Manufacturers often buy expensive stuff, including the enormous pieces of machinery and equipment necessary to efficiently run their production processes. In almost every state, manufacturers can purchase at least some items to be used in the production process free of sales tax or possibly subject to a reduced rate. However, the scope of available exemptions varies significantly from place to place. In this environment, knowing what exemptions apply and how your suppliers should (or should not) be charging you tax is critical. Further, as manufacturers grow and move into new geographies, the challenge multiplies.
Understanding the rules and holding your suppliers (and yourself) accountable is paramount in ensuring your organization pays every penny of tax it is obligated to pay but not a penny more.
Where do manufacturing exemptions apply?
Almost everywhere. Even though manufacturing, as we traditionally think of it, is more predominant in states like California, Texas, Ohio, Illinois, Michigan, and Pennsylvania, just about every state in the country has carved out a sales tax exemption for manufacturers. There are two noted exceptions. Neither South Dakota nor Hawaii has a specific statutory or regulatory sales tax exemption for manufacturers on the books. That does not mean that other existing exemptions may not apply to manufacturers. For example, South Dakota guidance specifically details how manufacturers may buy certain items tax free under their resale exemption, so long as all the following criteria are met:
- The items are used in fabricating, compounding, or manufacturing tangible property.
- The items become part of the tangible property.
- The final product will be sold at retail.
Likewise, Hawaii law specifies that materials that are to be incorporated by the manufacturer into a finished or saleable product are eligible to be taxed at the .5% wholesale rate, but only so long as the materials remain a perceptible component of the finished product.
What qualifies as manufacturing?
Taking something from an idea on a drawing board to a finished product ready for sale is incredibly involved. It starts with research and development, continues with the actual production process, involves rigorous testing and quality control, and is completed through packaging and transportation. In some manufacturing scenarios, conveyancing (moving the item being manufactured through the process) and pollution control can also be important.
Whether all or some of the components of the manufacturing process fall within the scope of an available manufacturing exemption varies from state to state. Generally, a manufacturing exemption will apply to qualifying items used on the production line, but, for example, only 34 states extend their manufacturing exemption to research and development activities, 37 to the conveyancing process and 33 to pollution control.
What items qualify?
Often, the most expensive items purchased by manufacturers are machinery and equipment, and mercifully, 42 of the 45 states that have a manufacturing-related exemption include machinery and equipment. Nevada is one of the outliers. Under Nevada law, only raw materials are eligible to be purchased by manufacturers tax free. This exemption is slightly broader than a traditional “resale” exemption, but not by much.
The New Mexico Department of Revenue publishes a fairly lengthy document describing the sales tax rues applying to manufacturers, but the list of available exemptions is brief:
Under Section 7-9-46 NMSA 1978, a seller may deduct receipts from sales to a manufacturer of tangible personal property that becomes an ingredient or component part of a manufactured product or is a consumable and is consumed in the manufacturing process.
For purposes of the deduction for consumables that are consumed in the manufacturing process, “consumable” is defined to mean tangible personal property that is incorporated into, destroyed, depleted or transformed in the process of manufacturing a product:
This exemption encompasses the “raw materials” rule articulated in Nevada, but also includes items that may be consumed as part of the manufacturing process.
Once you get beyond “machinery and equipment” and into items such as repair and replacement parts, materials and supplies, hand tools, energy, and software, the rules begin to vary from state to state more robustly.
Does the newness of the plant make a difference?
One of the reasons why manufacturing-related exemptions are so ubiquitous is because politicians want to encourage businesses to locate manufacturing activities in their states. Manufacturing plants create jobs and jobs generate tax revenue. Practically, once a manufacturer pulls the trigger and builds a plant in a state, the costs of leaving are significant. With that practical reality in mind, a solid handful of states limit their manufacturing exemptions to qualifying items used in creating new facilities or expanding existing facilities. When items are purchased for an existing plant, the exemption may not apply.
On this point, for example, Kentucky regulations are quite clear.
The machinery and the appurtenant equipment necessary to the completed installation of such machinery, together with the materials directly used in the installation of such machinery and appurtenant equipment, which are incorporated for the first time into new or existing plant facilities, or which are installed in the place of existing plant machinery having a lesser productive capacity, and which are directly used in a manufacturing or processing production operation shall be exempt from the sales and use tax.
