Understanding Sales Tax in Service Industries
Traditionally, sales tax applied only when goods, not services, were sold. This has been changing and now many service providers need to collect and pay over sales. tax.
The service industry covers a whole spectrum of different types of businesses, but a common element that they all share is the performance of activities in which there is little, if any, transfer of ownership or use of property. Service providers also share the common characteristic of generally not being subject to sales and use taxes on the services they provide. This exclusion is not absolute, however.
In the past few years, the number of small businesses in the service sector of our economy has grown at an incredible rate. This growth rate is due in large part to the fact that today's entrepreneurs recognize that any aspect of our busy lives that can be made easier or more efficient provides fertile ground for a service business.
In addition, there are now small businesses that are going head-to-head with the large corporations to offer services that were once provided only by the large corporations. For instance, in the past, telephone companies were often the only providers of networking and installation services. Now a great number of small local telecommunication firms offer both individual and corporate clients the same type of installation and maintenance services that the large phone companies do, and often at competitive prices. Accompanying this expansion in the service sector has been an expansion of the states' interest in imposing sales tax on services.
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When Are Services Subject to Sales Tax?
In many states, services may be provided without incurring any sales tax liability. Furthermore, this exclusion from sales tax also extends to any incidental property or equipment that may be included in the price of the service you provide.
If you're audited, the tax assessor may hit you with additional sales or use tax, and interest and penalties, for the services provided and any equipment installed if it looks like your customer was not buying your services, but instead was buying the equipment you were including in the cost of your services.
In order to properly comply with sales tax law of your state, you will need to determine whether the service you're providing is secondary in importance ("incidental") to the installation of the equipment. To help make the determination, a number of state taxing authorities have developed an analysis called the "true objects test" which they apply to the total transaction. Using the true objects test, you can get a better idea of whether a transaction will be taxable by determining whether the service provided or the property acquired was the main purpose, or the true object, of the transaction.
When you provide your patient with dental services as well as an X-ray or gold filling, the client is clearly paying you for the services performed. The actual tangible property received - an X-ray, gold filling or any other material you can actually hold in your hand - is incidental to the actual service provided.
On the other hand, if your computer repair business puts in a power supply and fan, a new RS232 cable, a new monitor and upgraded software for your customer, then you're probably going to have to pay sales tax. The computer equipment and software you installed is the object of the sale to the customer - not the actual labor it took you to install this new equipment.
Sales Tax Increasingly Applies to Pure Service Businesses
Currently, many states exclude service providers from sales and use taxes. However, a number of state lawmakers have begun to re-examine the exclusion of service from sales tax liability because they realize that a potentially large source of revenues is going uncollected. So as you might expect, these lawmakers are working on changing their laws to treat some, if not all, services as taxable.
For instance, in Hawaii, New Mexico and South Dakota, a sales tax is imposed on all services provided. In the other states, lawmakers have taken a piecemeal approach and included some types of services as taxable while leaving others not taxable.
In determining whether a service is taxable, we suggest you follow these steps:
- Determine your state defines your type of service as taxable (for example, janitorial services in Texas.
- Find out if the service you provide is exempt from tax because some other state agency or authority is regulating what taxes you are subject to.
- If neither (1) or (2) apply, use the true object test (if this test is allowed in your state) to determine if the purchaser's intent for the transaction was the service or the property.
When Are Purchases by Service Providers Taxed?
This issue of taxability on the purchase of supplies and materials is common to both the service industry and the construction industry. In most states, purchases of supplies and materials made by service businesses are generally taxable at the time of purchase because most states treat these businesses as the end consumers.
As end consumers, you are not expected to resell the supplies and materials, but rather use them for your own business consumption. Some states, however, may allow you to treat materials and supplies as a purchase of resale inventory if, when you bill your own customers, parts and supplies provided with the service are separately stated and billed on the invoice.
Your interior painting business is hired by a customer to paint all the rooms in a house for $2,000. Included in the price for this service are twelve cans of paint, for which you paid $240. If the invoice you send your customer includes only a single line item charge of $2,000, then you'll probably have to pay sales tax on the paint when you buy it.
However, if your state allows you to defer collection of sales taxes by separately billing labor, parts and materials, then you might want to itemize the bill to include separate charges for both labor ($1,760) and paint used ($240). This is generally a useful strategy, especially if you don't expect your customer to pay you soon after the paint is purchased.
Can Service Providers Take Advantage of Manufacturing Exemptions?
If you purchase equipment that is going to be used in your business, check with your state to see if you qualify for a manufacturing exemption. A number of states offer a manufacturing exemption if the equipment will be used to produce or manufacture goods or products for resale.
As the owner of an interior painting business, you purchase your own paint mixing machine so you can save money on paint by purchasing it unmixed at wholesale. If you can show that the mixing of different types of paint is a process that changes the original materials (unmixed paint) used in the process then, depending on the state you're in, you may be able to qualify for the manufacturing exemption.
To illustrate, in states like New York, the tax assessor may give you a manufacturing exemption if you can show that the mixing machine changed the color or texture of the unmixed paint you originally bought.
If you're in a state like Illinois, though, you'll get a manufacturing exemption only if you can prove that the mixer substantiallychanged the unmixed paint. This means that you probably won't get the exemption because even if the paint is a different color it's still pretty much in the same form and is still going to be used for the purpose of covering walls. Accordingly, if you're thinking of taking this exemption, we recommend that you check with your individual state to see what the requirements are for claiming a manufacturing exemption.