Ask About Sales and Use Tax
Can you explain the difference between sales tax and use tax? My Montana cousin and I can't seem to agree on what these obligations are.
Wondering in Wyoming
Dear Wondering in Wyoming,
Sales and use tax sounds so quaint—unlike the trendy "revenue enhancement" euphemism bandied about by legislators these days. But a tax by any other name is still a pain in the wallet, so let's examine these distinctions without a difference.
I'm not surprised that your cousin is having trouble grasping the sales-type tax concept because Montana is one of only five states (Alaska, Delaware, New Hampshire, and Oregon are the others) that have no state sales tax whatsoever. But that doesn't necessarily mean you can buy or sell stuff out of your cousin's garage with impunity—or tax immunity. You may escape sales tax but you may not escape use tax, or vice-versa.
Sales-type taxes defined: When we use the term "sales taxes" in a generic sense, we're referring to the taxes that states impose on retail sales. However, there are actually different types of sales taxes. In fact, in many states there are actually several distinct taxes that together comprise the state's sales taxes. Let's identify the three general types of sales taxes:
- Seller or vendor privilege taxes: These taxes are imposed on retailers for the privilege of making retail sales in the state. Retailers usually have the option of absorbing the tax (that is, paying the tax out of their own pockets) or passing it along to their purchasers.
- Consumer excise taxes: These taxes are imposed on the persons who make retail purchases in the state. In the states that impose this type of tax, sellers serve purely as agents who must collect the tax on the state's behalf. Because the tax is primarily the purchaser's responsibility, sellers don't have the option of absorbing the tax and usually must separately state the tax on the receipts or invoices they provide their purchasers.
- Retail transaction taxes: These taxes are imposed on the retail sale transaction itself, with the primary liability for paying the tax falling upon both the sellers and the purchasers. Sellers are responsible for collecting and paying the tax, and purchasers are responsible for paying the tax that the sellers must collect and pay. In essence, this type of sales tax is a hybrid of the other two types. Operationally, however, it's closer to a consumer excise tax because sellers are not given the option to absorb the tax.
Use tax defined: As a general rule, a state's taxing power reaches only as far as its borders. What this means for "sales" tax purposes is that a state cannot impose its sales tax on retail sales that are consummated in other states. This restriction created the concern that purchasers could avoid paying a state's sales tax by making their purchases outside the state. To close this perceived loophole, each state that has a sales tax also has a complementary "use" tax. The use tax applies to the "use, storage, or other consumption" within the state of tangible personal property, the purchase of which would have been subject to the sales tax had the transaction occurred within the state.
In recent years, most states have stepped up their attempts to require out-of-state retailers such as mail-order sellers and telemarketers to register for the purpose of collecting their use taxes. What you need to know is that a state can't compel you to register or to collect its use tax unless you have established a physical presence (sometimes called a "nexus") within the state. What's sufficient to create this requisite presence? Here are some possibilities:
- You maintain an office, store, or other business facility in the state.
- You or your employees enter the state to take orders, perform services, or otherwise do business on your behalf.
- Real property that you own or lease is located in the state.
- Personal property that you own or lease is stored or used in the state on a more than occasional basis.
We do know that if you truly limit your contacts with a state to communicating with customers in the state by mail or common carriers, you won't be obligated to collect the state's use tax. Presumably, a similar standard will apply with respect to telemarketers, catalog and direct mail retailers and sales made via the Internet, although this area of the law is not yet settled. At some point the states will have come to some agreement on a uniform, streamlined sales/use tax system. Something of this sort will need to be implemented if the states are to stem the tide of declining revenues from their inability to enforce used taxes on interstate sales.
Taxable transactions: Now that we know generally what sales and use taxes are, some discussion of what's taxable might be appropriate. In each of the 45 states that impose a general sales tax, the main target of the tax are retail sales of tangible personal property. However, in recent years many states have broadened the scope of their sales taxes to encompass at least some services. (Currently only Hawaii, New Mexico, and South Dakota impose sales tax on all services.) Or, in the case of contractors, for example, there may be some combination of property and services that give rise to a hybrid kind of sales-type taxable transaction.
Leases and rentals: Because states generally impose their sales taxes on retail sales of tangible personal property, you may be thinking that you can reduce your sales taxes by leasing property instead of purchasing it. If so, think again. Although there are many benefits to leasing your equipment and other business assets, avoiding sales taxes is not really one of them. With the exception of Illinois and Maine, all the states that impose general sales taxes have closed this potential loophole either by defining "retail sales" to include leases or by separately taxing rental charges at the same rate as ordinary sales transactions.
All these categories are, of course, subject to the usual exceptions and exemptions, special registration requirements, and a multitude of variations inter- as well as intra-state. The most common variation is the "resale" exemption, which excludes from taxation items bought for the purpose of resale to the ultimate end user. A restaurant, for example, need not pay sales tax on lettuce used to make into salads to be sold to customers but it must pay tax on the bowls in which the salads are served as well as the soap used to wash the bowls after use. And it must also remit the taxes collected when the customer pays for his meal.
For a comprehensive understanding of this important topic, go to our Toolkit for detailed information on "Your Sales Tax Obligations" on which this column is based.
In the meantime, just rejoice in the fact that our federal legislators have not yet seen fit to pass a National Sales Tax act, although this seems like a real possibility for the future. Check out this Streamlined Sales Tax site for the latest on that huge effort to unify state taxes.