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Service Providers: Understanding The True Object Test

There are roughly six million jokes about taxes, and the punchline is almost infallibly that it’s a boring subject full of rote, repetitive rules.

Well, it seems those jokesters didn’t know about the “true object test,” because this little corner of the tax universe is wonderfully subjective and takes some real brainpower. And it’s very (okay, a little?) fun to dive into with some examples.

In states that do not tax services outright, the true object test is applied to determine the taxability of transactions that combine taxable and nontaxable business activities and/or products that cannot be separated. These are known as "mixed transactions."

For example, if you buy a playset for your backyard that must be professionally installed, you're combining a taxable transaction (the purchase of the playset) with a nontaxable transaction (the service of erecting it).

What Is "The True Object"?

If a business provides Service X, which includes the provision of Product Y--or the other way around--is the taxability (or nontaxability) of the transaction based on Service X or Product Y?

In many states, one answers this question by ascertaining the true object of the transaction--that is to say, the main point. In the playset example, the true object was to purchase a product, and the service of putting the playset up in your yard was incidental to that objective. Therefore, the mixed transaction is taxable.

In another example, if Service X is diabetes treatment and Product Y is an insulin monitor, the service (treatment) is the true object of the transaction, so that is the basis for taxability. The good (or product--the monitor) is secondary to the true object in this case.

To figure out what should be the basis for taxation, think about which aspect of the transaction is incidental to the intended purpose of the transaction, and which one is central. If you buy a suit at a store and have it tailored there, the true object was to purchase a product, so the transaction is taxable.

Similarly, if you hire a photographer to take pictures of you, then you pick your favorite pictures as prints, the true object was to purchase a product, so the transaction is taxable.

However, if a veterinarian examines your sick dog and takes X-rays, the true object was the service of investigating your dog's health--not providing you images of his insides--so the transaction is not taxable.

When It Gets Tricky

Because so much of our economy is moving toward intangible services like digital info-sharing, application of the true object test is getting increasingly difficult.

One of the biggest decisions in the digital information space was in 2010, when the Missouri Supreme Court ruled on Western Blue Print Co. v Director of Revenue. Western Blue Print scanned paper documents for its customers, then returned the scanned files to them on CDs. The Supreme Court decided that Western Blue Print's service should not be taxable because the true object of the transaction was the service of transforming their intangible information into a different format.

One factor was that the information could have been shared completely digitally. Another was that the CDs were not for end use. Customers transferred information to their computers, then discarded the CDs, making the tangible product (the CDs) incidental and not the true object.

As digital media, telecom, computer services, and software become more pervasive, there will be more states trying to figure out how to tax lucrative service companies, and there will be more state-specific landmark decisions in the future.

It Pays To Be Informed

Because ignorance is never an excuse with the IRS, take an hour at the beginning of every tax year to search out current and potentially new stipulations.

Discover rules on service tax for your industry in your state on the Federal Tax Administrators' online database. You can search by state and see all taxable services there, or you can search by industry and see various tax rates in different states.

Remember, not every service within a taxable industry is definitely going to be taxed, so talk to your tax professional about specifics within your industry. A painful tax bill is a lot more unpleasant than a little complicated advanced planning.

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