On a regular basis, our firm receives questions from taxpayers and their CPA’s alike regarding businesses that provide both services and tangible personal property. In most states, tangible personal property is subject to sales tax while the sales of services is not. Alternatively, a similar question comes in with real property improvement contractors that sell some tangible personal property, some installation, and some real property contracts with installation. The question is even more pressing in the case in which the taxpayer is a real property improvement company that has significant sales to tax-exempt or governmental entities. The issue remains the same, how does the taxpayer exempt the service or minimize the sales tax ramifications in their business?
In a simple example, consider an interior design company. In most states the sale of the interior design services are not taxable. Conversely, the sale of furniture (TPP), is subject to sales tax. What about the scenario in which both are sold? In most jurisdictions the answer turns on whether the purchase of TPP is optional. Other states look to what is the “true object of the transaction,” services or TPP. In either scenario taxpayers are often left with an uphill battle on audit. If the taxpayer takes the position that only the TPP is taxable, it risks having to come out of pocket and pay tax on professional service transactions it never charged tax on.
In the real property world, taxpayers face a similar conundrum. In most states real property improvement contractors are considered the end user of tangible personal property. Therefore, they are required to pay a use tax on their material costs. In turn, they do not charge customers tax on their sales. Consider, however, they are installing items of TPP. In that case, suddenly the sale of TPP plus any labor charges may become subject to sales tax in many states. More commonly, the real property contractor incorrectly does not pay tax on its materials and then attempts to exempt the sale by accepting an exemption certificate from its tax-exempt customer. Unfortunately, in most states, an exemption certificate only works to exempt the sale of tangible personal property, not real property. Therefore, if the real property improvement contractor did not pay tax on its materials and did not charge tax, it could get slammed with a hefty sales tax bill.
So what can be done?
Many tax professionals will suggest that the taxpayer simply use two separate invoices. In the interior design company example, many professionals believe that if one invoice is for services only, then it is exempt and a later sale of tangible personal property on a different invoice will not taint the transaction. On the real property side, a tax-exempt sale of tangible personal property to a 501(c)(3) or a governmental entity followed by a separate invoice for labor only protects the taxpayer. While it may elude the lazy auditor if the company faces the dreaded sales tax audit, it likely will not pass muster.
Most tax professionals fail to mention or are unaware of a far better approach. Unlike federal tax, sales tax is a form driven tax. Consequently, it may be wise to use the form over substance to your advantage. Therefore, the better approach may very well be to set up two legal entities. Company One could only sell tangible personal property to its customer. All of its purchases would be tax-exempt sales for resale because it is selling TPP. On the sales side, it would charge and collect tax if appropriate or be able to accept an exemption certificate because the sale is of TPP. Company Two, through a separate contract, would only do only installation. Again, due to the form driven nature of a sales tax, this structure would likely hold up in most states.
While many taxpayers find the concept promising, many companies do not take the step due to internal issues. If structured correctly, one company could be the wholly owned LLC subsidiary of the other and be disregarded for federal tax and accounting purposes. As such, the bookkeeping and backroom burden would be minimal. However, the major pushback from clients is customer fear. This structure would likely require two separate contacts and two separate invoices to a customer. It is that fact that turns off many companies to this concept. It is also worth pointing out that some states do have a substance over form provision in their sales tax code. Therefore, this would not be ideal in every state.
For companies in most states that provide services and TPP or companies that sell construction jobs to tax exempt entities the cost benefit analysis appears to be an easy one. If you sell TPP and services, like an interior designer, the company in effect eliminates the risk of being taxed on its pricey services that really should be exempt. It eliminates the argument that TPP is being sold along with the service because there are two separate entities. The savings may often prove to be even larger for construction companies that sell to tax exempt entities. It can save the tax on its material costs and be allowed to sell its TPP tax free under the guise of an exemption certificate. These savings can be used to outbid your competition by getting more jobs or increasing your profit margins. While it may require an extra contact and separate checks, the burden is minimal if structured correctly. Therefore, if you or your clients are in this difficult boat, why not go for two?
About the author: Mr. Donnini is a multi-state sales and use tax attorney and an associate in the law Moffa, Gainor, & Sutton, based in Fort Lauderdale, Florida. Mr. Donnini’s primary practice is multi-state sales and use tax as well as state corporate income tax controversy. Mr. Donnini also practices in the areas of federal tax controversy, federal estate planning, Florida probate, and all other state taxes including communication service tax, cigarette & tobacco tax, motor fuel tax, and Native American taxation. Mr. Donnini is currently pursuing his LL.M. in Taxation at NYU. If you have any questions please do not hesitate to contact him via email JerryDonnini@Floridasalestax.com or phone at 954-642-9390. Please also visit his other sales tax blog, facebook, and Twitter