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Audit Notes: Sales Tax Exempt or Just Non-taxed?

author photo of Lloyd Geggatt

Two couples live side by side in identical houses and the husbands work in the same office doing the same job. They appear to be identical, but they differ in one important way―one couple has a wedding license and the other doesn’t.

The same is true in the sales tax world. Two transactions can have exactly the same fact set but be treated completely differently for sales taxes just because of a piece of paper. If two different companies each buy a desk from me and they each tell me it is for resale but they each use the desk rather than sell it and only Company A gave me a resale (exemption) certificate, then I will be liable for tax on the sale to Company B. Sellers must be certain they have proper support for every transaction on which no sales tax is charged if those transactions are to be accepted as exempt during an audit. Otherwise, those transactions are simply “non-taxed,” a condition the auditor will soon rectify.

Obtaining a piece of paper for every untaxed transaction isn’t always the answer. Transactions can be exempt from sales tax due to the nature of the buyer, the nature of the goods or services being sold or by the nature of the use. An exemption certificate is not always the proper support in every situation. Sellers must recognize why a certain transaction is exempt in a particular jurisdiction and understand what support is required for that transaction in that state. Please note the italicized phrase―the same transaction may or may not be taxable in different states and the required support can differ between states.

Collecting the Right Documentation

Nature of the Buyer

Sales may be exempt from tax because of who the buyer is. Some states exempt sales to nonprofit organizations. In many of these states, the proper support for sales to this class of buyer is a copy of a state-issued document whereby the state has recognized the buyer as qualifying for tax-exempt status. There is no standard “exemption certificate” per se that the seller can accept regarding the nature of the buyer that will be valid support at time of audit:

Wyoming requires the Streamlined Sales and Use Tax Agreement (SSUTA) Certificate of Exemption which needs only the non-profit organization’s identification number. However, Massachusetts requires nonprofit organizations to present both an exemption certificate (ST-5) and the state issued certificate of exemption (ST-2). [A Form ST-2 must be provided with the application or else a state-issued exemption number.]

Nature of the Goods or Services

Sales may be exempt because of what is being sold. Some states do not tax services and labor charges in general; some states do not tax food at all or under certain conditions. For these types of transactions, there is obviously no exemption certificate the buyer can provide since the exemption is based solely on what is being sold. The seller must be diligent in documenting the precise nature of the transaction.

A grocery store in California selling an apple may be able to easily show evidence that the transaction good is exempt; whereas a bicycle shop assembling a bicycle may not. The grocery store most likely has a receipt with a description and perhaps a universal product code (UPC) printed on it. For the bicycle shop, things get complicated.

California taxes fabrication and assembly labor but exempts repair, installation and re-assembly labor. So if the bicycle shop assembles a new bicycle for a customer as part of the original sale, the assembly is considered to be performing fabrication labor and is therefore taxable. If the customer comes back with all the parts in a box because he tried to do some work on it, and the same retailer re-assembles the bicycle, the charge is exempt from tax. In both cases the invoice should be descriptive and detailed enough to establish the circumstances so that the taxability of the service is evident during an audit.

Nature of the Use

Sales can be exempt because of how or where the goods will be used by the buyer. The most common example of this, and the most common type of non-taxed sale, is a purchase for resale. The generally accepted and required support is a resale (exemption) certificate on which the buyer affirms the purchases will be resold in the normal course of business. However, some states allow the non-taxed sales to be supported by alternative methods―statements from the buyer after the fact, number and quantity of sales made to the same buyer, etc.

The primary difference between a timely resale certificate and the alternative methods is that the resale certificate completely absolves the seller of any liability if the buyer is found to have made a taxable use of the goods while there is no such blanket protection in the other methods. In addition to having the certificate, the protection only applies if the certificate meets all the specific state’s legal requirements for form, content and good faith.

Hang On To Them

As demonstrated by these examples, it is one thing to make a non-taxed sale; it is another to make a sale that will be accepted as exempt. The seller must obtain and retain proper documentation to support or prove the circumstances of the transaction as appropriate for an exempt transaction.. Note the emphasis on the word “retain.” A supporting document is worthless if it cannot be produced upon request by the auditor. For some companies, storage and retention of the certificates is more difficult than obtaining them in the first place.

