Streamlining Sales Tax Exemption Certificate Management

The Importance of Managing Your Sales Tax Exemptions

Managing your company’s exemption certificates obtained from your customers is crucial for controlling your sales tax exposure. It’s a fundamental part of audit preparation or “Audit Defense 101”  – auditors typically request these certificates first. Without proper exemption documentation, your company will be liable for the unbilled sales taxes. That’s why it’s vital to ensure you not only have the certificates, but that the certificates are valid and properly completed. You might be wondering, “How can we achieve this?” The answer: Clarus Partners and its exemption certificate management (ECM) solution, AkuCert. But before diving into AkuCert, let’s explore the basics.

The Difference Between Exclusions and Exemptions

Exclusions

State sales and use tax rules, rooted in our industrial past, often don’t reflect the service-based nature of today’s economy. Consequently, most state sales and use tax laws focus on taxing the sale or transfer of tangible personal property and only certain enumerated services. For example, your house is real property (not tangible personal property), so it’s not subject to sales and use tax in any state. The same principle generally applies to professional services in most states since they’re not specifically listed as taxable services.

These examples illustrate exclusions – transactions that simply fall outside the scope of the sales and use tax imposition statutes. Another good example of an exclusion is software-as-a-service (SaaS) in North Carolina. Because it can’t be classified as tangible personal property in the state and isn’t a taxable enumerated service, sales/licenses of SaaS are not taxable in NC – they’re excluded from the imposition of sales/use tax. No exemption certificates are required to prove the nontaxability of exclusions. Additionally, the burden of proof lies with the taxing authority to demonstrate that these items actually do fall within the purview of the sales and use tax laws.

Exemptions

In contrast, exemptions are statutorily defined exceptions to the imposition of sales and use tax. These are specific types of transactions that would otherwise be taxable as a sale of tangible personal property or an enumerated service, but a state or local government has decided to exempt from its sales and use tax. As you might expect, some of these are lobbied exemptions (e.g., the datacenter industry lobbying a state to pass an exemption for hardware purchases above a certain threshold), while others are driven by the state to attract certain industries and jobs, and still others promote the common good (e.g., food for home consumption or prescription medicines).

Because these transactions would ordinarily be taxable absent the exemption, the taxing authority often requires some form of evidence to prove the transaction is exempt. Some exemptions – like those for prescription drugs and food for home consumption (i.e., food typically bought at supermarkets) – don’t require proof; they’re simply statutorily exempt. However, many of a state’s exemptions do require proof provided by the buyer to substantiate the exemption, and most often, that “proof” is the state-prescribed exemption certificate. Finally, unlike exclusions, the burden of proof for exemptions falls on the taxpayer. It’s the taxpayer’s responsibility to prove they are entitled to the exemption claimed on the transaction.

Types of Exemptions

Now that we’ve distinguished between exemptions and exclusions, let’s discuss the different types of exemptions. Exemptions generally fall into one (or more) of three categories:

1. Product-based
2. Entity-based
3. Usage-based

Product-based

Product-based exemptions are just that – exemptions from a jurisdiction’s sales and use tax based purely on what is sold. To use one of the examples I gave earlier, look at prescription drugs. Most jurisdictions have some level of exemption for prescription drugs, either a full exemption or a much lower applicable sales tax rate, like Illinois’ 1% tax rate.

Entity-based

Entity-based exemptions are dependent on the nature of the entity to which the goods or services are sold. For example, sales to the federal government are not taxed by any state because federal law precludes it. Additionally, many states offer exemptions for purchases made by qualifying nonprofit entities or their own state and/or local governmental agencies. These are examples of entity-based exemptions.

Usage-based

The final category of exemptions is usage-based. Of the three, these are typically the most difficult to interpret and understand, though some of them are very straightforward. For example, one of the most common and prevalent exemptions across the country is the sale for resale exemption. This is when an item is sold to a customer who in turn will either resale the item in its current form or will incorporate the items as a raw material of sorts into something else that it will sell. Using the products in such a way constitutes a resale and is afforded an exemption in all jurisdictions. 

