Does a company that dehydrates, powders, and encapsulates a customer's own product into vitamin capsules owe Service Occupation Tax, and if so, how is the tax base calculated?

Plain-English summary

An accountant asked the Illinois Department of Revenue how to tax a newly formed S-Corporation that takes a customer's own material, dehydrates it, blends it into a powder, and encapsulates it in vitamin pill capsules for that same person. The accountant argued this was mostly a service (encapsulation) with only a small taxable component (the capsules and packaging), similar to how a controlled substance would be handled under 720 ILCS 5/12-20, and asked the Department to confirm a reduced food/medical tax rate applied only to the capsules and packaging.

The Department did not adopt that framing. Instead, it explained that Illinois' Retailers' Occupation Tax and Use Tax (the general "sales tax") do not apply to services, but the Service Occupation Tax Act taxes "servicemen" — businesses that transfer tangible personal property as an incident to selling a service — on that transferred property. The Department concluded the company is acting as a serviceman and owes tax under one of four methods for calculating the tax base: (1) the separately stated selling price of the property transferred, (2) 50% of the entire bill if the price isn't separately stated, (3) cost price if it registers as a de minimis serviceman, or (4) Use Tax on cost price if it qualifies as de minimis but isn't otherwise required to register. In all cases, the tax base can never be less than the cost price of the property transferred.

Because this is a General Information Letter (GIL), it only points the requester to the relevant law — it is not a binding determination on these specific facts.

What this means for you

Business owners providing a hybrid service/product

If your business performs a service on a customer's own material and hands back a physical product (packaging, capsules, containers, etc.), you may be a "serviceman" under the Service Occupation Tax Act even if you think of your business as purely a service. The tax applies to the tangible personal property you transfer as part of that service, not to the whole service fee — but you must pick one of the four Department-sanctioned methods to calculate that tax base, and you can't simply carve out an arbitrary reduced rate on your own.

Accountants and tax return preparers

When a client's business transforms a customer-supplied product and returns it in a container or capsule, check whether the transaction is a "sale of service" incidental to a transfer of tangible personal property (Service Occupation Tax) rather than a straightforward retail sale (Retailers' Occupation Tax) or a wholly nontaxable service. The de minimis serviceman thresholds (35% of annual gross receipts, or 75% for pharmacists and graphic arts producers) in 86 Ill. Adm. Code 140.101(f) can materially change which of the four tax-base methods is available and beneficial to your client.

Nutraceutical, supplement, and contract-packaging businesses

Encapsulating, powdering, or otherwise processing a customer's own material for return to that customer was treated by the Department as a service-with-incidental-property-transfer, not as a sale of a food or drug product eligible for a reduced rate. If your business does similar processing, expect Service Occupation Tax exposure on the capsules/packaging portion rather than a blanket exemption or automatic reduced rate.

Common questions

Q: Is a company that dehydrates and encapsulates a customer's own material subject to sales tax as a retailer?
A: No. Retailers' Occupation Tax and Use Tax don't apply to sales of service. Instead, because tangible personal property (the capsules and packaging) is transferred to the customer as an incident of the service, the company is taxed as a "serviceman" under the Service Occupation Tax Act.

Q: How is the tax base calculated for a serviceman?
A: One of four ways: (1) the separately stated selling price of the tangible personal property transferred; (2) 50% of the entire bill if the price isn't separately stated; (3) cost price, if registered as a de minimis serviceman; or (4) Use Tax on cost price, if de minimis and not otherwise required to register under Section 2a of the Retailers' Occupation Tax Act. The tax base can never be less than the cost price of the property transferred.

Q: What makes a serviceman "de minimis"?
A: Under 86 Ill. Adm. Code 140.101(f), a serviceman is de minimis if the annual aggregate cost price of tangible personal property transferred incident to service is less than 35% of annual gross receipts from service transactions (75% for pharmacists and persons engaged in graphic arts production).

Q: Did the Department grant the reduced food/medical tax rate the taxpayer requested for just the capsules and packaging?
A: No. The Department did not adopt the taxpayer's proposed carve-out. It instead directed the company to the general Service Occupation Tax framework and its four tax-base calculation methods, concluding the company "appears" to owe tax as a serviceman under one of those methods.

