Sales Tax 101: Determining When Sales Tax Applies

You’ve been working with sales tax for a while, but you still find yourself asking whether a specific product or service is subject to sales tax or is exempt. Don’t sweat! Novices and sales tax nerds alike continue to ask this question every day. 

The truth is…

There are many different factors that go into answering this question depending on what you sell. However, there are some trusty general guidelines to follow that will help you determine whether something is taxable or exempt.

What should you know to best understand when a sale is taxable or exempt? And what should you know to ensure that a customer (or you) can claim an exemption? Ask these 4 questions to help find the answers you’re searching for.

 

What Are You Selling?

Classification of your product or service is the first key item to consider when determining if a sale is taxable or exempt. Sales of tangible personal property (personal property that can be picked up and moved) are typically subject to sales tax unless specifically exempted. But as you may know, in some states, certain services are also subject to sales tax. If you only sell services, your sales might be exempt.

You’ll need to consult the tax law in the states where you sell services to find out if the services you sell are taxable there. 

Watch out for bundling any tangible property with a service. This could change the taxability of the entire transaction. Check out this video to see how two differently formatted invoices for the same transaction (one bundled, one itemized) impact the taxability of the services you provide.

The taxability of your service could also vary based on some very discrete distinctions. For example, if you’re a repairman, the tax treatment of the services you provide may vary based on whether you are doing “repair services” or “maintenance services.” You should check the specific tax laws for a state to see what are considered taxable services. 

 

Who Are You Selling To?

You might find yourself selling to purchasers that are exempt. There are a few critical exemptions you should know about.

Many governmental entities are not required to pay sales tax on purchases. For example, states are prohibited from taxing sales directly made to the Federal Government. State and local government entities are also often exempt – but not always.

Nonprofit and charitable organizations are also often exempt. Examples can include schools, churches, nonprofit hospitals, and charitable organizations. 

Here’s the tricky thing about non-profits:

For most states that grant an exemption to non-profit organizations, the exemption only applies to their purchases of items used in conducting exempt activities. If the organization makes sales that compete with for-profit companies, their sales are generally subject to sales tax which would require them to be registered for sales tax.

You should keep in mind that many states also offer exemptions geared at specific industries such as manufacturing, research & development, and hi-tech, among many others. If you make sales to purchasers in these industries, an exemption may apply.

Remember that proper exemption documentation must be provided in order to claim an entity or type of use exemption. These vary by state – as you might have guessed!

At the most basic level, if the purchaser is exempt, it is their responsibility to declare their exempt status and provide the required documentation to the seller at the time of the purchase. If this doesn’t happen on an otherwise taxable sale, the seller is liable for the tax.

 

 

Where did the Sale Occur?

Sales tax is imposed on sales where the transfer of title or possession occurs within the taxing jurisdiction. Therefore, if a sale occurs in interstate commerce, the original state where the sale occurs cannot tax the transaction. 

However… 

The destination state will likely subject the transaction to its use tax. If the vendor is registered to collect the destination state’s tax, the use tax should be collected and remitted to that state. If the vendor is not registered, the purchaser has the liability to remit the consumer’s use tax.

Interstate transactions get complicated quickly because you don’t always have a simple pick-up at the seller location or a direct ship of tangible goods.

Many interstate transactions also tend to involve more parties than just the seller and end customer. This is where drop shipments come in. 

A drop shipment is a transaction where a seller accepts an order from a customer, then places the order with a third-party supplier – typically a manufacturer or wholesale distributor – and directs the manufacturer to ship the goods directly to the customer.

Drop shipments create challenges when a seller isn’t registered in the customer state but the shipper might be. 

If you sell services, should the state where the service is performed have the right to tax the transaction or is it where the customer is located? Does it matter based on the type of service? 

It can. 

With remote services, this becomes a real challenge. As the seller, you might not even know where the customer is located. So, then what happens? Some states have default logic which could result in using a customer billing address and if no address is available at all, it might be sourced to the seller’s location.

 

What is the Price?

The last key item you should consider what is included in the “sales price” that is subject to tax. You might wonder, is a discount included in the sales price subject to tax or is it excluded from the tax base? Is a coupon included in the sales price? Are delivery charges included? 

Whether or not these items are considered to be part of your taxable “sales price” can vary from state to state. 

 

 

Taxable vs. Exempt: Getting it Right

Taxability determination for sales tax is like writing a story. As you’ve seen, it’s all about the who, what, when, where, and why. 

Keep this checklist close:

  • Who: Who is your customer? 
    • Are they exempt because of their entity type? (Government, nonprofit, charity, etc.)
    • Are they exempt because of their industry? 
    • Are they exempt because of how they plan to use the product? (Like a sale for resale.)
    • Who has the responsibility to provide exemption documentation?
  • What: What are you selling? 
    • Are you selling tangible personal property?
    • Are you selling a service that is subject to tax in your state?
    • Are you bundling tangible property with services?
  • Where: Where did your sale occur? 
    • Are the seller and customer in different locations? 
    • Does the transaction involve a drop shipper?
    • Which jurisdiction has the right to tax the transaction? 
  • When: What is included in the price at the time of the sale?
    • Are discounts included?
    • Are coupons included in the sales price?
    • Are delivery charges included?
  • Why: Your “why” is to get sales tax right to stay compliant!

Still have questions? Watch our Sales Tax 101 on-demand webinar to learn more at your own convenience and feel confident that you’re handling sales tax correctly with training from one of the foremost experts.

Posted on August 17, 2020

About the Author:

Diane L. Yetter

Founder of the Sales Tax Institute

Diane L. Yetter is a strategist, advisor, speaker, and author in the field of sales and use tax. She is president and founder of YETTER Tax and founder of the Sales Tax Institute. You can find Diane on LinkedIn and Twitter.