In the U.S., businesses with nexus in a particular state are required to charge their customers sales tax on taxable transactions such as retail sales of tangible personal property or taxable services unless, and until, the proper exemption documentation (i.e., an exemption certificate or a resale certificate) has been accepted in good faith from the purchaser. U.S. states generally provide many full or partial exemptions based on the nature of tangible personal property (e.g., groceries, clothing), its use (e.g., manufacturing activities, purchase for resale, etc.) or the type of purchaser (e.g., non-profits and government agencies).
Without proper and timely collected exemption certificates, taxing authorities may deem exempt sales based on the use or type of purchaser as taxable. Issues with documenting exempt sales can lead to large tax audit assessments or identification of potential exposures during due diligence related to a transaction.
Following the Supreme Court’s 2018 decision in the Wayfair case—a decision that led all states that impose sales tax to establish economic nexus thresholds—vendors have a much broader economic nexus profile and should analyze whether to charge sales tax or, with exempt transactions, emphasise collection and validation of exemption certificates to document tax-exempt sales.
Sales to the government and agencies
Any misunderstanding of a purchaser’s status or assuming that sales to the government or its agencies are exempt from sales tax can result in an improper characterisation of taxable sales as exempt.
Sales to the U.S. federal government are exempt from sales tax. However, sales to the federal government’s instrumentalities that are not owned by the U.S, such as federal reserve banks, federal credit unions, federal land or federal home loan banks, may be subject to sales tax in some states. Contractors working with the federal government should fully understand the appropriate state sales tax rules since the tax-exempt status of their customers may not automatically flow through to them as an agent.
Special attention should be given to sales to state governments and agencies because some states—e.g., Arizona, California, Hawaii, Minnesota, South Carolina and Washington—impose tax on sales to government agencies.
With construction contracts, government supply contractors may issue a resale certificate on their purchases from subcontractors (i.e., purchase taxable products tax-free) if title to the purchased products passes to the government before use by the contractor. Subcontractors should not blindly rely on the status of companies working with the government; subcontractors should be aware of state-specific rules so they can properly determine whether their sales could be exempt and carefully document any exemption.
Sales to non-profit
Sales to non-profits are generally taxable unless purchases are used for charitable purposes, or another exemption applies. Vendors should not assume that sales to non-profits are automatically exempt and should request exemption certificates to document any exempt sales.
To qualify as an exempt organisation for sales tax purposes and to issue a valid exemption certificate, non-profit organisations must comply with state procedural requirements related to registrations, including registration for sales and use tax, and operations. Because federal exemption status is not binding on the states, certain jurisdictions, such as Pennsylvania, may require an organisation to prove that it is a “purely public charity” institution that operates free from private profit motive. Other states, such as Alabama, California and Oklahoma, generally do not provide a broad state sale and use tax exemption to non-profit organisations.
Sales tax is a transactional tax imposed on an entity-by-entity basis. In large organisations with numerous legal entities, one entity (Company A) may make a purchase, but a different entity (Company B) issues an exemption certificate. Tax authorities may deem tax exemption certificates issued by the wrong entity as invalid. In states with non-expiring certificates, vendors that have ongoing sales to the same organisation should track that a previously collected certificate matches the purchasing entity. In the case of corporate changes, such as reorganisations or name or address changes, etc., it is important for vendors to request updated exemption certificates.
Most states require exemption certificates to be issued at the time of the sale or shortly thereafter (e.g., 30, 60, 90 or 120 days, depending on the state). Although many states allow taxpayers to collect exemption certificates from their customers retroactively (in the context of an audit or otherwise), the taxpayer bears the burden of proof regarding the exempt nature of their sales. If certificates are not obtained within prescribed periods or cannot be collected upon request and provided during audit, tax authorities may consider them invalid and treat otherwise exempt transactions as taxable. Liabilities on audits have been known to arise if potentially exempt customers become unresponsive, are unwilling to provide an exemption certificate or are no longer in business.
In majority of states, including California, New York, North Carolina and Pennsylvania, exemption certificates do not expire. However, other states require exemption certificates to be renewed to remain valid (e.g., Alabama and Arizona – one year, Illinois – two years, Connecticut, Iowa, Oklahoma – three years, Florida, Maryland, Missouri, and Nevada – five years and Massachusetts – 10 years). Vendors should be aware of renewal period requirements and are encouraged to use technology solutions to alert appropriate staff about expiring certificates.
Multi-jurisdiction exemption certificates
States have been working with intergovernmental agencies or organisations, such as the Multistate Tax Commission (MTC) or the Streamline Sales Tax Governing Board, to create a uniform exemption certificate to simplify compliance obligations. However, there are risks and limitations associated with these multistate certificates. For instance, certain states do not permit the use of multi-state certificates and require use of their state-specific forms. Further, not all states allow for exemptions listed on the forms or may require the purchaser to be registered with a state to issue a valid exemption certificate. MTC certificates may not be used for reasons other than resale (e.g., ingredient or component exemption, manufacturing exemption, etc. cannot be claimed using the MTC’s certificate). Prior to accepting a multi-jurisdiction exemption certificate, vendors should check state-specific rules about their limitations and review them for completeness.
Approach to tax exemption certificate compliance
Sales and use tax exemption rules vary by state. Businesses should ensure they have a process in place to collect, validate and retain exemption certificates in conjunction with completing the transaction to avoid having to collect the tax or deal with the issue on audit. States are becoming stricter on both form and use, taking the position that where certificates are incomplete, invalid or misused, taxpayers may not avail themselves of the benefits the certificates offer.
Affected businesses should consider the following steps to meet their compliance obligations:
- Establish a process and procedure to collect, review, validate and store exemption certificates at a central location. Request exemption certificates from customers as part of the onboarding process or contemporaneously with the purchase order.
- If exemption certificates were not previously collected, collect them as soon as practicably possible.
- Validate all certificates by undertaking a comprehensive review for completeness, accuracy and timeliness. The seller’s registration status with the state must be confirmed if a seller is required to be registered with the state to issue a valid certificate.
- Monitor and timely update expiring certificates.
- Leverage technology to automate requests, manage certificates and respond to audit requests.
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