Q: Is this GIL binding on the company or the Department?
A: No. A General Information Letter merely directs the taxpayer to relevant regulations and other information; it is not a statement of Department policy and is not binding on the Department. See 2 Ill. Adm. Code 1200.120.

Citations and references

• 35 ILCS 120/2; 86 Ill. Adm. Code 130.101 (Retailers' Occupation Tax Act)
• 35 ILCS 105/3; 86 Ill. Adm. Code 150.101 (Use Tax Act)
• 86 Ill. Adm. Code 140.101 (Service Occupation Tax Act; four tax-base methods for servicemen)
• 86 Ill. Adm. Code 140.101(f) (de minimis serviceman thresholds: 35% / 75%)
• 86 Ill. Adm. Code 140.108 (de minimis servicemen who pay Use Tax to suppliers)
• 2 Ill. Adm. Code 1200.110 (Private Letter Ruling procedure)
• 2 Ill. Adm. Code 1200.120 (General Information Letters not binding on the Department)

Source

• Landing page: https://taxarchive.illinois.gov/research/legal/letter-rulings/sales-tax/2021.html
• Original PDF: https://tax.illinois.gov/content/dam/soi/en/web/taxarchive/research/legal/letter-rulings/sales-tax/2021/st21-0051-gil.pdf

Original ruling text

ST-21-0051 12/07/2021 SERVICE OCCUPATION TAX
This letter discusses the Service Occupation Tax. 86 Ill. Adm. Code 140.101.
(This is a GIL.)
December 7, 2021
Re: COMPANY
Dear NAME:
This letter is in response to your letter dated November 18, 2021, in which you
requested information. The Department issues two types of letter rulings. Private Letter
Rulings (“PLRs”) are issued by the Department in response to specific taxpayer
inquiries concerning the application of a tax statute or rule to a particular fact situation.
A PLR is binding on the Department, but only as to the taxpayer who is the subject of
the request for ruling and only to the extent the facts recited in the PLR are correct and
complete. Persons seeking PLRs must comply with the procedures for PLRs found in
the Department’s regulations at 2 Ill. Adm. Code 1200.110. The purpose of a General
Information Letter (“GIL”) is to direct taxpayers to Department regulations or other
sources of information regarding the topic about which they have inquired. A GIL is not
a statement of Department policy and is not binding on the Department. See 2 Ill. Adm.
Code 1200.120. You may access our website at www.tax.illinois.gov to review
regulations, letter rulings and other types of information relevant to your inquiry.
The nature of your inquiry and the information you have provided require that we
respond with a GIL. In your letter you have stated and made inquiry as follows:
To Whom It May Concern:
I. ACCOUNTANT, am the accountant and tax return preparer for
COMPANY, a newly formed S-Corporation in Illinois. I am writing
today to get some clarity on the taxability of the services provided by
this company as I have not been able to find any information in the
regulations that specifically speak to the nature of this business.
As you can see from the website article (copy attached), the company
takes PRODUCT1 and dehydrates them before blending them in to a
powder and then encapsulating them in vitamin pill capsules for the
PERSON where the product initially came from.
After reviewing this, we have come to understand that this service
generally falls under the same category as vitamin manufacturing with
a slight twist. It would not be fair to tax the whole service as the low
tax rate because the State would essentially be placing a tax on a
PRODUCT2 which is specifically addressed in 720 ILCS 5/12-20.
Instead, it would seem to make more sense to impose a low
food/medical tax rate on only the capsules and packaging which
those capsules are put in to since the encapsulation processing can
be excluded from tax since it is essentially a service.

FIRM./COMPANY
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December 6, 2021

