It can be very difficult to determine whether an item is tangible personal property, subject to sales tax, or real property which is not usually subject to state sales tax. Of course, the state is not left empty handed if an item is real property. Rather, if an item is real property, sales tax is not charged to the customer, but the contractor must pay tax on the purchase (the cost) of the materials that become part of the realty. Recently, Best Buy Stores, L.P., found itself squarely in the middle of the real vs tangible property debate during a dispute with the Illinois Department of Revenue.
Prior to 2016, Best Buy was the fortunate recipient of a sales and use tax audit from the Illinois Department of Revenue. During the audit, questions came up regarding its sales of appliances, an area of notable growth for the company. Upon purchase, the customer has the choice to pick up the appliance, have it delivered, or have Best Buy deliver and install the item. There is no disputing that if an appliance is picked up or delivered, it is a sale of tangible personal property subject to sales tax, which Best Buy collects and remits. However, if the item is installed, Best Buy believed it became part of the real estate (real property), so they taxed it as such. Thus, Best Buy did not collect sales tax on the sales price of appliances that were installed, rather, it paid tax on the cost of the item. While the point at which Illinois sales tax is applied seems semantical, this small discrepancy can quickly add up. For Example:
Tangible Personal Property:
Supplier > $100 > Best Buy > $200 (+ sales tax) > Customer
Real Property Installation:
Supplier > $100 (+ sales tax) > Best Buy > $200 > Customer
Illinois Sales and Use Tax Law
In Illinois, like most states, the law is not very insightful when it comes to the tangible / real property debate in the sales tax world. Illinois requires that sales tax is charged and collected by a “retailer,” which is a business engaged in the business of selling tangible personal property at retail. Conversely, a nontaxable construction contract involves a “contractor,” who performs construction work for owners. Not super helpful.
From there, Illinois left it to the Department of Revenue, and frankly, the courts, to fill in the gaps as to what its laws actually mean. Predictably, Illinois has turned to the incredibly subjective “substance of the transaction” test to determine how something should be taxed. Under that test, if the item provided has no value to the purchaser except as a result of the corresponding services, it is a service/installation contract. If the item provided has independent value without the related services, then it is a sale of tangible personal property.
In applying the “substance of the transaction” test to the Best Buy case, the court determined that the appliances purchased by Best Buy have substantial value without the installation services. It noted that the customer can, and often does, purchase the appliance without the service. To reach its conclusion the court also stressed its role to give the agency interpretive deference in a sales tax matter. In passing, the court also noted that an appliance is not permanently affixed to and does not become an integral part of the real estate. Therefore, the court concluded the installed appliances were sales of tangible personal property and Best Buy owed an additional $190,000 in sales tax.
Commentary on the Court’s Decision
Should the Court have treated the real property analysis as an exemption?
As an aside, In Best Buy’s case, the court seemed to incorrectly engage in an exemption analysis, but the taxpayer really argued the real property was excluded from sales tax because it did not meet the taxability definition to begin with. Although it seems minor, it would have completely shifted the lens of the case because the court should have looked at the transaction from the presumption of an exclusion, instead of burdening the taxpayer to prove an exemption exists.
Difference Between a Sales Tax Exemption and sales tax Exclusion & Why Does it Matter?
Often coined as the ‘exemption versus exclusion analysis’, it seems the court went down the wrong path in its Best Buy decision. For an item to be subject to tax it must be tangible personal property sold at retail within Illinois. If an item meets those elements, it is subject to sales tax absent an exemption. An exemption takes a normally taxable category of items and removes it from tax for political, social, or policy reasons. Conversely, an item is excluded from sales tax if it does not meet the statutory definition of taxability in the first place.
For example, if you go to the grocery store, a loaf of bread is tangible personal property subject to state sales tax absent an exemption. Most states, for policy reasons, provide an exemption for grocery items, that removes the otherwise taxable loaf of bread from the realm of sales tax. However, if you pay for a cooking lesson on how to prepare the bread, it is not taxable because the service is not tangible personal property. Further, no exemption is needed because the item was never characterized as taxable to begin with.
The exemption / exclusion debate is important on determining because it can tilt the scale in a close case. Generally, the state agency has the burden to prove an item falls within the taxing statute. However, if an exemption is in play, the taxpayer carries the heavy burden to show an item is exempt. Determining whether an item is exempt or excluded from sales tax can be just as difficult as the tangible / real property debate. Because the court determined (incorrectly in my opinion) that it was a sales tax exemption, the tie went to the government.
Should the Court Have Looked at the “Substance of the Transaction?”
The court’s “substance of the transaction” analysis was a bit suspect. Normally, the substance/essence of the transaction test, also known as the “true-object test,” is applied when evaluating whether a transaction is for a nontaxable service or for taxable tangible personal property. Here, the court’s debate was really about whether the appliances were nontaxable because they became part of the real estate, not whether the transaction was primarily for a service. It seems the court should have focused more on the agency’s rules and regulations to answer whether a real property contract was involved instead of devoting its time to whether Best Buy sold primarily a service. In my opinion, the court missed the mark on this point.
The Best Buy case is another of seemingly endless examples of the difficulty determining whether an item is a tangible or real property. If you or your client have a business that sells installation services, it can be almost impossible to determine which side of the line the transaction falls on. Absent obtaining a letter ruling, many companies try to insulate themselves by charging tax on the sales price, often resulting in over-collected sales tax. More directly, if you or your business has a sales tax assessment related to real property, we can help you fight the issue as backing down is money right out of your pocket.