Manufacturing businesses are experiencing wide-ranging operational impacts from the COVID-19 pandemic including stay-at-home orders, sick workforces, social distancing on the manufacturing lines, ‘non-essential’ designations, reduced material and supply access and fewer customers. Despite those challenges, some manufacturers better adjusted to the economic conditions by converting operations to respond to in-demand and essential products such as personal protective equipment (PPE).
Retooling operations to create products like ventilators, masks, shields, scrubs and other similar equipment, while an admirable contribution to the greater good and an opportunity for some businesses to stay financially solvent, may come with increased state and local tax exposure. For some businesses, this exposure may cause new compliance obligations or the loss of other benefits. A few states have already considered the impact of new PPE businesses on tax liabilities, but most have remained silent. The demand for PPE products will remain high as the economy cautiously reopens. Many businesses will continue to retool their operations to meet that demand.
Manufacturers that have converted operations to produce PPE products or those contemplating producing PPE should be aware of the state and local tax ramifications that may result.
Sales and use tax compliance exposure
Nexus and sales tax collections
Many manufacturing businesses sell their products to resellers, whether those resellers are other manufacturers, distributors or wholesale businesses. Often, those manufacturers are not charging sales tax on their sales to resellers, instead collecting an exemption certificate to the extent the business has nexus in other jurisdictions.
Recall that in a post-South Dakota v. Wayfair environment, sales and use tax nexus can be established in almost every state simply because of the number of sales into that state. While those nexus provisions generally target taxable sales, some businesses making exempt sales, but exceeding the sales threshold, may have a compliance obligation in that state, even if no sales tax is due. State economic sales tax nexus provisions typically do not address whether the sales thresholds include nontaxable or exempt sales for purposes of determining whether a nexus threshold has been exceeded. Some states have provided guidance confirming that exempt sellers will not have to register, while sellers making other types of exempt sales will.
It is important to understand that there could be nexus and compliance obligations for exempt sellers even before a manufacturer changes over to PPE. Many manufacturers may have made a business decision not to register because there was no tax liability. However, PPE is generally taxable in most states. If a manufacturer is not receiving an exemption certificate, or instead sells directly to end users such as hospitals and doctors’ offices, the manufacturer may be creating sales tax exposure by not registering, failing to charge sales tax on the sales, and not properly remitting the tax to the state. Manufacturers cannot necessarily rely on the same sales tax exemptions for producing and selling PPE as they may have for other manufacturing activities.
Exempt manufacturing equipment
Another consideration for manufacturers is that machinery and equipment used in manufacturing operations is often purchased by the business exempt from sales tax. To qualify for this exemption, many states require machinery or equipment be ‘directly or predominantly’ used, generally meaning that over 50% of the time the equipment must be used in an exempt manufacturing operation. Dedicating machinery to other purposes, such as creating PPE, may result in the equipment losing the direct or predominant use qualification. While it is likely that manufacturing PPE would still be considered an exempt manufacturing activity, manufacturers should carefully consider that using equipment purchased exempt in a new or different manner could result in a sales tax liability.
Use tax exposure
Use tax may also be a consideration for manufacturing businesses. Most manufacturers purchase supplies and inputs exempt for resale because the product created with the inputs will be further sold to another party. Use tax is generally accrued when items purchased exempt do not fulfill that exempt purpose, i.e., they are not resold. If a manufacturer purchases inputs for creating PPE exempt from the tax, and then donates the PPE, the manufacturer may have an obligation to accrue use tax on the items purchased to create the PPE as the sale for resale exemption may no longer be applicable because there was no subsequent sale.
Credits and incentives
Although many manufacturers may be reducing workforce, companies can instead look to workforce development grants for training and retaining their current employees. Many states provide support for workforce development, often in the form of cash reimbursement for training employees. Eligible training may include COVID-19 related items such as training employees to utilize virtual and remote technology, training for new work processes as retraining of existing employees to backfill vacant positions. Additionally, eligible training may include areas such as soft skills, leadership, technology, sales, process improvement, safety, and computer skills.
Retooling for PPE manufacturing may also provide employers an opportunity to retain workforce. Workforce retention credits and incentives exist both on state and federal levels. For example, California responded to COVID-19 with cash grants for employee training and job retention.
Additionally, states may provide incentives for capital expenditures in order to convert to PPE manufacturing or to refurbish old machinery and equipment to fulfill those operational needs. Retaining, hiring and training employees may qualify for incentives, as well as capital investment to retool operations. Other incentives may also be available due to retooling, such as research and development tax credits. Businesses should generally be aware of considerations for using credits and incentives during an economic slowdown.
Finally, converting to PPE production may prevent a recipient of incentives and credits from facing clawbacks or other payback of benefits. Many incentive and credit programs have employee thresholds and investment requirements. The pandemic has prevented many companies from meeting those requirements. Reassigning people and capital may allow companies to retain incentives, without exposure to clawback provisions.
Income and franchise tax
Depending on the retooling efforts, conversion to PPE production could have significant income and franchise tax implications. Moving to PPE manufacturing might entail different operations in different states. Changing the number of employees, property, or sales can affect apportionment formulas and income sourcing. Even small changes in the number of employees and property can affect income and franchise tax liability across state lines. Nexus and P.L. 86-272 issues may arise even if a company is merely selling PPE equipment into a state. A manufacturer producing and selling PPE may find itself in a very different environment with respect to its multistate income and franchise tax filing requirements.
Importantly, manufacturers considering retooling operations to respond to the pandemic should carefully consider all federal and state tax impacts. Other state considerations for the COVID-19 pandemic can be found in RSM’s State tax planning in response to economic distress. For more information on the coronavirus, please see RSM’s Coronavirus Resource Center which includes related and frequently updated developments.