What if you were putting your business at risk of incurring an unexpected cost every time you invoiced a customer? “How could I possibly be at risk?” you may ask. “My product or service is priced so there’s a profit. I’m invoicing my customers on a timely basis, and they are remitting payments in the time indicated.”
While these are all important aspects of the billing process, one factor that is often overlooked is the composition of the invoice itself. The importance of a well-constructed invoice may come as a surprise to some, but it should not be underestimated. In sales tax audits, we see many instances when the way sales are invoiced leads to assessments, interest, and penalties—all of which could have been avoided.
How do your invoices measure up?
Following are five key fundamentals of customer invoicing. The thoughtful and intentional presentation of these key components can help you avoid sales tax headaches.
Location, location, location!
While businesses are typically thorough about including a billing address on an invoice, the same cannot be said for the location of delivery. It may seem redundant to include the delivery location on an invoice, especially when the two addresses are the same. The issue arises when the two are not the same and only the billing address has been specified. Fast-forward four years to when you are sitting in front of a sales tax auditor and asserting where a transaction took place while your invoice tells another story.
The delivery address indicated on an invoice for the transaction is important for a couple of reasons. First, the location typically drives the tax rate for taxable transactions. If you include the billing address as the state next door and charge that state’s tax, but the invoice indicates the customer picked up the item at your location, an auditor is not going to be sympathetic to the fact that you charged the other state’s tax. He or she will assess the transaction in your state, and you will be left to decide whether you are going to go back to the customer to request payment of the appropriate tax.
Listing of the delivery location also serves as proof that a sale is in—or maybe more importantly, outside—a particular state. An inaccurate location or the lack of a delivery location altogether will give a state auditor the opportunity to make assumptions about where a sale took place and possibly pull a sale into his or her state for assessment. For example, if the billing address is present on the invoice, but the delivery location is not, the auditor will likely assume that the delivery location was the same as the billing location. If that delivery location was actually out of state, suddenly you’ve got an extra sale for which you have either not collected tax or collected the “incorrect” state’s tax and for which you will now be liable. And this error could be projected to all of your sales based on the sampling method.
- Say it like you mean it.
Poor, overgeneralized, or inaccurate descriptions of what is being sold can open the door for undue sales tax liability. Invoice descriptions can be your friend or enemy in the event of an audit. Consider the difference in sales tax treatments of “truck rental” and “trucking services.” Both involve provision of a truck in some capacity, but absent any other information, in most states the rental of a truck would be deemed taxable, and trucking services would be deemed nontaxable.
In the realm of sales tax, “form over substance” is the mantra, which gives more deference to the way an invoice reads than what the preparer’s true intention was at the time of preparation. If an auditor believes a transaction as described on an invoice is taxable, he or she will simply list that transaction as a potential error, and it will be the taxpayer’s responsibility to prove otherwise, leading to additional work. General descriptions like “labor” and “goods” can also result in rounds of discussion with the auditor about exactly what type of labor was provided or what types of goods were sold, to determine taxability.
- To separately state charges or not to separately state charges—that is the question.
Businesses may have varying reasons for combining multiple charges into one line item on an invoice. A company may combine items that are naturally connected, like a piece of machinery and the labor to install that machinery. Another company may believe that this is a way to more closely guard its pricing of individual items from competitors. Still others may hope simply to decrease the amount of time spent on the invoicing process itself in favor of attending to one of the many other duties they hold within the business.
Whatever the reason may be, it’s important to note that the sale of two or more distinct and identifiable products for one nonitemized price can create an unintended sales tax problem. In many states, a “bundled transaction,” as it is commonly described, can become problematic when a taxable item or service is combined with a nontaxable item or service. The nontaxable item becomes tainted by the taxable item with which it is combined, and the entire line item becomes taxable. “Distinct and identifiable products,” as used here, does not include real property and services to real property.
Another nuance of state treatment regarding separately stated items is the billing of labor—for example, Wisconsin taxes labor, even when separately stated, if the labor relates to a taxable item. Contrast this with Illinois, where separate statement of labor relating to a taxable item preserves the exempt nature of the labor.
Yet another issue that arises from the separate statement of items, rather than bundling, is the billing of an exempt service. Various states deem the service provider to be the consumer of any materials that are used in the service, but if the materials are separately stated on the invoice, that same state treats the materials as taxable to the customer.
The point here is not to discourage the bundling of items or the separate statement of items if there is a good business reason for doing so. Rather, it is to make businesses aware that the decision to invoice in those ways will give rise to an elevated obligation to monitor whether tax has been charged correctly.
- Special delivery!
Charges to a customer for shipping, delivery, and freight have long been a source of confusion for businesses, as well as a source of assessment upon audit. Some companies believe that if freight, shipping, or delivery charges are separately stated on an invoice, the charges are automatically exempt from sales tax. Unfortunately, that is not always the case, and treatment of these charges needs to be reviewed on a state-by-state basis. While some states do provide an exemption for separately stated delivery charges, others deem the charge taxable regardless of separate statement. If delivery charges that would typically be exempt when separately stated are combined with a taxable item as one single charge, the delivery would most likely become taxable. Refer to item #3 regarding bundled transactions.
To make matters more complicated, if you separately state a shipping charge on the invoice and both taxable and exempt items are being shipped, there can be multiple ways to treat that transaction. The charge might be taxed based on the same ratio as the price of all taxable goods to the total sales price of all goods (both taxable and exempt). Some states offer an option to apply a ratio based on weight of taxable goods to weight of all goods to determine what portion of the delivery charge is taxable. Still other states (i.e., Illinois) treat separately stated lump sum delivery charges as exempt if the selling price of the nontaxable items is greater than the selling price of the taxable items. If a vendor invoices some amount of markup over the cost of the delivery, typically the portion of the delivery charge that is greater than the actual delivery cost is taxable.
- When it comes to ZIP codes, more is more.
Remember the days when a five-digit ZIP code was an accurate way of determining the applicable rate of sales tax? With the availability now of the additional four digits (ZIP+4), it is possible to more accurately identify the tax rate associated with that location. It’s not as much of an issue if you bill to a customer in a town with one ZIP code and one tax rate. Using ZIP+4 becomes more important when there are multiple ZIP codes and the possibility of multiple tax rates within each of those ZIP codes. Typically states that make available an online tax rate database require the use of the ZIP+4 convention to accurately identify the tax rate that should be used. In some instances, even ZIP+4 is not enough to distinguish one rate from another, and geocodes are needed to pinpoint the correct one.
Taking the time up front to draft an accurate and complete invoice can save time, effort, and money at the time of a sales tax audit. Statement of delivery location, strong descriptions of transactions, attention to the combination or separation of charges, correct treatment of delivery, and use of ZIP+4 can make your invoices more robust and help to prevent the loss of hard-earned money by way of sales tax assessments. Should you have questions about how a state treats particular items or the presentation of those items on your invoice, we encourage you to contact a member of Wipfli’s State and Local Tax Team.