The evolution of service taxation
Sales taxes were initially only imposed on certain purchases. These were referred to as “real tangible personal property.” But with the boom of the service industry, many states have begun to expand sales tax to include services.
The story of taxes in the US has been a fascinating, long-winding one. Initially, taxes were placed on specific items such as alcohol and tobacco, but eventually, income taxes were also added. As the economy evolved, so did the types of taxes, including corporate, estate, payroll, and capital gains taxes. Now, many states have even extended sales tax to include services as well.
Types of taxable services
By now, you’ve realized that no two states are the same concerning sales tax treatment.
Sales tax rules vary by state, and each state determines which goods and services are taxable. Sales taxes are collected when the seller and buyer are located in the same state. However, when the seller and buyer are in different states, the state may impose a compensating use tax on purchases of goods. This use tax is typically set at the same rate and base as the sales tax, and it aims to prevent the avoidance of sales tax by purchasing from out-of-state vendors.
It’s worth noting that the taxation of services is also subject to state-level decisions. Legislators can expand the taxation of services in two different ways. First, they can choose to include additional services under the existing sales tax framework. The expansion of the taxation of services is often a contentious issue, as it can have significant implications for businesses and consumers alike.
That being said, there has to be a way of determining if your business is subject to sales tax. That’s where the general categories for taxable services come into play.
- Services to tangible personal property (TPP)
- Services to real property
- Business services
- Personal services
- Professional services
- Amusement/Recreation
Navigating state-specific taxable services
Each US state has its own way of taxing services. However, there are five states (New Hampshire, Oregon, Montana, Alaska, and Delaware) that don’t have a general sales tax on anything, whether it’s goods or services). This leaves us with 45 remaining states. Out of these 45 states, only four (Hawaii, South Dakota, New Mexico, and West Virginia) automatically tax services, except for those that are specifically listed as exempt in the law. The result is the latter 41 states, including the District of Columbia, determining their own specific list of taxable services.
Taxing SaaS businesses
The relationship between sales tax and SaaS (software as a service) is incredibly unique (and complex). This is due to the complexity of its classification. Is it a product or service or a software? The answer drastically affects the taxability and treatment. To help provide clarity and transparency around the topic, each state in the USA is trying to adapt its tax legislation to the digital world around them, which is why we encourage each individual SaaS to dive deeper into how to manage your sales tax obligations as a SaaS.
How to determine whether a service is taxable or not
Due to the lack of standardization across states, determining whether something can be categorized as non taxable services, is one of the most significant challenges in the sales tax landscape. However, we suggest following the steps below to best gauge your sales tax exposure.
- Start at a state level and evaluate whether or not your service is deemed taxable in that state.
- Determine whether your service may be exempt from tax.
- If neither of the above applies, some states allow the true object test to determine the purchaser’s intent for the transaction.
What is the true object test?
In certain vague or ambiguous cases, the true object test helps businesses determine whether a sale should be taxed. In most cases, this applies when a sale involves both a product and a service. This test helps decide if the main reason for the sale is the product or the service. The whole transaction gets taxed if the main reason is the product. But if the main reason is the service, no tax is usually applied. This kind of mixed sale happens more often in specific industries like construction, manufacturing, and healthcare.
