Five Hot Spots for Manufacturing Sales Tax Exemptions
By: Taylor Atwood, CMI, Manager, Sales & Use Tax
Most states offer a variety of sales tax exemptions to manufacturers as incentives for companies to locate and keep plants in their states. However, not all purchases used by manufacturers are exempt from tax, and many items only qualify for exemptions if they meet specific requirements. Unfortunately, a common misconception by manufacturers is that everything is exempt, but that is far from the truth. Discover the five hot spots within your manufacturing facility where most sales tax underpayments occur and learn how to identify taxable purchases.
Theories Used to Determine Taxability
First, understand that states generally follow one of two theories when making taxability rulings:
- Integrated Plant Theory: Machinery and equipment that is necessary and essential to the manufacturing process will be exempt from tax.
- Direct Use Standard: Only the machinery and equipment directly used (i.e., directly making a change to the physical product) falls within the exemption.
States interpret these theories differently which leads to confusion, especially for manufacturers with plants in multiple states.
Recent Ruling Showcases Confusion
North Carolina is a state that generally offers very broad exemptions for manufacturers; however, in a letter ruling issued in March 2021, the state ruled that purchases of fire detection and suppression systems were taxable. In the yarn production industry, a very high risk of spark and flammable hazards exist during the production process. The taxpayer, a yarn manufacturer, considered fire detection and suppression systems to be a necessary and essential part of production as these systems shut down the production process if they detect a hazard. The state ruled that although the systems were attached to the production equipment, they were not used directly in the production process as described in Sales and Use Tax Technical Bulletin 57-1 and were not considered exempt mill machinery, or mill machinery parts or accessories.
The North Carolina ruling above is a good example of how states offer narrow definitions of the sales and use tax exemptions that they extend to manufacturers.
Five Hot Spots Where Underpayments Occur
The five common hot spots where sales tax exemptions are frequently inapplicable include:
- Maintenance Items
- Production Supplies
- Safety Apparel
- Janitorial Supplies
Maintenance purchases may include repair parts for manufacturing machinery, maintenance equipment, and maintenance supplies. Many states offer exemptions for repair parts; however, maintenance equipment and supplies may or may not be taxable depending on how broad the manufacturing exemption is in your state.
Most states now have a broad exemption for production supplies. Some states only offer exemptions for production supplies that come in direct contact with the manufactured product. Other states offer exemptions for supplies that are rapidly consumed in the manufacturing process. Many states, such as Georgia, require that exempt purchases be “necessary and integral” to the manufacturing process. Several states, such as California, do not have any exemptions for production supplies. States that are more middle of the road, such as Arizona, exempt a production supply only if it comes into direct contact with the manufactured product and causes a chemical or physical change.
Storage of raw materials or finished products is generally going to be a taxable part of the manufacturing process. Some states also offer an exemption for items such as storage racks if used to store products during the manufacturing process before production is complete. Also, depending on the state, material handling equipment used to move raw materials, work in process, or finished products may be exempt from tax. In Michigan, machinery, equipment, or materials used within a plant site or between plant sites operated by the same business for movement of work in process may be exempt from tax.
Safety apparel worn by employees will generally be taxable; however, there are several states that may offer exemptions for safety apparel. In North Carolina, safety apparel is exempt if it protects the product but is taxable if it is for the protection of the employee. In Georgia, most safety apparel is exempt because it is considered to be necessary and integral to the manufacturing process. Included in the Georgia exemption are gloves, earplugs, facemasks, protective eyewear, hardhats or helmets, breathing apparatuses and headlamps.
In general, most janitorial supplies that are used to clean the manufacturing facility will be taxable if used to clean administrative areas of the plant. However, if used to clean the manufacturing machinery or areas close to the manufacturing process, these may be exempt from tax. South Carolina’s manufacturing exemption applies to chemicals used to clean the exterior or interior of an exempt manufacturing machine when the cleaning is integral and necessary to the manufacturing process and the use of such chemicals is an ongoing, continuous activity. However, the exemption does not apply to chemicals used to clean non-exempt machines, or to those used to clean floors, walls, and other parts of the manufacturing facility.
State auditors know where to look for taxability errors and typically their searches begin in these hot spots. Beat them to the punch by auditing these areas and addressing issues that could result in large audit assessments. Contact your Cherry Bekaert advisor for guidance.