Product classification: a fundamentally crucial concept for sales tax!
For sellers and purchasers, understanding the proper classification of products and services keeps you compliant for sales tax purposes (very important come audit time) and can lead to time and cost savings. A win for everyone.
How a product or service is classified determines the rate at which sales tax is collected and remitted on sales. This is very important for anyone making sales. As a seller, you don’t want to be charging sales tax incorrectly. The wrong classification will come back to bite you if you are audited. Not to mention customer relations issues and potential lawsuits if you’re overcharging (or even under collecting) sales tax.
With all that potential risk, you need to make sure you get product classification right the first time. And if you’re using an automated tax solution in your company, you’ll want to know how to correctly implement that information into the system so sales tax is charged correctly on each and every transaction.
With that in mind, let’s look at three types of sales: clothing, food and services – and explain some common issues that arise when it comes to product and service classification. Having knowledge of these items can help you avoid costly mistakes in the future.
You would think that the taxation of clothing sales would be pretty straightforward, right? Not so fast!
Every state treats the taxation of clothing sales differently, and some states have unique circumstances that determine whether clothing is taxable or exempt.
For starters, you should be aware of the difference in tax treatment between states that are members of the Streamlined Sales and Use Tax (SST) Agreement and those that are not. The SST agreement has strict definitions of what constitutes “clothing” and “clothing accessories and equipment.”
Clothing sales can be either taxable or exempt in SST member states, and each member state is required to provide a taxability matrix indicating the state’s tax treatment for clothing and clothing-related items under the Agreement. In SST member states that do exempt clothing sales, special rules may apply for specific types of clothing and accessories, such as fur clothing, sports and recreational clothing, and more.
Clothing sales can also be either taxable or exempt in non-SST states. But in some states that exempt clothing sales, there is a dollar threshold for the exemption. For example, New York’s exemption is limited to clothing and footwear costing less than $110 per item or pair. Clothing and footwear costing $110 or more per item or pair are taxable.
Where classification gets tricky is understanding what is classified as “everyday” clothing that could be exempt and what isn’t. Athletic wear usually doesn’t qualify – so are sweat pants everyday clothing or athletic wear?
Being aware of this sort of state-specific information can go a long way in ensuring that you are correctly classifying sales of clothing.
The sales tax treatment of food sales is fascinating and provides plenty of interesting examples.
You see, when states create laws regarding the taxation of food, they often include many very specific distinctions that determine whether or not a food item is subject to tax. While these distinctions are sometimes entertaining, they can make it much more difficult when you’re trying to charge and remit the correct amount of tax.
Much like clothing, the SST Agreement has strict definitions for food and food ingredients and prepared food; a major distinction you need to be aware of regarding the taxation.
States specify the taxability of prepared foods vs. unprepared foods. Generally speaking, many states tax sales of prepared food and exempt sales of unprepared foods. But beyond that, it gets more complicated.
Taxability may even vary depending on if the food is heated or not. In New York, tax applies to sales of prepared foods for consumption off the premises unless the food or drink is sold in an unheated state and in the same form and condition, quantities, and packaging commonly used by food stores not principally engaged in selling foods prepared and ready to be eaten.
Taxability can also change if utensils or seating are provided in conjunction with prepared foods. In California, taxable sales include food sold for consumption at tables, chairs, counters, or parking facilities provided by the seller.
And this is just brushing the surface when it comes to food sales. It’s a lot to chew on.
Taxation of services is an interesting topic because it’s currently evolving.
We’re seeing more states propose legislation to broaden their tax base by subjecting specified services to sales tax. Some states are actually getting this legislation passed! For instance, Kentucky recently expanded its tax base to include services, effective July 1, 2018. As states are looking to fill budget coffers, services have come into the crosshairs as a way to generate more tax revenue.
These sorts of efforts by the states are a more recent development. Generally, states have traditionally exempted sales of professional services. This includes accounting, legal, medical, engineering, architecture, advertising, and other services where the charge by the provider is for their expertise.
However, some states do tax various professional services and this is not new. The types of services taxed generally include professions where the service results in a tangible delivery like architectural services and engineering services. Other states tax business services such as human resources services, which can include temporary help, recruiting, and background checks.
When it comes to sales of services, you need to do your research and understand if the state(s) subject services to tax and if so, which ones and how do they define the service. Using the wrong terminology, which might not seem like a big deal, can result in significant tax consequences.
These are just a few examples of some of the complications and interesting rules that come up for three types of sales. Factor in additional industries like software and related services, manufacturing and real property transactions and you’ve got many more rules that can trip you up on classifying your products and services.
Regardless of if you are a seller or a purchaser, whether you are using an automated tax system or not, you need to get product and service classifications right the first time, maintain that information and keep up to date with changes.
By doing so, you can help ensure that you don’t have mistakes to account for come audit time.