Issue: Product Testing - Exempt?

I had a call today from a seminar participant and as we were talking, I realized her issue would be a perfect puzzle to present to you.

The company makes engines. The engines are taken out of finished goods inventory and placed in a testing area. Are the testing equipment and supplies taxable or exempt under the manufacturing equipment exemption? In most states, inline testing of manufactured products would be exempt as part of the manufacturing process. But in this state, the manufacturing process stops once the product has been put in finished goods inventory (in most states, the process stops at the last machine).

So testing the engine, after it's been placed in inventory, would be outside the scope of manufacturing and therefore taxable. But here's the fun part: if they had intercepted the engines before being placed in the warehouse, then the testing would have fallen within the scope of manufacturing and would therefore be exempt. Stupid, huh?

In my conversation with the taxpayer, I suggested she contact a local expert. While a strict reading of the laws is all I can go with, a local consultant (CPA, lawyer, etc.) will be familiar with enforcement practices in that state. I can foresee an undocumented position of, "well, yeah, we know this is really inline quality control testing; it's just getting placed in the warehouse for convenience and you haven't made the journal entry moving it to FG inventory, so we'll let this one slide." It isn't documented (as near as I can tell), but it may be the informal position the state takes.

There are three lessons here:

1. understand the rules for the exemptions that your company takes advantage of;
2. interpret the rules very strictly;
3. engage a local expert to identify any undocumented positions that will help you.

The Sales Tax Guy