I ask that you please review this information and provide guidance as
to the taxation of this business model
If you have any questions, please feel free to contact me directly
DEPARTMENT’S RESPONSE:
Retailers’ Occupation Tax and Use Tax
The Illinois Retailers' Occupation Tax Act imposes a tax upon persons engaged
in this State in the business of selling tangible personal property to purchasers for use
or consumption. See 35 ILCS 120/2; 86 Ill. Adm. Code 130.101. In Illinois, Use Tax is
imposed on the privilege of using, in this State, any kind of tangible personal property
that is purchased anywhere at retail from a retailer. See 35 ILCS 105/3; 86 Ill. Adm.
Code 150.101. These taxes comprise what is commonly known as "sales" tax in Illinois.
If the purchases occur in Illinois, the purchasers must pay the Use Tax to the retailer at
the time of purchase. The retailers are then allowed to retain the amount of Use Tax
paid to reimburse themselves for their Retailers' Occupation Tax liability incurred on
those sales. If the purchases occur outside Illinois, purchasers must self-assess their
Use Tax liability and remit it directly to the Department.
Service Occupation Tax
Retailers' Occupation Tax and Use Tax do not apply to sales of service. Under
the Service Occupation Tax Act, businesses providing services (i.e., servicemen) are
taxed on tangible personal property transferred as an incident to sales of service. See
86 Ill. Adm. Code 140.101. The transfer of tangible personal property to service
customers may result in either Service Occupation Tax liability or Use Tax liability for
servicemen, depending upon which tax base they choose to calculate their liability.
Servicemen may calculate their tax base in one of four ways: (1) separately stated
selling price of tangible personal property transferred incident to service; (2) 50% of the
serviceman's entire bill; (3) Service Occupation Tax on the serviceman's cost price if the
serviceman is a registered de minimis serviceman; or (4) Use Tax on the serviceman's
cost price if the serviceman is de minimis and is not otherwise required to be registered
under Section 2a of the Retailers' Occupation Tax Act.
Using the first method, servicemen may separately state the selling price of each
item transferred as a result of sales of service. The tax is based on the separately
stated selling price of the tangible personal property transferred. If servicemen do not
wish to separately state the selling price of the tangible personal property transferred,
those servicemen must use the second method where they will use 50% of the entire
bill to their service customers as the tax base. Both of the above methods provide that
in no event may the tax base be less than the cost price of the tangible personal

FIRM./COMPANY
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December 6, 2021
property transferred. Under these methods, servicemen may provide their suppliers with
Certificates of Resale when purchasing the tangible personal property to be transferred
as a part of sales of service. They are required to collect the corresponding Service Use
Tax from their customers.
The third way servicemen may account for their tax liability only applies to de
minimis servicemen who have either chosen to be registered or are required to be
registered because they incur Retailers’ Occupation Tax liability with respect to a
portion of their business. Servicemen may qualify as de minimis if they determine that
their annual aggregate cost price of tangible personal property transferred incident to
sales of service is less than 35% of their annual gross receipts from service transactions
(75% in the case of pharmacists and persons engaged in graphic arts production). See
86 Ill. Adm. Code 140.101(f). This class of registered de minimis servicemen is
authorized to pay Service Occupation Tax (which includes local taxes) based upon the
cost price of tangible personal property transferred incident to sales of service.
Servicemen that incur Service Occupation Tax collect the Service Use Tax from their
customers. They remit tax to the Department by filing returns and do not pay tax to their
suppliers. They provide suppliers with Certificates of Resale for the tangible personal
property transferred to service customers.
The final method of determining tax liability may be used by de minimis
servicemen that are not otherwise required to be registered under Section 2a of the
Retailers' Occupation Tax Act. Servicemen may qualify as de minimis if they determine
that the annual aggregate cost price of tangible personal property transferred as an
incident of sales of service is less than 35% of the servicemen's annual gross receipts
from service transactions (75% in the case of pharmacists and persons engaged in
graphic arts production). Such de minimis servicemen handle their tax liability by
paying Use Tax to their suppliers. If their suppliers are not registered to collect and
remit tax, the servicemen must register, self-assess, and remit Use Tax to the
Department. The servicemen are considered to be the end-users of the tangible
personal property transferred incident to service. Consequently, they are not authorized
to collect a "tax" from the service customers. See 86 Ill. Adm. Code 140.108.
If a transaction does not involve the transfer of any tangible personal property to
the customer, then it generally would not be subject to Retailers’ Occupation Tax, Use
Tax, Service Occupation Tax, or Service Use Tax.
It appears the company is acting as a serviceman and would owe tax under one
of the four methods described above.
I hope this information is helpful. If you require additional information, please visit our
website at www.tax.illinois.gov or contact the Department’s Taxpayer Information
Division at (217) 782-3336.
Very truly yours,

FIRM./COMPANY
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December 6, 2021

RSW:rkn

Richard S. Wolters
Associate Counsel