Any business engaged in the sale of goods or services must, as a matter of compliance, determine whether such goods or services are subject to sales tax, and if so, in which jurisdictions and to what extent. Although the classification of a transaction as “taxable” or “exempt” may appear to be a simple binary determination, the underlying legal analysis is considerably more nuanced.
This memorandum addresses the following topics:
- The legal nature of sales tax
- The categories of goods and services subject to taxation in the United States
- The determination of applicable sales tax rates
- The categories of goods and services exempt from sales tax
- Common pitfalls in product taxability analysis
- The obligation to collect and remit sales tax
The Legal Nature of Sales Tax
Sales tax is a form of consumption tax imposed on the sale of certain, but not all, goods and services. Unlike jurisdictions that impose a value-added tax (as in the European Union) or a goods and services tax (as in Canada), the United States has no federal or national sales tax. Rather, taxing authority is exercised at the state level and, in many instances, concurrently at the local level. Approximately forty states authorize the imposition of local sales taxes in addition to the state-level tax.
This bifurcated (and in many cases trifurcated) system of taxing authority is a principal source of compliance complexity. Only five states — New Hampshire, Oregon, Montana, Alaska, and Delaware, sometimes referred to collectively by the acronym “NOMAD” — do not impose a general state sales tax. Every other state, along with Puerto Rico and the District of Columbia, imposes a general sales and use tax; Alaska, notwithstanding the absence of a state-level tax, permits local jurisdictions to impose sales and use tax.
While certain principles of sales tax law are broadly consistent across jurisdictions, the specific statutory and regulatory requirements vary considerably from one taxing jurisdiction to another. This variance presents a substantial compliance burden for entities conducting business across multiple states.
Categories of Goods and Services Subject to Taxation
There is no uniform rule governing the taxability of goods and services across jurisdictions. As a general matter, however, states tend to tax the retail sale of most tangible personal property, while exempting a substantial portion of services — particularly those unrelated to tangible goods. This general principle, however, admits of numerous exceptions upon closer examination.
A. Taxable Sales of Goods
As a matter of general legal presumption, tangible personal property is taxable unless a specific statutory exemption applies. Accordingly, the retail sale of most goods is subject to state, and where applicable, local sales tax in the majority of states.
Numerous exceptions nonetheless exist. Food intended for home consumption, for example, is taxed at a reduced rate in certain states (including Alabama and Arkansas) while being fully exempt in others (including Ohio and Texas). Candy and soft drinks, though colloquially understood as food items, are frequently subject to sales tax at rates higher than those applicable to other food products.
The taxability of a given product may also depend on whether state or local tax is at issue: a product may be subject to local tax while exempt from state tax, or vice versa. In New York, for instance, clothing and footwear priced at $110 or less is generally exempt from the state sales tax, whereas items priced above that threshold are subject to state tax; whether local tax applies to items falling within the state exemption depends on the taxing locality.
The taxability of digital goods presents additional complexity. Certain states tax digital goods in a manner consistent with their tangible counterparts, while others apply distinct rules. In Washington, for example, both printed books and electronic books are subject to sales tax, whereas in California, printed books are taxable but electronic books are not.
B. Taxable Sales of Services
Hawaii and New Mexico impose sales tax on nearly all services, subject to limited statutory exceptions, and South Dakota and West Virginia each tax more than one hundred distinct categories of services. In these four jurisdictions, services are presumed taxable absent a specific exemption.
By contrast, California, Colorado, and Massachusetts tax a comparatively limited set of services, applying a general presumption of exemption absent a specific statutory provision imposing tax. The majority of remaining states fall between these two poles, taxing more services than California, Colorado, and Massachusetts but fewer than Hawaii, New Mexico, South Dakota, and West Virginia.
Determination of Applicable Sales Tax Rate
The applicable sales tax rate for a given transaction is governed by that jurisdiction’s sourcing rules.
The majority of states apply destination-based sourcing for both interstate and intrastate transactions, such that the applicable rate is determined by the location at which the purchaser takes possession of the goods — whether at a retail location or at the delivery address — or, in the case of services, the location at which the service is received.
Approximately eight states apply origin-based sourcing rules with respect to tangible goods, under which the applicable rate is determined by the location from which the sale originated (e.g., the location where the order was accepted or from which the goods were shipped). Four of these states extend origin-based sourcing to services as well.
California and Texas apply a hybrid approach, combining elements of both destination- and origin-based sourcing.
Categories of Goods and Services Exempt from Sales Tax
As with taxability generally, no uniform exemption framework exists across jurisdictions. Many states provide exemptions for certain categories of tangible goods, which may include, without limitation:
- Food for home consumption
- Machinery and equipment
- Prescription medications
- Textbooks used in connection with post-secondary education
In recent years, a number of states have enacted new exemptions for diapers, menstrual hygiene products, and similar items previously subject to tax — commonly referred to as measures addressing the so-called “pink tax.” Such exemptions appear to reflect a broader legislative trend.