Under these rules, machinery and equipment, along with their related materials, may be purchased tax free so long as those items are being incorporated into a new facility, incorporated for the first time into an existing facility, or are being installed in a way that will increase the productive capacity of an existing facility. New machinery that merely replaces machinery in an existing facility does not qualify.
Similar rules apply in North Dakota. Under published guidance, only new or expanding plants are eligible for their manufacturing exemption related to machinery and equipment used primarily for manufacturing or agricultural processing or used solely for recycling.
How fully does it need to be utilized?
When a qualifying item is always (100% of the time) used in manufacturing activities, then it is likely the case that an available exemption will apply. In fact, some state statutes and rules are written in a way that qualifying machinery and equipment are only exempt when used “exclusively” in the manufacturing process. However, it is easy to imagine a situation where a piece of machinery or equipment is used “predominantly” in the manufacturing processes but not necessarily “exclusively.” Take for example a generator where its primary purpose is to keep the production line going in the event of a power outage. However, the same generator also powers a handful of offices and other communal areas inside the plant. In this scenario, is the generator exempt? It might not be in states that have a requirement that uses the term “exclusively.”
Many states extend their manufacturing exemption to items that are used at least 50% of the time in the manufacturing process, but not all. For example, Florida restricts its exemption to machinery and equipment used in locations where “the primary business activity” at the location is the manufacture of items for sale. Likewise, in the Commonwealth of Massachusetts, the exemption only applies when the qualifying items are used “directly and exclusively” in an industrial plant in the actual manufacture of tangible property to be sold.
In Mississippi, an exemption applies so long as the items are used “exclusively or predominantly” in creating tangible property. West Virginia uses a “direct use” standard. The basic concept is that purchases directly used in activities which are an integral and essential part of the manufacturing process are exempt from sales and use tax, while purchases that are used in activities that are incidental, convenient or remote to manufacturing are taxable. If an item is used for both taxable and non-taxable purposes, tax may be apportioned using a “reasonable method acceptable to the Tax Commissioner.”
Finally, in Wisconsin the rules are far more black and white. Any machine not used directly (100%) in the manufacturing process is not exempt.
While only a handful of states demand perfection in the form of 100% utilization, once you are dealing with items used less than 50% of the time in manufacturing, all but 15 states remove their exemption.
Does useful life matter?
It is likely that when states create exemptions for manufacturing “machinery and equipment,” they are picturing in their minds large, expensive, mechanical devices intended to be used for years before they become obsolete. This mindset is borne out by the laws and rules. In a handful of states, exemptions for machinery and equipment do not apply unless the item has a “useful life” of three years or more. Directly to this point, the Florida guidance noted above specifies that for an item to be considered “industrial machinery and equipment” it must have a “depreciable life of 3 years or more.”
Once you get into machinery and equipment with a useful life of one year or less, even more state exemptions fall away. In California, which applies an extraordinarily complex reduced rate to manufacturing, it’s presumed that an item qualifies if the manufacturer is properly depreciating or capitalizing the asset on their income or franchise tax returns. Like any good rule though, there are multiple exceptions. Louisiana suggests that only manufacturing equipment that is eligible for depreciation under federal income tax rules are eligible for the exemption. Of course, that leaves manufacturers scrambling to understand the federal rules, which is no easy feat. In Wyoming, the law likewise directs you to the Internal Revenue Code, specifying excluding from its exemption any “non capitalized machinery” except machinery that can be expensed/deducted under Section 179 of the Code.
Putting it all together
The scope of an available manufacturing exemption can be extremely nuanced. While machinery and equipment used 100% of the time in a new or expanding facility may qualify for an exemption or reduced rate in a given state, that same exemption may not apply to replacement parts for that machinery. Likewise, the exemption may evaporate if the machinery is used in parts of the business not strictly tied to the manufacturing process. Further, that same piece of equipment may not be eligible for an exemption when purchased to replace failing equipment located in an existing plant. Finally, all bets could be off if you are buying machinery with a short useful life or other things like supplies, tools or energy.
If you provided your vendor with a blanket exemption certificate, they may not be looking too closely as to whether a particular purchase falls within the scope of the exemption and since sales tax liability is joint and several, it’s up to you to confirm with certainty whether sales tax should or should not have been charged. Best-in-class manufacturers will have a process in place to review vendor invoices for proper tax treatment, but to do so properly, you need to understand the nuanced rules outlined above.
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