7 Sales Tax Myths That Can Harm Your Clients Who Provide Services. By Michael J. Fleming
Sales tax is my passion and I love what I do. Everyday I get to speak with companies and/or their CPAs and other advisors. Most CPAs and other accounting professionals I speak with have a firm grasp of the importance of sales tax, especially in a post Wayfair world. However, I am always surprised by the number of professionals who have significant blind spots. For many, this blind spot is services.
At least once a day, sometimes several times a day, I hear statements like “services are not taxable” or “subcontractors perform the services so there is no nexus.” Unfortunately statements or assumptions like this are not true and can be very detrimental to your clients.
States know that compliance amongst service providers is often poor and auditors find companies to be good audit targets. As states beef up their discovery units looking to enforce economic nexus compliance, they will uncover all types of traditional nexus and non-compliant companies. If you haven’t spoken with your clients that perform services about sales tax, now is the time. Don’t let these 7 Sales Tax Myths Harm Your Clients.
Myth 1: Services are not taxable
In general tangible personal property (TPP) is taxable by default, unless there is an exemption of which there are many. In contrast, services are generally non-taxable by default unless they are enumerated or identified as taxable. This list of services is growing all the time.
Historically many states did not tax services or if they did the number and types of services were very limited. However, as states continuously need to increase revenue to pay for their ever growing funding needs, many states are broadening their tax base by taxing more and more services. This is a trend we predict will not only continue but accelerate.
Services can be added to a states list of taxable services either directly or indirectly. If a state passes a new law or modifies an existing law it is generally fairly straight forward. There would be a new service or list of services enumerated as taxable in the state. What is not so straight forward is when states add services indirectly. This can be done a number of different ways but, we always say that a state will look at your client’s products and services through the prism of their tax structure. In other words they will often stretch to make it fit.
Am example I like to use is website design and/or hosting in Texas. Neither of these services is enumerated as a taxable service. So according to the big print many assume these services are not taxable in Texas. However, Texas does enumerate data processing as a taxable service. When I think of data processing and these two services I do not immediately draw a connection in my mind. However, Texas has consistently taken the position that these services are taxable as data processing. In this instance we see Texas expanding their definition of data processing.
A major problem we often see is when companies try to do stretching of their own. Of all the groups of services professional services are taxed the least. So we often see companies or advisors calling services professional services and not collecting tax. The problem is that states often have narrow definitions and will take exception to the classification. Professional services are often limited to those of attorneys, CPAs, and doctors. Many times a company’s services are not professional services, but are actually taxable as business services, services associated with TPP, or even personal services. Services to real property, and amusement or recreational services are two other types of services that are often taxable.
Before we move on to the next Myth I want to point out the states of HI, NM, SD & WV are actually different than most states in that they tax most services unless they are specifically identified as exempt. The states of HI & SD actually tax accounting and attorney’s fees so if you have remote clients in those states make sure you are not over the economic thresholds. If you are over the threshold or have a physical presence in either of these two states sales tax collection may be required on your firm’s services..
Myth 2 Independent and/or subcontractors do not create nexus
Independent and/or subcontractors can create nexus. This activity is the number one activity we see that creates exposure for all types of companies, not just service providers. It’s hard to imagine that a true third-party, someone we don’t have any connection to other than the service they provide can create nexus. However there are actually two US Supreme Court cases that address this. They are Scripto, Inc. v. Carson, 362 U.S. 207 (1960) and Tyler Pipe v. Wash. Dept. of Rev., 483 U.S. 232 (1987).
In Scripto the Court basically said the difference between employees and contractors is constitutionally insignificant. In Tyler Pipe the Court goes further and states that it doesn't matter if someone represents your exclusively or not or even full time or not; what matters is ‘are they helping to establish or maintain a market.’ This language is very important because so many states incorporated it directly into their statutes, rules, or regulations. Or, they use it to provide guidance and state courts can use it as precedent.
While these two cases were about sales, the language of “helping to establish or maintain a market” has really grown to include a whole host of activities. Some examples are: onsite repair, installation, maintenance, implementation, training, sales, marketing ,and other provisions of service on location. A test I use to see if a third-party service is nexus creating is whether there is interaction with the customer. If so, then it is possible a market is being created or maintained. If they are doing back office work like accounting or software development work than it would generally not be nexus creating.
