Common State Tax Issues for Manufacturers

Written by Grant Shaver, CPA, MPAcc, and Jacquelyn Martin, CPA

Manufacturers with operations in Washington state often face a myriad of issues when reporting state excise taxes, which can lead to unintended overpayment or underpayment of tax. This article highlights the challenges and opportunities associated with Washington sales taxes on equipment used in a research and development (R&D) operation, as well as the reporting of business and occupation (B&O) tax on manufacturing activities involving related business entities.

Sales and Use Tax

Washington sales and use tax generally applies to all purchases of tangible personal property delivered and/or used in the state, including machinery and equipment. However, Washington state provides a sales and use tax exemption for qualified machinery and equipment that is used in a manufacturing operation. To qualify for an exemption in Washington, a business must:

• Meet the definition of a manufacturer,
• Purchase equipment meeting specific qualifications, including having a useful life of more than one year, and
• Use the equipment directly in a qualifying manufacturing or R&D operation.

Manufacturers should consider many nuances when determining whether they meet these three criteria. This article primarily focuses on what constitutes a manufacturing operation and what equipment is “used directly” in that operation.

Leveraging TerraPower: Unlocking Tax Savings for R&D Operations

In 2022, the Washington Board of Tax Appeals determined in Terrapower, LLC v. Department of Revenue, BTA Docket 19-065 (2022) that the definition of a Washington manufacturer includes businesses that manufacture goods for their own internal commercial or industrial use. In other words, businesses are not required to manufacture items for sale to other parties to qualify for the sales tax exemption in RCW 82.08.02565.

Washington law provides eight examples of when machinery and equipment are “used directly” in a manufacturing operation, including equipment that is “integral to research and development.” R&D is broadly defined and includes activities aimed at discovering new technologies through creating new products, improving existing products, developing more new or improved processes, innovating new techniques, formulating new solutions, and inventing new technologies.

Accordingly, companies that produce items for their own internal use and consumption may be eligible to purchase R&D equipment without incurring sales taxes. For more information on what constitutes qualifying machinery and equipment for purposes of sales tax manufacturing exemption in Washington, please contact a member of the Clark Nuber state and local tax team.

Washington B&O Tax

Processor-for-Hire Opportunities

As summarized by the Washington Department of Revenue:

“The state B&O tax is a gross receipts tax. It is measured on the value of products, gross proceeds of sale, or gross income of the business.

Washington, unlike many other states, does not have an income tax. Washington’s B&O tax is calculated on the gross income from activities. This means there are no deductions from the B&O tax for labor, materials, taxes, or other costs of doing business.”

Because the B&O tax is separately levied on each legal entity with nexus in Washington, transactions between affiliated parties are generally subject to the tax. Additionally, the manufacturing B&O tax base is measured by the value of products manufactured in Washington. Consequently, many manufacturers incur significant manufacturing B&O tax liabilities on the transfer of work-in-process inventory between related entities. The B&O tax on each transfer is typically calculated based on the gross value of the work-in-process inventory at that point in production. When multiple entities contribute to the unfinished product, it results in a pyramiding tax effect, leading to excessive tax bills for manufacturers.

However, a properly implemented processor-for-hire structure can significantly lower the B&O tax liability of many manufacturing operations involving separate, but related, legal entities. Under a processor-for-hire structure, an entity performs services on property owned by another entity for a fee. The tax base for determining the B&O tax of a processor-for-hire is the fee earned for services, not the gross value of the product produced. The processor-for-hire tax rate of 0.484% is the same as the manufacturing rate.

Multiple Activities Tax Credit

When a business performs more than one taxable activity as a part of a single revenue-generating activity, it may be required to report tax twice on the same amount. The multiple activities tax credit (MATC) exists to prevent double taxation in that scenario. This allows a Washington manufacturer—reporting B&O tax under both the manufacturing and wholesale/retail classifications on sales to Washington customers—to claim the MATC for the wholesale/retail B&O tax paid on those sales.

What You Can Do

Navigating the complexities of Washington state excise taxes can be challenging for manufacturers. However, understanding the nuances of sales and use tax exemptions and B&O tax implications can lead to significant savings. By leveraging opportunities such as the one highlighted in the TerraPower LLC ruling, manufacturers can reclaim taxes paid on eligible machinery and equipment used in R&D operations, freeing up resources to reinvest in innovation and development. If your company has previously been denied these exemptions, consider reapplying or appealing past decisions to maximize future savings. For personalized assistance and to explore how these tax strategies can benefit your business, contact a member of the Clark Nuber state and local tax team.

Jacquelyn Martin, CPA, is a manager in Clark Nuber’s State and Local Tax Services Group.