As more U.S. states look to do away with state income tax, they are shifting the burden onto sales tax—and specifically sales tax on services. But how and what constitutes a “taxable service” can be a confusing question. Any number of factors—from the different ways states tax services, to how they categorize services, to contradictory sourcing rules—can complicate this process and add undue complexity to transactions.
Sales Tax Rules: From Goods to Services
When sales tax was first introduced in the 1930s, the U.S. economy was supported mainly by the sale of goods or tangible personal property (TPP). People didn’t have the same level of expendable income then. Today, services play a much larger role in our economy. Americans have more disposable income and can spend money on services as well as goods.
Yet, when states first started taxing services, they didn’t take this into consideration. Nearly as quickly as laws were introduced, they were retracted.
In 2007, Michigan introduced a tax on services that included consulting, office administration, and business center services among others. It was repealed within hours.
Massachusetts proposed collecting sales and use tax on computer services in 2013. Three months later, the bill was abolished. Several other states—Oklahoma, Louisiana, Kansas, Nebraska, Ohio and North Carolina—introduced similar initiatives; all but one failed.
The problem was that the states were taxing services primarily used by businesses, not individual consumers, and receiving a lot of backlash as a result.
In 2014, Washington DC introduced a services tax based on personal consumption. The so-called yoga tax applied to services related to health clubs, bottled water delivery, car washing, carpet cleaning, tanning services and the like. Unlike previous laws enacted by states, DC’s bill targeted very few services consumed by businesses. This removed many of the complaints and the tax remained in effect.
Are You on the List?
Just because states are taking greater care to define who is being taxed doesn’t mean they’ve made it easy to understand what is being taxed.
In general, states tax services in one of two ways:
- Specifically enumerated services. If the service is not on the list, it is exempted from sales tax.
- All services, except those specifically exempted. If the service is not on the list, it is taxable.
Four states broadly tax most services: South Dakota, Hawaii, West Virginia and New Mexico. And five states tax fewer than 20 services. These are Colorado, Illinois, Massachusetts, Nevada and Virginia.
Aside from these few exceptions, determining how states impose sales tax on services can be difficult. Below is a summary of common categories of services as defined by the states for sales tax purposes:
- Services to Tangible Personal Property (TPP): These include installation, repair, inspection or maintenance of tangible personal property (TPP). Tax Tip: The service may be exempt if the item itself is exempt, but not always. For example, if the sale of a television is taxable, it would be logical to assume the repair of the television would be subject to sales tax as well, but that’s not always the case. Installation services are subject to sales tax in most states.
- Services to Real Property: Most states don’t apply sales tax to real property but may tax services on that property. State rules vary widely and are applied differently based on residential vs. commercial, repair vs. maintenance, new vs. remodeled, and fixtures vs. additions. Tax Tip: The service to the real property may be exempt, but sales tax may be owed on the materials used in that service. Most states treat contractors as consumers of those materials. Contractors that resell materials or operate retail stores should take care to apply sales and use tax rules appropriately to these transactions.
- Business Services: These include advertising, lobbying and consulting, public relations, computer services, HR/staffing services, and security services. States that tax business services are Connecticut, Washington DC, Hawaii, Iowa, New Mexico, New York, Ohio, South Dakota, Texas and West Virginia. Tax Tip: Many business services can be done remotely in another state or even country, which may not make them the best source for generating in-state tax revenue.
- Personal Services: These are based on personal consumption, with the primary customer being an individual versus a business, and include photography, tanning, dry cleaning, hair care, and hunting and fishing guides. Tax Tip: Many economists believe this category lends itself best to sales tax, yet only a few states tax personal services.
- Professional Services: States have a distinct definition for professional services, which require specific education, licensing or certification. They are generally related to accounting, legal, medical, engineering, and architectural services and include little or no tangible personal property. The consumer may get a physical document like a will, contract or plan, but for the most part, those items don’t have material value. Tax Tip: Some states require professional services providers to register for and pay use tax on equipment or goods used in their business.
The Bungling of Bundling
It’s fairly common for sellers to provide a mix of goods and services, for example offering installation or maintenance for a specific item. To determine how to properly apply sales tax and exemptions on commingled goods and services, states use a method called the True Object Test, sometimes referred to as the Real Object Test, Essence of the Transaction Test, or Incidental to Service Test.
The point of the True Object Test is to determine whether the purchase is primarily a taxable sale of goods (TPP) or an exempt service. The state is attempting to gauge whether the customer’s intent was to receive the goods or receive the service, with the TPP being incidental in the delivery of the service. The burden is on the seller to prove to the state how much of the sale is taxable and how much is exempt.
A best practice for sellers and service providers is to separate out any TPP from the service on the invoice. Failure to do so could result in the state viewing the entire transaction as taxable, even if a portion of it is exempt. It’s also important to separate out any reimbursable expenses. If the expense is built into the price of the product charged to the customer, the state won’t exempt it, and it’s possible that sales tax could be applied twice—once at the time of purchase and again when the cost is passed on to the customer.
Sourcing Rules for Services
Two different sourcing rules are used by the states to determine sales tax on services:
- Benefits Received: The state taxes the service if the benefit of the service is received within the state where the customer is located rather than the state where the service was performed. For example, a customer ships a laptop to another state for repair. The customer’s state charges sales tax on repair services, so the provider of the service should charge that state’s tax rate. If the provider is not registered to collect sales tax, the state can require the customer to pay use tax.
- Services Performed: The state taxes a service if it is performed in its jurisdiction, even if the benefit of the service is enjoyed outside of its jurisdiction. States that follow this rule take the position that the service is conducted in their state and the first use of any property used in providing the service occurred in their state and therefore it should be taxed. This is usually the rule for real property services and personal services.
Issues can arise when an interstate transaction is performed in a service-performed state for a customer located in a benefit-received state. It doesn’t happen often, but it is possible for sales tax to be collected twice. Therefore, in order to ensure compliance, it’s important to know the rules for your state as well as the rules for the states where your customers are located.
To learn more, view the on-demand Avalara webinar, The Fool Proof Guide to Sales Tax on Services.