Sales Tax Exemption Certificates: How do they work?

Sales taxes fund state and local government operations. In recent years, companies have been required to collect these taxes in a growing number of situations as states have sought out new revenue sources. 

In fact, in 2018, the Supreme Court began allowing states to collect sales tax on online sales on the basis of economic nexus. And, as the world moves increasingly online, many states have also amended sales tax laws to collect taxes on software-as-a-service and other digitally delivered goods. 

Not every purchase is taxable, though. Some goods and services and buyers are exempt from sales tax. This complicates collection, especially as exempt buyers must show they don't have to pay tax when others do. These buyers must use sales tax exemption certificates to prove they don't have to pay, and sellers must manage these certificates in case of audits.

What Is a Sales Tax Exemption Certificate?

A sales tax exemption certificate is a form that a buyer must submit to a seller to prove that the buyer isn't required to pay sales tax on a purchase that would otherwise be taxable.

Companies and individuals can obtain sales tax exemption certificates if they are eligible for sales-tax-free transactions. Exemptions may be available to:

• Retailers purchasing products for resale
• Manufacturers purchasing raw materials that will be used in manufacturing other goods that will be resold
• Government entities such as state-run schools
• Charitable and non-profit organizations

Rules can vary by state for who is exempt and when. For example, nonprofits or charities may be able to make tax-exempt purchases only if the item goes directly to the core mission of their operation, not for general operational expenses.

Eligible entities are responsible for obtaining sales tax exemption forms and submitting them when they make qualifying purchases. Sellers must keep these certificates on file so they can justify not collecting tax on exempt transactions if they are audited.

The exemption certificate typically must include a few key details to be valid, including:

• The buyer's state tax ID number
• The seller's name
• The buyer's name
• The type of exemption
• The customer's signature.

States have different rules for how long forms are legally valid. The timeline could range from indefinite, as long as business information does not change, to as little as one year before renewal is required of an exemption certificate is required.

Businesses that collect these certificates should keep them on file for the full length of time that they could potentially be audited, which is determined by the state's statute of limitations. 

Types of Sales Tax Exemption Certificates

Buyers are responsible for obtaining the correct sales tax exemption certificate based on their organization type, the products they are buying, and state laws. Some of the most common types of tax-exempt certificates include:

• Resale Certificates: Resale certificates are used by companies purchasing goods they intend to resell and charge tax on. Some states have separate certificates for resellers, while others use the same documents for both exempt businesses and resellers who are not exempt from all sales tax but who simply aren't taxed when buying the items they plan to resell. 
• Exempt Organization Certificates: Some types of organizations are exempt from sales tax more generally, not just on goods they're reselling but also on items the organization intends to use to perform their core mission. Organizations like government entities and schools often fall into this category and can obtain exempt organization certificates. 
• Manufacturing Exemptions: Special exemptions exist for raw materials used by manufacturers. Exemption certificates should specify what kinds of purchases are tax-exempt, including materials and sometimes equipment and machinery. 
• Agricultural Exemptions: Specific types of exemption certificates may be available for the purchase of products used in farming and agriculture. For example, Florida allows exemptions to qualifying farmers for animal and aquaculture health products; aquaculture feed and fuel; electricity used for agricultural packaging; fences and trailers used in agriculture; and certain other products used in their trade.
• Direct Pay: Some companies engage in many complex transactions including those that are taxable and those that are not taxable. To simplify the process of paying taxes only on the correct items, businesses can apply for a Direct Pay Permit. When they submit this to a seller, the seller doesn't charge sales tax because the purchasing company is promising to self-assess the sales tax owed and pay it directly. 
• Interstate and Multijurisdictional Certificates: Businesses that operate in multiple states may be able to get exemption certificates that are good in several locations instead of having to get an individual certificate from each state. There is a Uniform Sales and Use Tax Certificate Multijurisdictional available from the Multistate Tax Commission that eligible individuals and businesses can explore. 

Buyers of tax-exempt goods have the responsibility of ensuring that they select the right type of certificate, which is valid for their purchases. 

Sellers who provide goods to exempt buyers must collect the appropriate exemption certificates and keep them on file in case they are audited. The certificates are used to prove they complied with their obligations to collect sales tax except when doing so was not required. 

Responsibilities When Purchasers Present Exemption Certificates to Sellers

Sellers of goods are responsible for collecting sales tax on non-exempt transactions and making sure they follow the rules for exemptions.

