In this chapter, we review sales tax overpayments and how to use them to fight an audit.

Chapter 5

Sales Tax Overpayments

Learn the five areas where companies overpay, when you should present a credit to the sales tax auditor and how to prepare a sales tax refund claim.

We’ve also included sales tax rules for manufacturers, SaaS providers and construction contractors.

Fighting the Sales Tax Audit

Some people are uncomfortable with the terminology of “fighting” an audit. They may prefer to call it “sales tax audit defense.” Either way you refer to it, we can assure you the state auditor has one major objective when they audit you: get the most money out of you with the least amount of work possible. This may sound too harsh, and maybe there are a few auditors out there who aren’t like this. But if there are, we haven’t met them.

By the time you get to this Chapter, we’ve already talked about the audit process is and how to negotiate with the auditor. Now we’re going to talk about going on the offensive. Since the focus in many audits is on underpayments of tax rather than overpayments, it’s a great idea to do a refund review to determine if there are opportunities for refunds.

Finding Offsetting Sales Tax Refunds

You know the old saying: “the best defense is a good offense”. That’s where refunds and overpayments come in.

Every state with a sales tax also provides for either a refund or credit of the tax due for overpayments. This could apply in the case of bad debts, repossessions, returned goods or simple errors with regard to taxable and exempt transactions.

Since sales tax is due on a sale, it stands to reason that when the product is returned and the moneys are refunded, the sale is undone and the tax collected and remitted should therefore be returned to the vendor. Where there is no sale, there should be no tax. Because the vendor remitted sales tax on a voided transaction, they are eligible for refund of that tax. The same theory applies when it comes to repossessions and bad debts (there was no legitimate sale).

Overpayments of sales and use taxes are actually fairly common, especially in larger businesses. When an overpayment is discovered, the taxpayer is responsible for organizing, documenting and presenting the claim for recovery. The auditor’s role is limited to reviewing the evidence, weighing the legal and procedural arguments, and deciding whether the claim is justified.

You can request refunds and credits in various ways, including:

  • Offsetting assessments in an audit
  • Filing amended sales and use tax returns
  • Taking credits against liabilities on current tax returns
  • Filing stand-alone claims for refund.

Some of these methods are not available for every state. For example, some states have no provisions for amended returns. Some do not allow credits against current liabilities unless the overpayments also occurred in the current period.

We generally recommend that if you discover any overpayments, and the state allows it, to offset any audit deficiencies first, before getting a cash refund from the state.

The primary reason for this is that although many states pay interest on refunds, the amount of interest on overpayments is usually less than the interest rate you are charged on underpayments in an audit. Therefore, it’s more favorable for you if the auditor applies the overpayments identified as credits in your sales/use tax audit.

Regardless of the state’s system, the taxpayer should prepare a report and document packet. The auditor will review any credits and approve/reject them as they deem appropriate. Having the refund claim report and packet organized in this way gives you the best chance for the review process to go smoothly.

Overpayments can arise in many different situations. Common reasons for overpayments include the following:

  • Self-assessed use tax on exempt transactions
  • Unclaimed deductions or credits for bad debts
  • Refunds not pursued because the whole process was deemed too difficult
  • Clerical errors in reporting or recording

Frequently Asked Sales Tax Refund Questions

Should We Do a Refund Review Before an Audit? How?

Many companies perform refund reviews and self-audits in anticipation of a state audit. In a refund review, the focus is identifying overpayments of tax. It is your responsibility to make sure all refund claims are claimed. You can’t count on the auditor to do this for you. By performing a refund review, you will be in a position to offset any audit deficiency with a refund claim.

In a refund review, you review all tax-paid purchases in the same manner that the auditor reviews purchases where no tax is paid. Then you look for situations where tax has been paid in error.

That’s where a refund review differs from the pre-audit self-check described elsewhere. In a pre-audit self-check, the emphasis is upon lapses and breakdowns in procedures that could result in additional assessments by an auditor.

How Do I Prepare Our Refund Claim?

If you find some overpayments of tax, you should treat each category of overpayment separately in the refund claim report packet and should provide the following elements for each category:

  • Copies of original documents: These documents might include sales invoices, purchase invoices, purchase orders, exemption certificates, shipping documents or similar supporting detail. Each document copy should be indexed to the appropriate line of the summary schedule.
  • Summary and supporting schedules: Unless there are only a few transactions, each transaction should be listed and categorized on a summary schedule. Supporting schedules (such as ratio computations) should be cross-indexed to related worksheets, summary schedules and source documents. No particular system is required, but the indexing should make the flow of transactions and documents easy to understand and trace.
  • Citations: If several legal issues are involved, include an abbreviated list of citations as an exhibit. Each issue should have an assigned number or letter that will serve as a cross reference to the applicable transaction(s) on the summary sheet.
  • Narrative description: The taxpayer should provide a detailed analysis of each aspect of the claim. This includes an introduction, an explanation of the facts and issues, the legal justification (including legal citations), detailed arguments and a conclusion that ties the report together.
  • Cover letter: If you’re requesting the refund in a stand-alone claim, write a cover letter to the taxing agency. The letter should be signed and dated and state that a refund is being requested pursuant to the state law permitting such claims. (Cite the specific state law.)