Don’t Throw Out The Old

The other thing to remember about retaining certificates is to not discard the old one if/when the files are updated. Those old certificates will be needed to support sales made prior to when the new certificate is dated.

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Comments

7 Responses to Audit Notes: Sales Tax Exempt or Just Non-taxed?

  • Posted by Paul on September 19, 2012 4:50am:

    Lloyd- Our MN hydraulic pump mfg co is going through a CA sales tax audit next week and they are going back 8 yrs. We are unable to contact approx 10 customers to get their sales exemptions because they have gone out of business. We do have customer records on file for these companies indicating whether they are a mfr, distributor or end user and probably could access their old website in some cases to determine their business status above. Will we be liable for sales tax on these out of business customers of ours if we can somehow show that they were not an end user despite being unable to produce a signed exemption?
    Thanks!
    Paul

    • Posted by Author photo of Lloyd GeggattLloyd Geggatt on September 19, 2012 5:26am:

      Paul - Hard to predict how any given auditor is going to deal with situations like yours and what they will or will not accept. You are on the right track by accumulating the type information described. CA auditors should also accept sales for resale even when a resale card is not on file if the sales can be supported based on "number and scope". This means that if the customer is buying 100 pumps from you every week, it is rather obvious they wouldn't be consuming/using them. Of course a one time purchase is at the other end of the spectrum. So I would prepare a schedule for each of these 10 customers with the dates of sale and number of units. If it looks like "number and scope" fits, present it; if not, don't.
      Some auditors will go so far as to research what the customer reported on their sales tax returns in an attempt to determine if it reasonable to belive the purchases from your company were reported by them.
      One other thing that may help you persuade the auditor is how well your other exempt sales are supported. If you have all other non-taxed sales locked down tight, then a reasonable arguement could be made that these customers were also exempt.
      Finally, the impact of these 10 customers will depend in great part on how the sales are audited. If it is an actual basis, then each stands on it's own. But if there is sampling of any kind it is possible that none of them will ever be looked at directly. Your strategy on dealing with the auditor will depend on number of customers/sales in the audit period, impact of these 10 customers, amount of effort to support each and every sale, etc. You may want to discuss this with your CPA or other advisor.

      • Posted by Paul on September 20, 2012 5:40am:

        Thanks so much Lloyd!

  • Posted by Alan on August 30, 2012 11:58pm:

    Be warned of accepting an exemption certificate that is "qualified"! Meaning if a certificate states "...per PO...", you now have to produce hundreds of documents (all the POs) along with the certificate.

    • Posted by Author photo of Lloyd GeggattLloyd Geggatt on August 31, 2012 12:56am:

      The "qualified" exemption certificate can be a gold mine for auditors. Many was the time when a taxpayer would proudly produce their collection of resale cards thinking they were fully protected only to see the audit result in a large liability because of "taxable" PO's behind qualified resale certificates. This was es[ecially true when the customer was buying parts and tooling - the parts were for resale but the tooling was indicated as taxable on the PO.

  • Posted by Ronald on July 14, 2012 2:58am:

    Lloyd, this is a good post. Nevertheless, your readers should be aware that many States, New jersey included, requires contemporaneous Exemption Certificates (NJ ST-8). This is true even if the Buyer is a well-known Non-Profit.
    My suggestion is all exemption certificates be kept in a file (or scanned as a PDF) by year. When there is a Sales Tax audit, it is easy to produce the exemption certificates.
    I hope this helps!
    Ron Cappuccio

    • Posted by Author photo of Lloyd GeggattLloyd Geggatt on July 16, 2012 1:09am:

      Hey Ron, Thanks for the comment and suggestion. Retaining exemption certificates by year works well for those that are "single use" or relate to a specific event (NJ ST-8). But this method could make it difficult to locate blanket certifcates that cover transactions spread over several years. I recommend simply filing these together alphabetically. Lloyd

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