Direct pay permits are a great tool to have in any eligible company’s tool belt. Direct pay permits allow the holder to self-assess, accrue, and remit use tax directly to the taxing jurisdiction on all its qualifying purchases instead of to their vendors collecting sales tax at the time of their purchase. Sometimes it is difficult to know when a purchase should have sales tax applied to it at the time it’s purchased. This is because the items being purchased may be used in either a taxable or nontaxable manner later on and it’s not clear at the time of purchase how/where it will be used.
In Hegar v. Texas Westmoreland Coal Co., taxpayer argued successfully that excavators qualified for exemption. Taxpayer is a coal manufacturer. As part of its processes, taxpayer used excavating equipment to scrape up coal from the ground, break it apart, and dump it into trucks below, breaking it further. Westmoreland requested refunds of sales tax paid on the excavators.
The idea of a direct pay permit is to make it easier for the permit holder to be more precise in their sales and use tax compliance. Direct pay permits help alleviate the often complex and time-consuming process of the taxpayer trying to work with its vendors every time an order is placed to determine if the taxpayer needs to pay sales tax on each and every invoice. The direct pay permit instead allows the permit holder to self-assess use tax on their own purchases based on their pattern of use.
Generally, a taxpayer looking to become a direct pay permit holder must apply for the permit with the state in which it has or will have use tax compliance obligations. Companies such as manufacturers, construction contractors, or other companies that make large volumes of purchases that often have mixed taxability treatment based on their usage may be good candidates for direct pay permits. The application process varies from state to state, but generally entails completing an application and providing the state with supporting documentation about the taxpayer’s volume and mix of taxable and exempt purchase transactions.
One must also be aware of any vendor-type or purchase-type limitations imposed by states around issuance of a direct pay permit. There are states that offer a direct pay permit but provide that it cannot be issued to certain vendor types or for certain types of purchases. This is typically seen when a vendor has an obligation to bill and collect multiple different tax types on a single purchase (e.g., hotels with occupancy and sales taxes) or it’s not really a sales/use tax (e.g., tire disposal tax/fee). In these instances, the direct pay permit holder must continue to pay those taxes directly to the vendors. In North Carolina, there are 10 categories of purchases or tax types for which the direct pay permit cannot be used. For example, a North Carolina direct pay permit holder cannot use their permit for purchases of prepared food and beverages or purchases of electricity, piped natural gas, and telecommunications services.
One benefit of having a direct pay permit is it helps direct the focus of a sales and use tax audit on specific types of purchases the taxpayer claims to have a taxability position on. Taxpayers should have already created the support for their positions on the frontend—at the time they set up their direct pay permits. This helps to alleviate any potential scrambling that can occur during an audit when taxpayers try to pull their support together at the last minute and hastily craft taxability arguments to try to explain why tax wasn’t paid on certain of its purchases. Not having the supporting documentation on the frontend can unnecessarily prolong an audit, putting strain on a taxpayer’s resources for longer than needed.
Taxpayers may think that once they have their direct pay permits, they don’t have any requirements to review and update their agreements with the state. This is not true. Some states (e.g., Ohio) have expiration dates set on direct pay permits, which typically sets a direct pay permit to expire 3-4 years after issuance. Other states may not explicitly state an expiration date on a taxpayer’s direct pay permit, but the permit may expire if there is some sort of corporate “life event” – for example, a change in entity structure, an acquisition or divestiture, or if a sales and use tax account is closed. In any case, the reason a state allows a taxpayer to utilize a direct pay permit is to make better, more accurate taxability determinations that benefit both the taxpayer and state. Therefore, this privilege comes with the expectation the holder is doing its due diligence to accurately report its tax liabilities by periodically reviewing and making changes as facts, purchases, or other things change in its business.
Additionally, sales and use tax laws are ever changing. Newly enacted statutes and regulations, along with newly decided case law both have the ability to change the taxability of services or specific tangible items at any time. An example of this is Ohio’s statutory change of the taxability of employment services. Prior to October 2021, these services were taxable in Ohio, but are now exempt from sales tax. Clarus Partners helped a taxpayer, whose direct pay permit was set to expire in the next year or two, update their agreement with the state so that this taxpayer no longer had to self-assess sales and use tax on their purchases of employment services sourced to Ohio. Had this taxpayer just waited until the expiration of their direct pay permit agreement to update their taxability position on employment services, they would have been erroneously overpaying sales and use tax on these services for at least one to two years when that money could have been going to other important operations in their business.
Next, it’s important to note that some states may not explicitly require a taxpayer to send in supporting documentation of their taxability positions on their purchases at the time they submit their direct pay permit application. The instructions in the application may be vague, saying the taxpayer should simply maintain documentation in their records that supports their taxability positions and make said documentation available to the state upon request. This is the case with South Carolina. The problem with not putting together documentation in support of your taxability positions and providing that to the state up front is that the beginning phases of a sales and use tax audit may become long and drawn out as the taxpayer spends it justifying why they did or did not pay sales and use tax on their purchases. This could have the effect of encouraging an auditor to expand their review of more purchases than the taxpayer may necessarily want them to. Clarus Partners recently assisted another taxpayer with creating a process document for their direct pay permit in South Carolina, establishing when to issue the permit to vendors and a taxable vs. nontaxable methodology to apply to their purchases and accruing use tax, as needed.
Navigating the direct pay permit application for the first time or updating your current direct pay permit agreement can be complicated and has the potential to leave you open to exposure under audit if not done correctly. If you currently have a direct pay permit or think it’s something you’d like to explore, Clarus Partners has the technical expertise to answer any questions you may have. Call us at (614) 362-2730 and we’ll be happy to discuss ways to improve your direct payment permit policies and procedures to help protect you in the case of a sales and use tax audit and to help ensure you aren’t overpaying sales and use tax to the state(s).
By Sarah Sparks