Exemptions for services are more prevalent than exemptions for goods in most jurisdictions. Commonly exempt categories of services include:
- Admissions
- Healthcare services
- Personal services
- Professional services
- Security services
Numerous additional categories of goods and services, including certain digital products, qualify for exemption in select jurisdictions. Additionally, approximately twenty states provide for temporary sales tax holidays, during which specified categories of goods are exempt from tax for a limited period.
As the foregoing illustrates, the determination of product taxability is inherently complex.
Common Pitfalls in Product Taxability Analysis
Several recurring issues warrant particular attention.
A. Taxability Rules Are Subject to Legislative and Regulatory Change
A determination of taxability that is accurate today may cease to be accurate tomorrow. In some instances, changes to taxability rules are announced well in advance of their effective date; in others, they take effect with little notice. South Carolina, for example, enacted an exemption for tampons and other feminine hygiene products on May 13, 2024, with the exemption taking effect immediately upon enactment. Similarly, although Colorado enacted the nation’s first retail delivery fee in 2021, the Colorado Department of Revenue did not issue implementing guidance until May 2022 — less than two months before the fee’s effective date.
B. Taxability Varies by Jurisdiction
As discussed above, certain goods and services are taxable in some states and exempt in others — food for home consumption, clothing, and digital products being illustrative examples. In most states, taxability determinations apply uniformly at the state and local level, such that a transaction subject to state tax is also subject to local tax (and vice versa for exempt transactions). This uniformity does not necessarily hold, however, in home-rule states such as Alabama, Colorado, and Louisiana, where local governments retain independent authority to administer and levy local sales tax.
By way of illustration, the City and County of Denver exempted feminine hygiene products from local sales tax effective July 1, 2019, and extended a similar exemption to diapers and adult incontinence products effective October 1, 2022. Notwithstanding these local exemptions, such products remained subject to Colorado’s state sales tax until January 1, 2023.
C. Bundled Transactions May Convert Exempt Sales into Taxable Sales
Where taxable and exempt items are bundled and sold as a single unit — as in the case of a gift basket — many states require that sales tax be applied to the full charge for the bundle. Other states permit the seller to apportion tax to only the taxable component of the bundled transaction, subject to jurisdiction-specific requirements governing when and how such apportionment is permitted.
Where a bundled transaction consists of a taxable good and an exempt service, sellers may be required to apply a “true object” test to determine the primary purpose of the transaction — that is, whether the transaction is properly characterized as the provision of a service or the sale of a good — with the taxability of the true object controlling the taxability of the transaction as a whole.
In certain circumstances, if the taxable component of a bundled transaction is de minimis (generally defined as ten percent or less of the total sales price), the entire transaction may be treated as exempt.
Given the jurisdiction-specific nature of these rules, careful analysis is required whenever a transaction combines both taxable and exempt items.
D. Exceptions Exist to Nearly Every General Rule
Most states maintain an extensive body of taxability rules, each subject to numerous exceptions. In Vermont, for example, following the extension of sales tax to sweetened beverages, certain products that might reasonably be presumed taxable were in fact exempt, and vice versa: sweetened iced teas are generally taxable, while a particular bottled coffee beverage containing comparable or greater sugar content is exempt. Sales tax holidays, by their nature, constitute a further category of exception to otherwise generally applicable rules.
Obligation to Collect and Remit Sales Tax
A business is required to register with the relevant taxing authority and to collect and remit applicable sales and use tax in any state in which it has established nexus.
Sales tax nexus refers to the connection between a business and a state sufficient to permit that state to impose a tax collection obligation on the business. Nexus may be established through physical presence, economic activity within the state (economic nexus), or other statutorily defined connections, with specific requirements varying by state.
Notably, in many states, a business may establish nexus even where all of its sales within that state are exempt from tax.
Compliance Obligations Continue Beyond the Taxability Determination
The determination that a product is taxable is only the first step in the compliance process; the seller must thereafter apply the correct tax rate, which varies not only by state but by local jurisdiction. Texas alone contains approximately 1,500 distinct local tax jurisdictions, and more than 12,000 such jurisdictions exist nationwide.
The compliance burden is further compounded by the frequency with which taxability rules and tax rates change. In 2023, there were 85,836 recorded taxability rule changes across the United States and Canada, together with 98,910 changes to sales tax holiday rules within the United States.
Given the volume and pace of change reflected above, businesses operating across multiple jurisdictions should maintain rigorous, ongoing monitoring of applicable taxability rules and should consult qualified tax counsel regarding jurisdiction-specific compliance obligations.