However, on the other end of the spectrum, another common type of usage-based exemption is related to manufacturing.Most states have some level of manufacturing exemption but they are varied to say the least. Some states stipulate that it’s only for capitalized machinery, while others include consumable supplies too. Some states mandate that the item has to be directly used in production while others offer a more broadly applied approach (i.e., the integrated plant theory). Even the definition of “production” or “manufacturing” is different across the states, and as a result where production is deemed to start and end often varies.

Substantiating an Exemption

Regardless of the exemption type, states generally require the proper exemption documentation be provided to the retailer in order to claim an exemption. As mentioned earlier, some exemptions don’t require documentation. However, a good many of them do, and it’s extremely important to ensure that your customers are providing you with not only the correct certificate for the exemption being claimed, but that it is properly completed and validated.

For illustration purposes, let’s look at Wisconsin’s general sales tax exemption certificate. There are three key parts to ensuring this certificate is properly completed and validated, and all are the responsibility of the buyer/customer to complete:

• Purchaser Information
• Seller Information
• Reason for Exemption

It’s important to point out the “Purchaser’s Tax ID Number’ in the Purchaser Information section. This isn’t just a Wisconsin issue and is very important for validation/verification purposes. This is the sales/use tax account number for the purchaser. That same number would be entered in the space beside “Resale” if the buyer in this instance is claiming the resale exemption. This ID/account number is a key field to ensure that the buyer is a registered taxpayer with a valid sales tax account, and that the name of the purchaser matches the account holder’s name in the state’s system. This brings us to the “why.” Why is it so important to maintain valid certificates?

Why Do I Need an Exemption Certificate Management Solution?

If a taxing authority finds a certificate supplied to a vendor is invalid, incorrect, or shouldn’t have been accepted by the seller, they can reject it and assess the retailer the unbilled sales tax. Expired certificates (like in Florida) can cause the same problem. This can be a big financial blow, and I’ve witnessed it firsthand.

A Real-World Example: The $2 Million Mistake

Years ago, a client in the semiconductor industry who manufactured chips for computer companies engaged me to help them defend their California sales and use tax audit. Their products were clearly meant for resale – computer manufacturers incorporated them as raw materials. But during the California audit, we discovered the client had lax ECM processes and oversight. Many of their customers in Silicon Valley were going out of business, so the client couldn’t obtain certificates later. Other companies simply ignored their requests. Even though the client sold 100% of their products for resale, California auditors assessed them over $2 million in unbilled sales taxes, interest, and penalties because they lacked valid exemption certificates from their customers to prove the resale exemption.

That’s why I call exemption certificate management Audit Defense 101. To use another euphemism, “an ounce of prevention is worth a pound of cure.” A little bit of effort on the front end can save your company costly headaches and assessments in the future. Back to the question posed at the beginning – “OK, so how do we manage our certificates?” The answer is Clarus Partners and its AkuCert ECM solution.

Clarus Partners’ AkuCert Exemption Certificate Management Solution

AkuCert

Our AkuCert ECM software is a powerful yet extremely affordable solution towards eliminating audit risk around your company’s exemption certificates. Current clients that used to be on competitive ECM products say that AkuCert is much more user-friendly. They also don’t feel they are sacrificing any of the tools and functionality even though the cost is less than the competitive products.

Not only does AkuCert store all of the exemption documentation, but it also tracks expiration dates and alerts the user when certificates are set to expire in the next 30/60/90 days and when they have actually expired. There is email functionality as well, allowing users to alert customers when the certificate provided is invalid, the reason(s) why, and giving them the ability to directly upload a completed certificate. The reporting capabilities of the software is extremely robust and easy to use. Users can simply click on the state(s) for which they need the exemption documentation and in an instant, a spreadsheet listing all of the customers that have provided documentation is at your fingertips and more importantly, so are PDFs of all the certificates from those customers – ready to hand to the auditor.

The Clarus Difference

Our AkuCert solution is backed by our in-house ECM team. We offer a service component that allows us to manage the entire process for you. You’ll have complete access to everything in the system, but our team will enter all the data, validate all the certificates, and perform periodic “bump ups.” During a bump up, we compare certificates on file with your actual sales data for customers who weren’t charged tax. We then contact those customers to request a certificate.

Don’t let invalid or missing exemption certificates cost your business money. Contact Clarus Partners today to learn more about how our Exemption Certificate Management (ECM) solution, AkuCert, can help ensure that your exemption certificates are valid and up-to-date, saving you time and money.