The Shift to a Service-Based Economy
States that rely on sales tax revenue to balance their budgets are particularly affected by the change, and they’re reacting. In 2016, North Carolina extended sales and use tax to many previously exempt services, notably installation, maintenance and repair services.
Similarly within the last few years, martial arts and many other athletic and amusement activities became taxable in Washington State. In 2015, among other changes, website hosting services became subject to Connecticut sales tax, Chicago slapped a tax on many amusement services, and cloud computing and video game services became taxable in Tennessee.
If this looks like a trend, it’s because it is. An increasing number of states are taxing a growing number of services for the first time. As consumption in the United States continues to shift from goods to services, states that rely on sales tax revenue will look to tax more services to keep their budgets in the black.
For businesses that provide or consume services, understanding service taxability will become increasingly critical to sales and use tax compliance.
How States Determine Sales Tax on Services
- Impose tax on specifically enumerated services (all others are exempt)
- Impose tax on all services, except those specifically exempted
Four states take the second approach, imposing sales tax on all services except those specifically exempted by law: Hawaii, New Mexico, South Dakota and West Virginia.
Five states tax fewer than 20 services: Colorado, Illinois, Massachusetts, Nevada, Virginia.
The majority of states take the first approach, applying sales tax to only certain, specifically enumerated, services. And five states (Alaska, Delaware, Montana, New Hampshire, and Oregon) do not have a general sales tax.
How States Define Services
- Business services
- Personal services
- Professional services
- Maintenance and repair services
As consumers, most of us don’t stop to consider if we’re purchasing a “personal service” or a “professional service.” However, the distinction is important because the type of service often affects taxability.
Services primarily consumed by businesses are known as business services. These are numerous and include advertising, computer services, human resources services, lobbying and consulting, and payroll services. Some surprising states, including New York, Texas, and the District of Columbia, tax several business services.
Personal services are primarily consumed by individuals, although they may also be purchased by businesses. They include dry cleaning, hair care, hunting and fishing guide services, and tanning. Hawaii, New Mexico and South Dakota tax all personal services; a few other states tax most personal services.
Professional services providers include architects, attorneys, doctors, engineers—people who need to obtain special certification, education and licensing in order to practice in a state. As with personal services, they are consumed by both businesses and individuals. Little or no tangible personal property is involved in these transactions, but when it is (e.g., architectural or engineering plans), taxability can be impacted.
Again, Hawaii, South Dakota and New Mexico tax a broad range of professional services. States that don’t tax the service typically tax the business inputs.
Repair, Maintenance and Installation Services
Repair, maintenance and installation services can be provided to tangible personal property (like your refrigerator or car) or to real property (like your house).
Often—but not always—these services are taxable if the tangible personal property (TPP) is taxable and exempt if it’s exempt. It can be critical for businesses to separately state service charges on invoices that include TPP, as some states exempt services if they’re separately stated but tax them if they’re combined.
The taxability of services provided to real property often hinges on whether the property is residential or commercial and whether the project is new construction or a remodel. Here again, the fact that tangible personal property is often involved (e.g. materials) can complicate taxation. To make matters worse, states don’t define construction services in the same way.
Sourcing Rules for Services
- The location where the service is performed
- The location where the benefit of the service is received
Often the location is the same, as when hair is cut or a car is repaired. But that’s not always the case. In fact, one reason many states have opted not to tax many professional services is because it’s easy to purchase those services from providers located in other (more tax friendly) states.
Once sourcing is understood, varying rules and rates can come into play and make sales tax compliance more complex. For example, confusion can arise when a service provider is located in a state that applies tax based on where the service is performed but the consumer is located in a state that applies tax based on where the benefit is received. Audits invariably arise.
States are Changing the Rules
Nonetheless, the trend to tax more services continues as more and more states attempt to broaden sales tax on services, expand the tax base, or simply increase existing rates.
For a more comprehensive look at services taxation nationally, download Avalara’s Service Taxability by State guide to learn more about which services are taxable in each of the 50 states.