Vendors who accept sales tax exemption certificates from purchasers incur risk of an under-collection assessment. The sale of an otherwise taxable object in a transaction where no tax is collected, absent a legitimate and legal explanation, is a classic audit finding. An exempted sale of a taxable object presents an opportunity for an auditor to examine the basis for the specific exemption, but also in turn, peel back the curtain on the processes your organization uses to manage exemption certificates.
How do the states approach the question of legitimate exemptions?
In other words, what are the limits of a vendor’s obligation to ensure a proffered certificate is legitimate and reliable? From a legal perspective, there are two broad approaches taken by states when determining the effectiveness of a certificate: a “good faith” standard and a “four corners” standard. The “good faith” standard relates to the conditions by which a certificate is received, the nature of the purchases made under the certificate and the elements of the actual transaction. A “four corners” standard relates to the elements and content of an actual exemption certificate.
The “good faith” standard. This standard places a greater burden on the vendor to determine whether or not an exemption certificate’s use is appropriate. For example in Arizona, a vendor’s good faith is tested by the “honesty of intention and freedom from knowledge of circumstances that should cause the vendor to deny the claimed deduction or exemption.” Ariz. DOR Director’s Decision No. 200700222-S (June 15, 2009).
In Texas, vendors are under even a greater burden: an objective ‘should have known’ standard that requires a vendor to analyze particular transactions through the lens of the exemption certificate: “the “should have known” concept seeks to determine whether a reasonably prudent seller, under the same or similar circumstances, would have acted the same way (i.e., accepted the certificate) or would have acted differently (i.e., rejected the certificate and collected sales tax or obtained further documentation from the purchaser).” Texas Comptroller Decision 201202374H.
The “good faith” standard looks far beyond the contents of an actual certificate, requiring a vendor to gain an understanding of the underlying transactions before relying on a certificate to exempt a sale. Under “good faith”, a vendor can’t be relieved from its obligation to collect sales taxes when it accepts an exemption certificate when they “should have had the knowledge” that the purchaser will not be using the purchased object for the stated exempt purpose. The existence of a fully completed certificate is simply not enough to protect a vendor under this analysis.
In a “good faith” state, vendors are expected to evaluate a particular purchase in order to determine whether the purchaser, the exemption claimed and the objects being sold all support the vendor’s decision to exempt a sale. It probably goes without saying, but the “good faith” standard invites a great deal of gray areas surrounding the acceptance of exemption certificates. A form of the “good faith” standard exists in about half the US sales tax states.
The “four corners” standard. The “four corners” here refers to the actual physical dimensions of a printed exemption certificate. This standard reduces the burden on vendors in determining whether a sale is exempted or not. The crux here is the completeness of an actual exemption certificate as presented. Absent fraud or specific information of an intended misuse of a certificate, vendors who accept certificates must only ensure the certificates are filled in completely in order to make exempted sales under a “four corners” standard.
Even in a “four corners” state, there is a subjective element that obligates a vendor who has specific knowledge of an unintended use to prohibit an exempt sale. A vendor who knows a certificate’s use is inappropriate or encourages the use of a certificate inappropriately cannot rely on a “four corners” test to make an exempt sale. Note, though, there is no objective “honesty of intention” or “should have known” standard at work, as exists under a “good faith” analysis.
The roughly half of states that utilize a “four corners”, (or perhaps better stated a “fully completed” standard), are the member states of the Streamlined Sales and Use Tax Agreement (SSUTA). The “four corners” approach is an element of the SSSUTA’s efforts to simplify tax administration for vendors. The core test at work is whether all data fields on a given state exemption certificate are filled in completely.
The “four corners” standard is more straight forward and easier to comply with than the good-faith standard. Vendors can accept a fully completed exemption certificate, even in instances in which the same acceptance would not be in “good faith." Obviously, a fraudulent acceptance is not allowed, but because fraud involves an active intent to deceive, it is more difficult to prove than lack of good faith, and most vendors that make substantial efforts to manage certificates and ensure their completeness will avoid strong challenges to those sales exempted by fully completed certificates.
Vendors who manage their certificates in a repeatable and reliable process are always better prepared for challenges to the use of this certificates to exempt sales. However, the depth of analysis required by “good faith” states is far more complex than the review required in “four corners” states.
Other recent “Audits and Sales Tax” posts by Shane Ratigan:
- Audits and Exempt Sales: “Good Faith” vs “Four Corners” Standards
- Avoiding Sales Tax Audit Assessments: 4 Tips