Naturally, sales tax applies to products, and while rules may vary, they are fairly straightforward in terms of when it is required. What’s more challenging, however, is knowing when services are taxable. In the past, services typically did not incur sales tax, but as small businesses make headway into industries that were formally only controlled by a handful of companies (like telecom), states have become more interested in collecting taxes on services. It’s critical that you understand under what circumstances and in which states sales tax applies to a service.
The rules governing service related sales tax are complex and vary from state to state. In Alabama, if you are an interior designer, you are not taxed unless your services are employed for the retail sale of personal property. That is, you can supply interior design for private customers but not for resale purposes. In Tennessee, pet washing is taxable unless it’s for medicinal purposes because, believe it or not, it’s considered “laundering” and that is taxable in Tennessee. Therefore, other pet grooming services are not taxable.
For states that do not tax a service outright, most use something called the “true objects of transaction test” to determine if sales tax is needed on any part of the service. This is not a tax on the service itself; these taxes are collected when a service or related equipment is incidental to the service. For example, a dentist’s exam is a service, but accompanying X-rays or fillings are incidental. When a business is determining whether they are liable for this tax, they must consider the “main purpose of the sale” versus objects that are related to that main purpose.
It’s tempting to think of products as the tangible incidentals, but it’s more complicated than that. For example, if you provide computer repair services, the equipment is the main object – your labor is incidental and taxable. However, this is not always the case. For example, the Pennsylvania sales tax on computer related services was repealed, but hardware and software sold or used in the service are taxable.
Some states are now collecting sales tax on services or certain service industries. For example, in Connecticut, computer services are taxable at 1% and anything considered tangible goods at 6%. They host an entire page on the tax regulations for computer-related services at the official Connecticut government website, breaking down which services or products require what percentage of tax.
As you can see, none of this is cut and dry. Service providers need to be aware of tax requirements for the states they operate in and how that state defines a “true object.” They also need to keep abreast of these changes as more states add or redefine sales tax rules for services. Both Pennsylvania and Connecticut have made changes to their tax codes in the last 10 years regarding these issues. As the service industry evolves (think “cloud computing”), cash-starved states that are looking for more avenues of revenue are likely to redefine the rules for sales tax.