Ignorance is bliss is a mantra for many taxpayers when it comes to compliance and tax obligations. When contacted by taxing authorities, taxpayers often respond with stories, no matter how unreasonable, that they had no knowledge of the particular tax or that any tax was due. Much of the time these arguments do not work and taxpayers are assessed large liabilities as a result. This is never truer than with use tax.
With the growing popularity of e-commerce, use tax obligations can be among the largest tax liabilities incurred and ignored by consumers, over $20 billion per year according to some estimates. Why do taxpayers commonly turn a blind eye to use tax? Of the top reasons, lack of awareness of its applicability and the difficulties associated with the self-assessing nature of the tax are commonly cited. As taxing authorities become more aggressive at targeting those skirting the tax, it is important for taxpayers to understand their use tax obligations and when the tax is imposed.
Simply stated, use tax acts as a complement to a state’s sales tax. While sales tax laws were established to levy an excise on commerce within a state, legislatures became concerned that property brought into their states might escape sales tax if the particular transaction did not occur within the state. This would create inequities, with in-state transactions being subject to greater taxation than property brought in from out of state. From this concern grew the complementary tax known as “use tax.” Every state having a sales tax has an accompanying use tax. In effect, it creates a level playing field between in-state and out-of-state retailers.
While sales tax is generally assessed upon retail sales of tangible personal property and certain enumerated services, use tax is assessed upon the use or consumption of tangible personal property and enumerated services purchased and upon which no sales tax was paid. For most individuals and businesses, the practical effect of use tax is the assessment of the tax upon purchases made from out-of-state retailers for use in the taxing state. For example, law firm XYZ Partners purchases its office supplies from a local office supply store and an Internet retailer. The local supply store charges the law firm the applicable state and local sales tax on its purchases. The Internet retailer, not having established tax nexus with the state, is not required to collect sales tax and does not do so. As a consequence, the firm must remit use tax upon its purchases from the Internet retailer.
Other situations in which use tax may be applicable include purchases made from a vendor not authorized to collect sales tax, and purchases of real estate that include transfers of tangible personal property. In such situations, use tax is applicable as sales tax was not paid. However, should sales tax not apply to a particular transaction, or if another state has previously imposed a sales tax, use tax would generally not apply or would only apply to the extent the in-state use tax rate exceeds the out-of-state sales tax rate.
Like sales tax, use tax is assessed upon the consumption of all tangible personal property not specifically exempted and certain select services. Many states interpret their use tax laws quite broadly and apply the tax to any physical manipulation of, or the exercise of any right over, tangible personal property. If a person or business makes any use whatsoever of tangible personal property in a state, the language of the state’s definition of taxable use typically causes the person to be liable for use tax on the value of the property.
In order to not discriminate against interstate commerce, the rates of tax imposed for sales tax and use tax are the same. Imposing a lower rate on taxable sales by in-state vendors subject to sales tax would be an impermissible discrimination against out-of-state vendors. To ease the compliance burden, most states request businesses to report their use tax liabilities on their sales tax returns however frequently filed. For individuals, most remit use tax with their personal income tax returns, though for larger transactions a separate use tax return may be necessary.
As with sales for resale and wholesale sales, use tax statutes often include exemptions for tangible personal property purchases that are resold or become a component part of other products manufactured for resale. However, if the wholesaler or manufacturer uses the property for its own purposes as the end user or consumer, the tangible personal property is subject to use tax. An example of this is a business’s use of sample merchandise. If a retailer of tangible personal property gives away free samples from its inventory, the retailer must generally remit use tax on that merchandise because the retailer is considered to have used that merchandise in its business. It should be noted that states vary as to the tax base of the sample goods. Some states impose use tax only on the cost of materials, yet others include labor or overhead costs as well.
Public opinion polls often identify sales and use taxes as the preferred form of taxation rather than income-based taxes. This preference stems from taxpayers’ belief that they can control their level of taxation by controlling their expenditures or consumption. Sales and use taxation has become a major source of revenue for state governments. As a result, states have started placing greater emphasis on audits to maximize their revenues from these taxes. Accordingly, failure to self-assess and remit use tax is a frequent cause of audit assessments. Therefore, all businesses should establish a use tax self-assessment procedure to avoid unnecessary assessments and penalties. Generally, this requires the review of purchases on which a retailer billed no sales tax, with a determination made regarding the tax status of the purchases.
As a cause of large audit assessments, use tax obligations cannot be taken lightly. How to determine if and when use tax is due are problems faced by many taxpayers. Further complicating use tax compliance is determining whether an exemption is applicable, and if not, the proper remittance of the funds. Use tax compliance is a very challenging endeavor for most taxpayers and it is not an obligation in which ignorance is bliss.
When it comes to use tax special attention is required to ensure compliance with state laws. Consulting a state and local tax professional can assist you with your state filing responsibilities. If you have any questions regarding sales and use taxes, please contact Alan Goldenberg, Senior Manager of State and Local Taxation and Tax Controversy, at firstname.lastname@example.org or 212-897-6421, or your Friedman LLP tax professional.