Risky Business: Is Your Company in Compliance with Tax Laws?
Originally published on November 2, 2021
Updated on October 30th, 2023
Being aware of tax laws does more than open a plethora of savings opportunities. It also reduces your business risk. Noncompliance with IRS or state Departments of Revenue rules can lead to tens of thousands of dollars in penalties. Yet many times, violations are simply the result of not knowing about tax obligations in the first place.
In a recent episode of Moore on Manufacturing, James Moore partner Mike Sibley covered this topic with firm state and local tax director Melody Lechleidner.
“We’re seeing a lot of manufacturers—particularly new clients—that haven’t assessed their (tax) risk before,” Mike said. “They haven’t looked at tax laws, they haven’t thought about it. And it’s something that normally only rears its head when you’re selling a business. Or all of a sudden you’re in a state or local sales tax audit.”
As they say, knowledge is power. So Mike and Melody discussed the most common pitfalls facing manufacturers, starting with sales tax.
Buying, Selling… the Basics on Sales Tax Obligations
Businesses need to keep both the buying and selling components of sales tax laws in mind. On the buying side, many business owners know they’re generally exempt from sales tax on the purchase of raw materials that go into the product.
“The idea is that if you’re going to produce a product you ultimately sell, the sale would be subject to sales tax in the end,” explained Melody. “So we’re trying to avoid double taxation.”
But that’s where the courtesy ends. Manufacturers often use supplies consumed in the manufacturing process but not actually added to the product itself, such as towels or cleaners. These materials are generally subject to sales tax, as are computers and other supplies used to run the business itself.
It’s also important to be aware of online sales tax laws and the corresponding obligations. The U.S. Supreme Court’s 2018 Wayfair decision allowed the collection of state sales tax from out-of-state online businesses. However, not all companies selling across state lines are collecting sales tax on these transactions. And that puts buyers in a tough spot.
“If they purchase something they think they should pay sales tax on but they didn’t, it’s still ultimately their responsibility to pay the sales tax, or potentially the use tax in the state that they’re using,” said Melody. “So it’s really important that they pay attention to where they’re being charged, sales tax, where they’re not being charged, sales tax and thinking about how they’re using the items they’re purchasing.”
On the selling side of sales tax laws, you might sell products to a wholesaler or someone further refining them. Such a transaction is typically exempt from sales tax. However, you must receive and maintain an exemption certificate from the buyer and keep it for your records. If your company undergoes an audit, you’ll need this certificate to demonstrate why sales tax wasn’t collected.
Sales to end users are, as you’d imagine, subject to sales tax laws. Before the advent of online sales, transactions out of state had some protection due to lack of a physical presence. However, many manufacturers now sell their products online to buyers across the country. This makes determining nexus a far more complicated matter often based on transactions instead of physical location.
“(It can be) the number of transactions they have in a particular jurisdiction, the dollar amount of the transactions, or a combination of both,” explained Melody. “Since the Wayfair decision, when states started implementing these rules, we’ve seen evolution in the thresholds in the last few years… We’ve seen a lot of states move away from the transactional quantity number and move more toward the dollar value.”
Rental agreements also come into play with sales tax laws and obligations. Manufacturers often have a real estate entity that holds property separately from the company itself. This helps reduce liability and serves certain legal purposes. The manufacturer then pays rent to the real estate entity. This is also sometimes done with vehicles used in manufacturing or transporting goods. Unfortunately, sales tax is due on the rents paid—even though both entities are owned by the same party.
That said, Florida sales tax laws provide exemptions for manufacturers. Some of the equipment you use to produce the goods you’re selling is not subject to sales tax. Neither are certain utilities used at your facilities, such as electricity .
Interstate Nexus and Income Tax Obligations
When you’re dealing in multi-state transactions and tax laws, each state wants its piece of the pie. And Mike and Melody have seen a step up in enforcement of these laws.
“They’ve definitely gotten more aggressive over the years and more creative in the way they try to tax various revenue streams,” Melody said. “And what keeps it interesting is that income tax nexus can be different than sales tax nexus.”
Physical presence is obviously a big trigger for income tax nexus. If your company owns property, has people working, or has equipment or inventory in another state, this establishes a physical presence. In the age of telecommuting, these triggers are more prevalent than ever.
With an ever-changing landscape of interstate commerce, the rules often try to keep pace. Thankfully, existing laws often play a role. Public law 86-272, for example, is a federal law that limits the taxing power of states on businesses selling tangible property. The law came about in 1959, when it was common to see door-to-door salesmen working for a company in another state. Because that salesperson was simply selling—and not making operational decisions—such arrangements were not seen as subject to local income tax at the seller’s location.
Today, the public law applies to a more modern version of interstate sales.
“ you’re a manufacturer and have your presence in the state you’ve identified. You have the equipment and people there, but you’re selling to customers in other jurisdictions where you don’t have any physical presence,” explained Melody. “The public law protects you from being taxed for income tax purposes in those other jurisdictions, where you’re simply delivering goods to a client.”
It’s important to note that public law 86-272 only applies to income tax obligations and not sales tax on transactions.
The Impact on Business Value
Keeping track of tax laws and your obligations does more than keep you in compliance now. It also affects the value of your business as you plan your future. And with so many caveats and different state laws, it’s easy to miss a collection or remittance somewhere.
That said, unfulfilled tax obligations can throw a wrench in the works of a business sale.
“If you’ve never filed in a state, that’s an open liability that can go all the way back to when you first triggered that nexus in that jurisdiction,” Melody said. “And once investors or buyers look at that, it can really impact the sale price of your company.”
Sometimes this can be worked out. For example, an investor might require some of the proceeds from the purchase price be put in escrow to deal with that liability in the future.
“They may hold that escrow for a period of 12 months, 18 months, 24 months…” said Mike. “But certainly as a seller, you want to get as much of your purchase price as you can, as soon as you can. The more (tax) risks there are, the greater the chances you’re going to end up in a situation like this. And should the DOR or some other state come knocking, you potentially lose that escrow if there are fines, penalties or back taxes owed.”
Be Vigilant… and Open to Help
There’s much to think about when it comes to tax laws and obligations. Increase your chances of staying on top of them by:
- Being mindful of your costs incurred when producing goods (what they entail, when they occur, etc.)
- Keeping good records on all transactions
- Utilizing the services of a manufacturing CPA well versed in state and local tax laws
“This is a very complicated area, filled with risk” said Mike. “But certainly it’s never too late to start looking at it—particularly if you’ve got the sale of your business coming down the road. So as always, for our listeners, please reach out for help.”
All content provided in this article is for informational purposes only. Matters discussed in this article are subject to change. For up-to-date information on this subject please contact a James Moore professional. James Moore will not be held responsible for any claim, loss, damage or inconvenience caused as a result of any information within these pages or any information accessed through this site.
Other Posts You Might Like