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:
- Florida uses a form DR-14 “Consumer’s Certificate of Exemption” – According to the Application For Consumer’s Certificate of Exemption (Form DR-5) the exemption is “…granted only to certain political subdivisions and nonprofit organizations….”
- Missouri uses a “letter of authorization” – The request is made by filing a Form 1746.
- Maryland uses “…sales and use tax exemption certificates…[for]…qualifying organizations….”
- Illinois requires an Exempt (E) number.
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.
Other recent “Audits and Sales Tax” posts by Lloyd Geggatt:
- Software Audits for Buyers & Sellers – and the 3 Key Questions
- Luxury Audits: Empty Boxes Full of Champagne Wishes & Caviar Dreams
- Sales Tax Audits: Actual Basis Approach Can Result in "Win-Win".
- What Auditors Should Understand About Outsourced Sales Tax Returns
- Auditing Sales Tax Credits: An Auditor's Top 2 Considerations