Thursday, September 17, 2009

Direct Pay Permits

This is a compilation and enhancement of several previous articles on direct pay permits.

First of all, what is a "Direct Pay Certificate?"

It's an exemption certificate that the buyer hands to the seller. It relieves the seller of the responsibility of collecting the sales and use tax from that particular customer. This is because the buyer has made a deal to pay the use tax directly to the state. They have gotten a direct pay permit from the state.

Why would these certificates exist? Larger organizations (eg. manufacturers, contractors and utilities) find them helpful because they buy lots of different things, some exempt and some taxable. They have very complex operations, and it may be impractical to have the seller collect the tax. In some cases, the buyer may not even know if a purchase is taxable at the time of the billing. So this makes it easier for both parties.

The customer buys pretty much everything without the vendors having to charge sales tax. The direct pay permit holder then self-assesses the use tax. And the vendors have one less customer to worry about.

Sometimes the purchasing and operational issues are so difficult that the user may even come up with a calculation. A manufacturer might say, "We bought $400,000 worth of shop supplies last month. Our studies indicate that 40% of those supplies become ingredients in the product and the rest are used in our operations. So 60% of the $400,000 is taxable, and that's what we accrue and pay use taxes on."

It's not easy to arrange that kind of allocation if the tax is being collected by the seller. How are they only going to bill for 60% of the tax? On the other hand, all the buyer has to do is make a journal entry, and the problem is solved.

What's in it for the state? First of all, not all states grant direct pay permits, so don't assume you can just apply for one. But the benefit for the state is that the audits are less detailed. Since the user comes up with calculations and ratios as described above, the auditor theoretically has to grind through fewer transactions. And I think another reason is that the state may actually get overpaid! See the discussion below.

Now you may think this is a pretty good idea. But there are catches:

1. States don't like to hand direct pay permits out like Skittles. They often have volume requirements and expect to see adequate accounting systems in place. If you don't have professional accounting management, and you use QuickBooks, you're not going to be able to get a permit.

2. Don't think of this as a way of avoiding/evading tax or getting to hold onto the tax money a little longer. You're going to probably have to pay your use taxes monthly, and you can pretty much count on getting audited every few years. Because the state is now relying solely on your company to self-assess (and we know how reliable most of us are at that), the state is going to be much more likely to audit you. Regularly. Frequently. Set up an office just for the auditors, if you know what I mean.

3. Tied in with number 2, you're likely to get audited before they even give you the permit, just to see if you have those systems in place to self-assess properly. And they're going to want to look at those studies you're using for your calculations to make sure you're doing it right.

4. Beware of mixing up which vendors you pay sales tax and which ones you don't (by giving them the direct pay certificate). I've talked with taxpayers who were not consistent in using their certificate. This resulted in paying sales tax on purchases and then turning around and self-assessing tax on the same purchase. Keep very close track of who you give a direct pay certificate to and who you don't.

5. One of the things I've talked about is that you should be careful about overpaying your taxes because you mistakenly believe something is taxable. A clue to this is when you think something is taxable, and the vendor hasn't charged you tax. A phone call is in order. But if you have a direct pay permit, your vendors aren't going to tax you at all. You'll now be relying solely on your own understanding of the tax laws, and you won't be getting the reality check from your vendors. You may not realize it, but there is some education that is happening because of the give and take with your vendors. Get a direct pay permit and you're on your own.

Whether or not you get a direct pay permit is simply a question of how much easier it would be to self-assess versus the risks of overpayment and audits. I'd strongly recommend you sit down with a local expert to see what they're recommendations are based on your specific situation. And if that alternative seems too costly, then you probably shouldn't get a direct pay permit.

Sales Tax Guy

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