3 Tips to Assess if Your Business Needs to Collect Sales Tax on Service Items

Today’s consumers are busy people and anything that make their lives easier is appealing. So it’s not surprising that more small and midsized businesses are venturing into the services sector. It’s also not surprising that state and local governments are taking notice and starting to apply sales tax to services as well as goods.

As a service-based company, you may not even be aware that you have to collect sales tax.
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How states tax or exempt services varies widely. Only four states –– Hawaii, New Mexico, South Dakota and West Virginia — tax all services. Texas and Minnesota are two of the states actively expanding service taxability. Home Rule states (Alabama, Alaska, Arizona, Colorado, Illinois and Louisiana) allow local jurisdictions to apply sales tax rates, rules and boundaries to products and services.

As a service-based company, you may not even be aware that you have to collect sales tax, which can make compliance difficult, especially if you deal in both goods and services, sell into multiple states or operate as part of a supply chain. It can be easy to overlook tax obligations or make errors in how you collect or report sales tax.

It can be easy to overlook tax obligations or make errors.
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Here are three basic rules to follow to determine if you need to collect sales tax.

Identify Your Service Category

“Pure” services, such as medical care or legal advice, are typically treated as tax exempt by most states. A more common practice is to require sales tax to be collected on services performed in connection with goods or in the production of goods.

Standard classifications include:

• Tangible personal property services: The most commonly taxed services, these include installation, repair, inspection or maintenance of tangible property.
• Professional services: These are typically defined as services where the provider is charging for their expertise, for example accounting, legal, medical or advertising services. Professional services are generally tax-exempt.
• Business services: Viewed as less specialized than professional services, business services include engineering, human resources and data processing. Many states tax business services.
• Real property services: Sales of real property (land, building, fixtures, structures, etc.) are exempt from sales tax, but services related to real property may be taxable. Residential property services are often exempt while commercial property services are typically considered taxable. New construction is generally not taxed (although the contractor is subject to tax on the cost of materials) while remodeling is a taxable service.

Break Out Goods and Services Separately on Invoices

While it’s fairly easy to determine the taxability of retail products like clothing, furniture or food items, it’s less clear how to tax various services associated with those goods. In some states, tax is owed on the entire amount charged for a taxable service, including labor, materials and even mileage. Others exempt the service while taxing the goods.

This helps with customer service, especially if your clients aren’t expecting to pay sales tax.
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To be safe, it’s best to break out goods and services on your invoice and apply the right tax to each line item separately. This also helps with customer service, especially if your clients aren’t expecting to pay sales tax on services and see these charges on their invoice.

If you service tangible goods or provide service contracts as part of your sales to customers, you may also be obligated to collect sales tax. Again, this varies widely by state. Businesses typically affected include companies servicing installation contracts, construction services, manufacturers that provide services along with products and service-based businesses along the supply chain.

Apply the True Object Test

Depending on the states where you sell, you may have to pay sales tax on the services provided in conjunction with physical goods sold. A methodology commonly used by states to determine taxability in this case is the “true object” test. Here’s how it works:

• If the main purpose of the transaction (the true object) is the purchase of a good and the service is secondary to support that good, then the entire transaction is subject to sales tax.
• If the service is the true object of the transaction and the physical good is only incidental to the sale, then taxability rules for the service apply.

A Simple Solution to a Taxing Problem

The lack of uniformity in how states apply sales tax to services makes it difficult to know if, when and on what sales tax is owed. To be compliant, service providers have to review each state’s tax statutes for a list of taxable services and apply those taxability rules to their business.

Given the sheer volume and variances of both taxable and exempt services, this could be a daunting task. And it will only get harder as more states start rewriting the rules for how services are taxed. To make this process easier for your business, especially as you scale to additional physical locations, we recommend installing an automated tax service to keep track of all changes and properly charge every customer, every single time.