Some states require a particular format for the claim, and others require specific claim forms. If the state mandates use of a particular form, you can submit that form in lieu of a cover letter or file it in conjunction with the letter.

Even if the refund is claimed through an amended return or as an offset against a current liability, you should still prepare and retain the document copies, summary schedules, citations and narrative description for reference by the auditor.

What is the Statute of Limitations for Sales Tax Refunds?

A state’s sales and use tax statute of limitations applies as a limit to how far back a state can go when they audit you — that is assuming your company has been registered and filing sales tax returns in that state. Some states have different limitations for audit assessments than they do for refunds.

The steps for claiming a sales tax refund or credit vary greatly by state, but the most common procedures include:

  • Adjusting the sales reported or tax due (or taking a credit) on a following return
  • Amending the original return(s)
  • Filing a separate refund claim either by letter or specific form

The easiest and quickest way to get a “refund” of taxes overpaid is by taking a credit on the return you’ll be filing next month. But, be careful here. Just because a state allows this method does not mean that it’s allowed in all situations. For example, do not assume you can take a credit on next month’s tax return for tax you paid to a vendor in error. If a state allows you to do this, it’s usually only in the case where you paid tax in error on inventory for resale.

Helpful Charts on Taxability

We’ve assembled a number of charts with information on identifying credits. They should be useful to you for finding sales tax overpayments and reducing an audit assessment.

Manufacturing Equipment

How Do States Tax Manufacturing Equipment?

Check out this chart from CCH that summarizes the taxation of manufacturing machinery across the US.

Are you a manufacturer? If so, there may be significant exemptions available to you, depending on where you have manufacturing operations. But even if you aren’t a “manufacturer” per se, there may be some exemptions available to you if you perform some “manufacturing” activities.

For example, in some states, cooking food is considered manufacturing. Therefore, convenience stores who make food, or even use soda machines, would qualify for that state’s manufacturing exemption.

To determine if you can purchase certain manufacturing equipment tax free, you’ll have to ask, “What is manufacturing?”

If you’re familiar with state sales tax, it should come as no surprise that the definition of the term “manufacturing” varies from state to state.

For example, all manufacturing probably includes some processing and/or fabrication, but not all fabrication or processing is manufacturing. Similar questions arise over refining, assembly and construction. The confusion arises in trying to distinguish between fabrication, processing, refining, assembly, etc.

In general, the manufacturing process begins when the raw materials are removed from their first point of storage and ends when the completed product is taken off the line and placed in storage.

However, there is some ambiguity as to when the “manufacturing process” begins or ends. Machinery used outside the manufacturing process usually does not qualify for a state’s sales tax exemption for machinery used in manufacturing.

Other typical areas not qualifying for the manufacturing exemption include receiving, inspection, shipping, intra plant transportation and finished goods warehousing equipment. The key is usually whether the activity or equipment contributes to a change in the product being produced or is an essential step in the manufacturing process.

Then comes the question of whether a state’s manufacturing exemption applies strictly to “manufacturers” as that term is defined by the state (usually by reference to an SIC code) or if the exemption is for equipment used in “manufacturing”. Equipment that is only exempt if it is used by a “manufacturer” in the “manufacturing process” is less broad than if the exemption is for equipment that is simply used in the “manufacturing process.”

Cloud Computing

How Do States Tax Cloud Computing? Including Application Service Providers (ASPs) and Software as a Service (Saas).

Check out this chart from CCH that summarizes the taxation of Cloud Computing across the US.

Do you purchase software? If so, you may be due a refund of sales tax. SaaS and ASP (AKA “cloud computing,”) are now a very common model for software delivery. Cloud computing means that customers access specific software applications over the internet through third-party providers rather than through a single purchase loaded on a single computer.

The sales and use tax implications of Cloud Computing are far reaching and prompt many questions including:

  • Does the ASP or SaaS provider have nexus in the jurisdiction in which it is providing its product or services? (Quick answer: “probably, yes, especially in light of Wayfair.”)
  • Is the ASP or SaaS involved in the sale or license of software or the performance of a service?
  • Does the state consider cloud computing the sale of a service? If so, are those services taxable?
  • Does the state consider cloud computing the sale of software? If so, is it canned or custom software?
  • If the state considers cloud computing the sale of software, is an exemption available?

The basic problem in taxing cloud computing is that it’s not clear what is being sold. Is it considered tangible personal property or a service? It’s not always clear whether anything has been delivered where it has been delivered or whether the concept of delivery even applies.

Adding to the confusion, the distinctions between software, digital goods and SaaS have become blurred. As a consequence, some states that do not tax software delivered electronically will tax digital goods, like Colorado. Other states, such as New Jersey, taxes personal use software delivered electronically and digital goods, but do not tax SaaS.

