Historically, there was a significant difference between the sale of products and services when it came to sales tax. While this is still mostly the case, there are a number of exceptions (and a growing list of examples) in which a service is subject to sales tax. If you operate a service business that may fall into one of these categories it is important to know exactly when and how you must collect sales tax and how it will impact your business in different states.
The Growth of the Service Industry
The service industry has grown substantially in recent years as part of the “gig” economy. It is not only possible, but very profitable for a small business to form and offer a very specific and very catered service to people – sometimes only locally and sometimes online.
These services typically don’t result in the transfer of any property or ownership over any manufactured goods. Most states in the past defined goods subject to sales tax in this language, so a lot of new businesses have been exempt as they offer services. However, because the service sector has grown so substantially and will continue to do so as certain things fracture further, many states have addressed possible sales tax applying to certain types of service businesses.
Which Service Businesses Must Pay Sales Tax?
Typically, the cost of equipment that is used as part of a service rendered, along with the service, were exempt from sales tax in most states. While you will likely get audited and owe additional sales and use tax if it is deemed that the purchase of the equipment was the trigger for the transaction and not your services, there are other situations in which this has changed.
To determine if the equipment is the primary or secondary action as part of the service rendered, there is a true objects test that will determine the taxability of a transaction. In this test, you should consider what the true object of the transaction was. For example, if someone purchases a service plan from a heating and air conditioning contractor for a new boiler, the true object of that transaction is the boiler and therefore sales tax will apply. However, if they have an existing boiler and purchase a service plan for it, after which a new part is needed to service the boiler, the true object is the service rendered on the boiler and depending on the state, is likely exempt from sales tax.
Sales Tax on Pure Service Businesses
Until recently, the above true objects test would have been the extent of this conversation. However, there is an increasing number of situations in which pure services are being taxed.
The following states charge taxes on all services rendered:
- Hawaii
- New Mexico
- South Dakota
- West Virginia
The following states have additional situations in which they charge sales tax on fewer than 20 services:
- Colorado
- Illinois
- Massachusetts
- Nevada
- Virginia
- Connecticut
There are still other states that tax on certain services. Examples include:
- Florida – In Florida, cleaning services are generally tax exempt, unless they are of non-residential buildings. Exceptions to this rule, however, including carpet cleaning services for both residential and non-residential spaces, which is not taxable.
- Utah – Utah now charges sales tax on service agreements for software programs at the time of purchase.
- Alabama – The state charges tax on photography services because they deem it a necessary part of the process of selling the prints that these services render.
- California – California has added a number of services to the list of what they tax including installation and service charges for physical goods (such as a water heater), and creation of a new good such as the work of a tailor – both the suit and the service to create that suit are taxable.
The sourcing for these taxes will apply depending one of two possible methods – some states will charge the tax based on where the benefit is received. Other states will charge sales tax according to where the service is performed. This would be the easiest method as it applies to the location at which the service is rendered, regardless of where the resulting benefit is received. Interstate transactions can result in collection of tax twice on a transaction – for this reason, it is important to track the current regulations in your state as relate to this process.
The key to determining if you may owe sales tax for the services you render start with determining how your state defines those services. Here are four steps to help make this determination:
- Check the State Definition – How do your State define your service business? You can call the local revenue service to determine how this would be labeled or use their website for a more specific definition of your service business type.
- Check All Exemptions – There are a number of other exemptions that might apply due to a separate agency in the state affecting that tax. Check to make sure none apply.
- Use the True Object Test – Is your service the true object of the transaction? There are some states in which this test is not applicable, but for most at this point it will finalize the decision.
- Review Variable Transactions – If you sell a single service, this will not apply, but if there are numerous services or service types you offer, check each of them against this list.
More than ever before, it’s important to review the process for determining sales tax liability for service businesses depending on the state in which you operate and any states in which you do business.
The Argument for Sales Tax on Services
The standard has long been that products are taxed and services are not, but State officials are looking more towards including all final consumption in their sales tax revenue. As David Brunori wrote in a recent Forbes.com article, “there is no economic or tax policy reason to tax the purchase of a toaster oven but exempt the purchase of a haircut or accounting service. They’re both consumption.” He goes on to list reasons to support this including that exclusion of services raises other taxes, creates a government-led incentive to seek out service-based solutions over goods, and results in a regressive system as wealthy people use more services than those who are poor.
For these reasons, states continue to look at options for taxing services – both professional and non-professional. While most attempts to do so have failed in the recent past, some changes have been made and will likely continue to be made as states strapped for cash look for ways to increase revenue without adding additional taxes to the same businesses and individuals already paying into the system.
