3 Hidden Use Tax Liabilities for Manufacturers

Manufacturers focusing solely on whether purchases fall within or outside a manufacturing exemption are missing a potential use tax liability. This liability can quietly accumulate creating a costly surprise in an audit.

Use tax is an obligation to self-report sales tax. It applies most often when a vendor doesn’t charge the proper sales tax. To be compliant, businesses must evaluate each purchase: Is this item taxable? If so, was the correct tax charged?

For manufacturers, however, an additional question must be asked of exempt purchases – how ultimately did we use the item purchased? That question likely can’t be answered until long after the invoice is paid, which is why the issue is often missed.

Below are three common situations where this question is relevant.

A manufacturer typically enjoys sales tax exemptions on raw materials used in production. But if the manufacturer incorporates or installs the finished goods into real property, or hires a subcontractor to do so, the tax treatment changes. In many states, the raw materials, manufacturing labor, and even installation labor can become taxable to the manufacturer. If the manufacturer fails to accrue use tax, they lose the opportunity to pass that cost on to their customer, and if audited, in addition to the tax, they’ll owe a penalty and interest as well.

The risk in this situation heightens when installation occurs in another state. Not only can the manufacturer incur a use tax liability, but performing installation services across state lines may also create an income tax filing obligation, leading to additional compliance requirements.

Many manufacturers showcase their craftsmanship in showrooms or promotional spaces or they’ll set aside finished product to be used as samples. When finished goods are pulled from inventory for these uses, the materials lose their exempt status. In general, material lose their exempt status when the finished product is manufactured other than for sale.

A third, subtler risk arises when materials are consumed in non-manufacturing activities. Consider a company that purchases parts to repair its fleet of forklifts. If some of those forklifts are used in manufacturing while others handle distribution tasks, the tax treatment can vary. Parts and supplies used outside the production process are generally taxable, even if it’s a minority of the use. If a manufacturer does not track the percentage of parts used for production vs. nonproduction an auditor may declare all purchases to be taxable until the manufacturer can prove otherwise.

Use tax compliance isn’t just a back-office task, it’s a crucial part of managing risk and protecting profit margins. Manufacturers should regularly review purchasing and usage patterns and train staff to recognize when taxability changes based on use.

At CSH, our State and Local Tax (SALT) team has deep expertise in helping manufacturers identify and mitigate hidden tax exposures. From multi-state use tax reviews to manufacturing exemption analysis and audit defense, we help ensure compliance while minimizing tax costs.

If you’d like to uncover potential savings and reduce risk in your indirect tax processes, contact CSH’s manufacturing and SALT specialists today.