Specifically, this means that sellers must:

• Collect exemption certificates from every exempt customer. Companies should collect a certificate any time a new tax-exempt customer makes a purchase or when a tax-exempt customer has an expiring certificate. Obtaining certificates should be done at the point of sale because getting one months or even years later is harder. It's advisable to collect exemption certificates even in states where the business does not currently have nexus so the certificate is on file in case circumstances change later. 
• Validate exemption certificates. Sellers are protected from legal trouble for not collecting taxes on exempt sales only if the exemption certificate on file is legally valid. Always check for missing or incorrect information, and ensure the proper certificate is submitted (for example, don't accept a resale certificate if an exempt organization certificate is necessary for a particular transaction).
• Keep track of expiration dates. An expired certificate isn't valid, and many exemption certificates expire after one to five years. Keep track of when certificates are expiring and allow ample time to collect new ones from exempt customers before the deadline. 
• Store exemption certificates appropriately. Sellers must be able to retrieve an exemption certificate when necessary, so be sure the forms are accessible and easy to locate.  Exemption certificates should also be kept on file until the statute of limitations for a sales tax audit has expired.

If a seller doesn't have a valid exemption certificate and allows a tax-free sale, the seller could be held legally responsible for the unpaid tax. This could have serious financial consequences as sellers could owe a substantial amount of money in back taxes and penalties as a result of carelessness in collecting and managing exemption certificates. 

Exemption Certificates and Nexus 

Economic nexus is triggered when a business or entity establishes a certain amount of economic connections with a state. Selling a certain volume of goods within each location can create economic nexus, which means the business must register to collect sales tax and remit the taxes due.

In many states, exempt sales still count when determining whether a company has established economic nexus. This means even if a seller doesn't collect sales tax on the items purchased because the buyer is exempt, the value of the items the buyer purchased will count towards the threshold that establishes nexus.

Companies must collect exempt certificates for every state in which they have economic nexus since they are required to collect and remit sales tax to those states. Sellers should also collect certificates in states where they haven't established nexus yet. Otherwise, if they establish nexus later, they'll face an arduous process of obtaining exemption certificates from buyers they may have been doing business with for years.

State-by-State Variations

Different states have different rules regarding:

• What entities are exempt from sales and use tax
• What types of transactions are exempt
• What types of exemption certificates businesses can use
• How long exemption certificates are good for
• How long sellers must keep exemption certificates on file when a buyer submits a certificate and completes a tax-free transaction

Challenges and Solutions in Managing Exemption Certificates

Managing exemption certificates can be very challenging for a business -- especially one that sells products or services in many states. Some of the biggest obstacles for complying with sales tax exemption requirements include:

• Keeping track of expiration dates: All certificates for exempt transactions must be current and valid. 
• Ensuring proper documentation for audits: Sellers must be able to prove the buyer had a valid exemption for any transaction in which the seller did not collect sales tax. Otherwise, this could lead to unpaid taxes and penalties the seller is on the hook for. 
• Managing certificates across multiple states: Different states have different requirements for exemption certificates. Sellers must ensure they comply with the rules across all states where their business has economic nexus.

There are ways to overcome these challenges and to protect against financial consequences that occur as a result of a failure to follow sales tax rules. The two best steps to take include:

• Training staff: Staff members should understand when and how to collect an exemption certificate when an eligible sale is made and must learn how the exemption certificate should be validated and stored. 
• Using software solutions: Numeral makes managing exemption certificates effortless. Numeral provides a centralized location to store collected certificates; confirms the validity of certificates and whether a transaction is exempt; and sends an alert when an exemption certificate will soon expire so a new certificate can be obtained.

With the right software solutions and a training program in place, every company can effortlessly ensure full compliance and reduce their audit risk. 

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How Purchasers Can Obtain a Sales Tax Exemption Certificate

Buyers eligible for sales tax exemption must either request one from the relevant taxing authority or create one when they are allowed to do so under state law. Exemptions usually must contain specific information including:

• State tax ID numbers
• The date 
• The customer's name
• The seller's name
• The type of exemption
• A valid customer signature.

States have different requirements for exemption forms so buyers should check the Federal Tax Administrators database to find their state tax agency's website and learn local rules. For example, under Florida law, political subdivisions must submit Form DR-5 to the Department of Revenue. The DoR then provides a Consumer’s Certificate of Exemption (Form DR-14).

Final Thoughts

Sales tax exemption certificates serve an important purpose by allowing sellers to sell items to tax-exempt buyers without collecting the sales tax that would normally be required on the purchase of those items.

Buyers must have the correct certificate to make exempt purchases, though, and sellers must make sure they are taxing transactions when required to by law -- as well as collecting and storing exemption certificates when the law says a particular buyer is exempt.

Sellers can make collection and storage of these exemption forms easy and effortless with Numeral. Numeral facilitates the uploading of exemption certificates and then stores and manages the forms for you. This is just one of many tasks that Numeral handles so you can spend less than five minutes monthly on sales tax compliance. 

Don't spend your time and effort struggling to find a sales tax solution that works. Contact Numeral today to find out how this CPA-designed software can make worrying about sales tax exemption certificates a thing of the past.