Not surprisingly, the answers states have taken varying and inconsistent positions on these questions. In some states, Cloud Computing may not be taxable because they do not tax the sale of software delivered electronically or because there is no sale of tangible personal property (such as California).

Other states may not tax Cloud Computing because they consider it to be a nontaxable service. Still other states tax Cloud Computing as an information or data processing service (like Texas).

Construction Contractor Purchases

How Do States Tax Construction Contractors?

Check out this chart from CCH that indicates whether a contractor’s purchases of materials or equipment are subject to tax when used in performing a construction contract that is billed on a lump sum basis. Special rules may apply when construction is performed for government or not-for-profit entities.

Are you a construction contractor? If so, we feel your sales tax pain! In most states, when a contractor is performing work on real property, the contractor is deemed to be the final consumer and must pay sales tax upon those purchases. Accordingly, in most states, as a purchaser of construction services, you would not owe any sales/use tax on the contract price.

In the early days of sales tax, states applied the tax to tangible personal property (because real property was already taxed with property taxes). Services were not taxed in the early days. Therefore, construction historically has generally not been taxed because it was deemed a service. However, for construction and other service providers, they still owe sales or use tax on the tangible personal property used in performing those services.

This seems rather clear on its surface. A contractor is the end user of the tangible personal property because when the contractor finishes the job, the tangible personal property (the nails, sheet rock, lumber, cement, iron, etc.) has transformed into real property.

Unfortunately though, just paying sales tax on purchases does not begin to cover all the multitude of activities contractors perform.

In addition to contract jobs on real property, contractors sometimes act as retailers of fixtures or other tangible personal property such as furnaces, water heaters, cabinets, and air conditioners. Construction contractors will usually have questions over the different sales tax treatment depending on the types of contracts, such as cost-plus, fixed-price, time and materials. There are further complexities regarding contract work with federal and state governments, churches, and not-for-profit organizations. And then the distinction between real property and tangible personal property contracts is not always clear.

Construction contractors face some of the most complicated sales tax questions of any industry especially if they do business in different states. A contractor must always consider the impact of sales tax on its purchases when making a bid. They can be caught between a rock and a hard place because they face constant competition and the bid price is a major criteria for who gets the contract. But they also have to be very careful to accurately estimate the tax cost of the materials incorporated in the job so they don’t end up losing money. If state law requires it, they’ll need to be careful to bill the sales tax on the overall job.

Gross Receipts Taxes and Contractors

While the guidelines just provided are applicable to the majority of states, it is important to remember that there are always exceptions.

Arizona is one such exception. Arizona has a gross receipts tax called the Transaction Privilege Tax. In many ways, it operates like a sales tax in that it is billed separately. But technically speaking it is a tax on the seller, not the buyer. The differences become very apparent when you consider how the tax impacts construction.

In Arizona, “Prime Contractors,” purchase their construction materials free of tax. Why? Because the Prime Contractor must pay a “Transaction Privilege Tax” (TPT) on 65% of the gross receipts on their contracts, a tax that is passed on to the building owner in much the same way a sales tax is passed on to a purchaser.

At first glance, the TPT on contractors may seem simple enough. But if a contractor performs maintenance, repair, replacement or alterations (MRRA) work for the owner of real property, or the owners of improvements to real property, that contractor becomes a service contractor, not a prime contractor. As a consequence, instead of buying their building supplies free of tax like a prime contractor and paying tax on 65% of their gross receipts, a service contractor pays tax on the building materials when they buy them.

You can quickly see how this could be confusing. First, a contractor has to know what is included in MRRA and what is still modifications that are prime contracting. Second, contractors could be a prime contractor, or subcontractor to a prime, on one job and a service contractor on another job. In these cases, the prime contractor inventory and service contractor inventory must be accounted for separately.

Other states imposing special taxes upon contractors in addition to a general sales tax include Mississippi and South Dakota.

How Do States Tax the Most Common Services?

Check out this chart that shows what states tax certain key services that most companies would purchase in their business. The chart shows if sales tax applies to:

  • Data Processing
  • Debt Collection Services
  • Heating and Cooling System Repair – Commercial Real Property
  • Information Services
  • Installation Services Separately Stated
  • Janitorial Services
  • Landscaping Services
  • Mandatory Equipment Maintenance Agreement
  • Optional Equipment Maintenance Agreement
  • Repair of Tangible Personal Property; Labor Only
  • Security Services
  • Temporary Staffing Services – Personnel Perform a Non-Taxable Service
  • Temporary Staffing Services – Personnel Perform a Taxable Service
  • Waste Removal

Most states tax only a few services. On the other hand a few tax almost all services, like Hawaii, New Mexico, and South Dakota. Connecticut and Texas tax many services.

Many vendors tend to err on the side of taxing a service, if they’re not sure. It’s also worth noting that vendors often tax services based on the bill-to address, when it should be taxed at where the service is performed. So there may be a refund opportunity for you if you purchase a service that is only partially consumed in your home state.