the excess to the customer or it forwards the excess to the state government.

Private Letter Rulings

What if an organization is in an unusual line of business that doesn’t seem to be covered by any of the sales tax regulations? In that case, you can request a private letter ruling from the state government. To do that, you send them a letter that describes your circumstances – along with a fairly hefty fee – and they send back a ruling. You can usually rely on this ruling in deciding whether to charge sales tax.

In addition, the state government then deletes all identifying information from the ruling and then posts the letter on-line for everyone else to see. The private letter ruling can only be relied on by the business that asked for it, but everyone else can use the ruling to make an estimate of how the letter pertains to them. I strongly suggest bookmarking the page on your state’s website where these rulings are listed, and checking it every now and then to see if any new rulings have been posted that might apply to you.

Use Taxes

Let’s switch topics, to the use tax. How do you calculate it? The most labor-intensive approach is to review every single supplier invoice to see which ones don’t contain a sales tax and aren’t covered by an exemption certificate, and then accrue an expense for the use tax on the remaining invoices.

To save time, create a report in the accounting system that aggregates all invoices coming from out-of-state suppliers. Then include a flag in the vendor master file for all of the out-of-state suppliers that still charge the company a sales tax, and use this flag to exclude those suppliers’ invoices from the report. Then use the same approach to flag suppliers that only ship goods that are exempt from sales tax.

After you’ve completed these refinement steps, the total use tax due on the final report should be fairly accurate.

Sales Tax Payments

And one final comment. Sales tax payments usually – but not always - go to the state government, which turns around and allocates a portion of each payment to the applicable county, city, and special tax districts. This makes the remittance of sales taxes fairly easy for the seller.

This is not always the case for the payment of use taxes. You may need to make separate use tax payments to each one of those entities. That means a separate use tax payment to the state, and the county, and the city, and each one of the special districts.

In short, I think you can consider the sales and use tax regulations to be a sort of full employment guarantee for accountants.

Related Courses

Sales and Use Tax Accounting