If your business sells goods or services, understanding product taxability is essential. It determines whether you need to collect sales tax, how much to charge, and where to remit it.
At first glance, sales tax seems simple, some things are taxable, others are not. However, taxability rules vary significantly across states and industries, creating a complex compliance landscape.
For example, a bottle of iced tea might be taxed in one state but exempt in another. With additional variations based on sweeteners.
Multiply this across thousands of products and 50 states, and the challenge becomes clear.
This article will break down product taxability, highlight common pitfalls, and provide strategies to help your business stay compliant.
What is Sales Tax, and why does it matter?
Sales tax is a tax collected from consumers when they purchase goods or services. Unlike income tax, which businesses and individuals pay on their earnings, sales tax is a pass-through tax, businesses collect it at the point of sale and remit it to the appropriate tax authorities.
What makes sales tax complex is that there’s no national system in the U.S.; instead, each state (and often local governments) sets its own tax rules. This means tax rates and exemptions vary widely.
For example, some states, like New Hampshire and Oregon, have no statewide sales tax, while others, like Alaska, allow local governments to impose their own.
Groceries might be tax-exempt in one state but subject to a reduced tax in another. Even digital products can be taxed differently, some states tax downloaded software the same as physical copies, while others do not.
For businesses, the challenge isn’t just knowing whether sales tax applies, it’s keeping up with frequent rule changes and ensuring every transaction is taxed correctly.
Which products and services are taxable?
In most states, sales tax applies to tangible personal property, physical products like electronics, clothing, and furniture. But some exceptions exist:
- Clothing is taxable in some states and exempt in others: New Jersey doesn’t tax most clothing, but in New York, only items under $110 are tax-free.
- Digital goods, like e-books and streaming services, are taxed differently across states: Some states tax them the same as physical goods, while others don’t tax them at all.
- Food and beverages follow complex rules: A sandwich from the grocery store might be tax-free, but the same sandwich from a deli counter could be fully taxed.
What About Services?
Services are generally not taxed as widely as goods, but the rules are inconsistent:
- Some states tax almost all services: Hawaii and New Mexico impose sales tax on nearly every service, from haircuts to accounting services.
- Other states tax only specific services: Texas taxes telecommunications, cable TV, and some labor services but exempts many professional services.
- A few states tax almost no services: In California, most services are exempt unless specifically listed as taxable.
If you sell both goods and services, it gets even more complicated.
For example, if you sell software and provide installation services, some states might tax both. While others will only tax the software.
How Sales Tax rates are determined
Sales tax isn’t just about whether something is taxable, it’s also about how much tax to charge.
The rate you apply depends on the sourcing rules of the state:
- Destination-Based Sourcing: Most states use this rule, meaning sales tax is based on the buyer’s location. If you ship a product to a customer in New York, you charge New York’s tax rate.
- Origin-Based Sourcing: A few states, including Arizona and Missouri, tax sales based on the seller’s location. If your business is in Phoenix, you charge Arizona’s rate, even if your customer is in another city.
- Hybrid Sourcing: Some states, like California and Texas, use a mix of both. California applies origin-based sourcing for state-level tax but destination-based rules for local taxes, making compliance even more complex.
This means businesses must track where their customers are, determine the correct tax rate, and apply it at checkout. Failing to do so can result in under-collecting or over-collecting tax, both of which can lead to penalties.
Common Sales Tax exemptions
Some products and services are automatically exempt from sales tax. Common exemptions include:
- Essential goods like groceries, prescription medications, and medical devices.
- Certain business purchases, such as machinery used in manufacturing.
- Educational materials, including textbooks for college courses in some states.
Many states also offer sales tax holidays, where specific products are temporarily tax-free. For example, Florida has an August “back-to-school” tax holiday, where clothing, school supplies, & laptops under a certain price are exempt from sales tax.
Top challenges businesses face with product taxability
Sales tax compliance isn’t just about knowing the rules, it’s about keeping up with constant changes and avoiding common mistakes. Here are a few challenges businesses face:
- Sales Tax rules are always changing: Tax laws change frequently, and businesses must stay updated.
- The same product can be taxed differently in different places: A hot coffee in one state might be tax-free but taxable in another. In some states, hot coffee is taxed only if it’s sold to-go, but not if consumed in-store. These small details can create major compliance headaches.
- Bundled transactions can create confusion: If you sell a gift basket with a mix of taxable and non-taxable items, some states require the entire basket to be taxed, while others let you tax only the taxable portion.
- Different nexus rules impact tax collection: If your business has nexus in a state, you’re required to collect sales tax there. Nexus can be established through physical presence (like a store or warehouse), economic activity (exceeding a state’s sales threshold), or affiliate relationships. Even if all your sales are tax-exempt, you may still need to register in states where you have nexus.
Navigating product taxability is one of the most challenging aspects of sales tax compliance, with ever-changing rules and variations across states.
To stay compliant and avoid costly mistakes, businesses must take a proactive approach. This includes staying informed about tax law changes, leveraging automation tools to ensure accurate tax calculations, and consulting with tax experts to handle complex exemptions and regulations.