It is important to remember that not only is nexus created where these contractors live, but generally anywhere they travel on your behalf to establish or maintain a market. This type of nexus is generally the most dangerous to your clients because some of them may have been using independent contractors for years, creating all sorts of past exposure.
Myth 3 Employees performing services do not create nexus
This myth is closely related to the independent contractor link especially when talking about traveling. When it comes to employees the added protection of establishing or maintaining a market is often not there. So some states, like an AZ or MI basically say that having an employee in the state for greater than 48 hours for pretty much any reason barring a few exceptions is nexus creating. Remote employees often create nexus also. Whenever a company has nexus and what they sell is taxable a state will expect the company to register to collect and pay tax. If there is back tax owed the state will want that tax, plus penalty and interest.
Myth 4 Economic nexus doesn't apply to services
We keep hearing that economic nexus is an internet tax. Unfortunately economic nexus potentially impacts all companies who sell in or into more than one state. It doesn't matter if the sales are made over the internet or not. It generally applies to all companies making taxable sales into a state that doesn’t have a physical presence.
Many services are offered remotely. There may not be any physical presence at all, but now we have to look at the economic sales thresholds and/or transaction thresholds. If over a threshold, taxability should be checked. If the services are taxable, and the thresholds have been crossed, there is a tax collection and remittance responsibility.
Since economic nexus for sales tax is a relatively new reality, past exposure should be limited. I say relatively new, because even though the states agreed to pursue sellers prospectively from their respective effective dates, some of those dates are now a year old and exposure is building everyday. As the states are increasing their discovery efforts, we believe there is a sense of urgency to become compliant.
Myth 5 My clients are too small for a state to mess with
Unfortunately there is no truth to this statement at all. In fact some state audit manuals suggest having a mix of small, medium and large audits. Although a smaller tax payer will result in a lower amount of fees for the state, smaller audits are generally quicker and taxpayers generally resist less.
In addition, the state or an auditor will often not know how big a company is prior to an audit. States often cast large nets catching companies of all sizes and to the best of my knowledge I do not know of any catch and release programs. In fact, I know of a pool cleaning company in Texas that had total sales per year of around $70,000. The state of Texas found him and wanted 12 years of records so they could get all the back taxes penalty and interest. How many people keep records back that far, or even for 7 years, which is what the state ultimately agreed to. Unfortunately pool cleaning services are taxable in Texas, which this service provider did not know and he owed seven years of back tax, penalty, and interest.
So even if your have small clients who sell only in one state they could have big problems if they are unaware of the tax consequences of their business.
Myth 6 States will not find my clients
States are always looking for clients that they believe are non-compliant and have many tactics they use. One is information sharing with the IRS. Contractors are often paid on a 1099 basis and remember we said contractors can create nexus. States routinely get lists of taxpayers in their state who have received a 1099. They then look at who issued the 1099 and if the issuer is not registered to collect tax they are often placed on a list for follow up. States also find companies that show up in an audit of their customers. When auditors audit a company then not only look at the sales to make sure all the tax is being collected and remitted but also all purchases to make sure that consumer use tax is being correctly self-accessed and remitted. While reviewing purchase invoices auditors often create lists of companies not collecting tax on their invoices.
We have only mentioned two tactics that states use, there are more. What is most important to know right now, is that states are currently beefing up their discovery units. These states are almost salivating at the prospect of tracking down companies with economic nexus. They have been waiting almost 25 years for this. In their zeal to find companies who have economic nexus, these state will uncover all different types of nexus almost by accident.
Utah has already started a new program where they purchased a list of companies that have potentially crossed the economic thresholds which were effective on 1/1/2019. Some of our clients, who were already registered were called. We were told that the state’s discovery unit will be calling everyone on the list.
Myth 6 My clients know I do not do sales tax
Unfortunately our clients see us as their trusted advisors. They expect us to know everything tax related. One of the worst things we can hear from one of our clients, after they are found by a state, is why didn’t you tell me. At that point we at best have a damaged relationship or at worst a client hurt so badly they go out of business or begin litigation. So even when we don’t offer a service, if we know there is potential for exposure, clients expect us, reasonably or not, to point them to someone who can help
As a result of the Wayfair decision sales tax is becoming more & more relevant. Many of us are doing a great job of staying abreast of at least the major issues or are aligning ourselves with someone who does. With the states gearing up to increase their enforcement and discovery efforts I think we all could relook at sales tax. Not just those clients who over services or who meet economic nexus thresholds but all of our clients to ensure they do not have hidden exposure.
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