During my 20 years as an auditor with the California Board of Equalization, my colleagues and I noted that tax understatements were generally due to misunderstanding of Sales and Use Tax Laws and Regulations. A few of these misunderstandings were so pervasive that even some technicians answering taxpayers' inquiries were giving erroneous advice on a few issues. Let me try to clarify just a few of these misconceptions…
MYTH #1: Transportation charges are always exempt from Sales Tax
This is false. Certain conditions must be present to make these charges exempt. Generally, to be an exempt freight charge the following three conditions must be met:
Why is this? Well, let's say you were selling $10,000 worth of something taxable and you delivered the goods yourself. If you charged $200 for the delivery, and you were allowed to exempt the delivery charges, how long would it take for you to decide to sell the goods for $200 and charge $10,000 to deliver them? You'd get the same amount of revenue, the State would get almost no sales tax and your customer would be very, very happy!
By requiring the use of a common carrier and requiring separately-stated, actual charges, the sale is no longer bundled. There is no confusion about who is getting the delivery charges and how much the actual selling price was.
And, don't forget: if you add a fuel surcharge to your delivery charges when you deliver with your own vehicles, these become part of the taxable sale! It's simply another way of stating your delivery fee. I remember one company that added over $400,000 in fuel surcharges during a three-year period when fuel prices started going crazy. That was about $30,000 in tax they owed that they weren't aware of until audited. They could have charged tax on these surcharges if they'd found out in advance. The Board of Equalization did notify all permit-holders immediately when surcharges became fashionable, which is why it is vital that mailings from the Board of Equalization are given immediate attention.
Another misconception, still part of Myth #1, is that by separately stating your cost of freight to get the goods delivered to your store (freight-in) as an add-on to the selling price of the goods to your customer, you can exempt these freight-in charges. Those charges are not exempt- That was your cost to obtain the inventory. It is fully taxable as part of the selling price you are passing along to your customer. Think of it this way: if it was not a special order and you were getting a shipment of 50 widgets to place into inventory, you would allocate the freight charges to the unit cost before adding a markup. Thus, the freight-in would just be hidden in the selling price of each widget.
There are instances when charges can be exempt even when you deliver with your own trucks. These generally apply to shipments of rock, sand, etc. If you have a customer sign an agreement that title to the goods passes before the goods are loaded onto the truck and the customer acknowledges all risk of loss, the freight charges can be exempt. Another instance is when delivery was not contemplated at time of sale but title passes and the goods are subsequently delivered by you – for an additional charge. An example of this is when a customer brings their own trailer to pick up 5 units of railroad ties, buys them, then an axle breaks during the loading. You agree to deliver them for an additional $100. This is an exempt delivery service unconnected to the original sale.
MYTH #2: Sales tax does not apply to labor
This too is false. Actually, most labor is subject to sales tax. It is usually hidden in the selling price of the goods bought or sold. Almost everything sold has been fabricated and fabrication labor, which is any step in the process of creating a product or getting it prepared for sale/use, is taxable. The computer you are reading this on was manufactured. The retailer cannot deduct the value of the labor cost paid to produce it. Nor can the allocated overhead, payroll taxes, profits, etc. be deducted. The gross selling price is taxable.
Sometimes the fabrication labor itself is taxable. Rock crushing is a good example. Rock crushing machinery makes little rocks from big rocks. They change the essential nature of a thing by transforming it. Every penny that a rock crusher charges, including mobilization/set-up, etc, is a taxable sale, unless sold for resale to a rock pit, where the charges will be added-on to the material before sale. The sales tax will, therefore, be collected and paid when the rock is eventually sold. Some rock crushers have been handed tax determinations in the hundreds of thousands of dollars! They were crushing rock for paving contractors, who are consumers of the rock, and the sale to the contractor was a retail sale. They had no idea that their activity was subject to sales tax.
Here are some other examples of fabrication labor being taxable: Splitting wood for others or welding a swing set for a neighbor using their steel (if you have a Sellers Permit or should have had one). If you bought some bicycles still in boxes and decided you couldn't assemble them so you took them to a bike shop they would have to pay sales tax on the amount they charge you to simply assemble the bikes. A cabinetmaker owes sales tax on the entire charge for all the cabinets they sell or install, except for a small allowance for installation charges (10% is generally the maximum allowed by the Board). Granted, there are some conditions that can be satisfied by the cabinetmaker to exempt his/her fabrication labor, but less than 5% of all cabinetmakers qualify for this treatment, based on my 20 years with the Board.
In the future I'll explore and explode other myths for you. But for now, I hope you're starting to realize that some commonly held beliefs may be very incorrect. It could, in fact, be very costly to find out too late that something you thought was exempt is actually taxable.
If you have any questions or concerns, I can either discuss the situation on the phone, at the office or at your place of business. In just a short time I could even perform a mini-audit for you and give you the opportunity to make corrections before being audited by the Board. The Redding office has recently increased their audit staff by 60% and it's not because they want the extra auditors to sit around the office! It would be a lot less expensive to give me a call and discuss your situation/types of transactions in advance.
For any additional questions about Sales and Use Taxes, please contact our office at (530) 926-3881 and we'll be happy to assist you.
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