Service Providers' Sales Tax on Sales

April 13, 2006

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The following are some questions that commonly arise in regard to sales taxes on sales by service providers:

When will I have to pay sales or use taxes on the services I provide? In many states, services may be provided without incurring any sales tax liability. Furthermore, this exclusion from sales tax also extends to any property or equipment that may be included in the price of the service you provide. However, if you're audited, the tax assessor may hit you with additional sales or use tax, and interest and penalties, for the services provided and any equipment installed if it looks like your customer was not buying your services, but instead was buying the equipment you were including in the cost of your services. A problem that you will probably run into is figuring out how to determine whether the service you're providing is secondary in importance ("incidental") to the installation of the equipment.

Because of this uncertainty, a number of state taxing authorities have developed an analysis called the "true objects test" which they apply to the total transaction. Using the true objects test, you can get a better idea of whether a transaction will be taxable by determining whether the service provided or the property acquired was the main purpose, or the true object, of the transaction.

When you provide your patient with dental services as well as an X-ray or gold filling, the client is clearly paying you for the services performed. The actual tangible property received - an X-ray, gold filling or any other material you can actually hold in your hand - is incidental to the actual service provided.

On the other hand, if your computer repair business puts in a power supply and fan, a new RS232 cable, a new monitor and upgraded software for your customer, then you're probably going to have to pay sales tax. The computer equipment and software you installed is the object of the sale to the customer - not the actual labor it took you to install this new equipment.

If I provide services that do not involve putting in or installing any equipment, am I free from the hassle of paying sales and use taxes? Currently, many states exclude service providers from sales and use taxes. However, a number of state lawmakers have begun to re-examine the exclusion of service from sales tax liability because they realize that a potentially large source of revenues is going uncollected. So as you might expect, these lawmakers are working on changing their laws to treat some, if not all, services as taxable.

For instance, in Hawaii, New Mexico and South Dakota, a sales tax is imposed on all services provided. In other states such as Connecticut, state lawmakers have taken a piecemeal approach and included some types of services as taxable while leaving others not taxable.

To plan for this new trend, we recommend that in determining whether a service is taxable, you do the following:

find out if the service has been defined by state law to be taxable, e.g., janitorial services in Texas, then
find out if the service you provide is exempt from tax because some other state agency or authority is regulating what taxes you are subject to,
then if the first two don't apply to you, use the true object test (if this test is allowed in your state) to determine if the purchaser's intent for the transaction was the service or the property.