As an advertising agency, which of our 'nonbillable' expenses (items and services we buy but can't fully bill back to clients) owe Texas sales/use tax, and which don't?

Subject

Advertising Agency — Items (Services/Tpp) Billed By Agency To Clients — Taxable And Nontaxable Partial Lists

Plain-English summary

An advertising agency wrote in to explain what it called "nonbillable" expenses -- items and services it purchases that it either cannot or does not fully charge back to its clients -- and asked the Comptroller to confirm which of these owe Texas sales/use tax. The Comptroller's answer restates the basic rule and then applies it to the agency's specific examples.

The core rule: all purchases of tangible personal property (and certain taxable services) are taxable unless a specific exemption applies, such as the resale exemption. An agency that buys a taxable item intending to resell it to a client can claim the resale exemption on that purchase. But if the item is never actually resold -- for example, it's given away, used internally, or otherwise not billed to a client -- the resale exemption falls away and the agency owes use tax on it. On the other hand, if the agency did resell the item to the client but at less than its cost (creating the "net loss" that shows up as a nonbillable expense), no additional tax is owed on that discount, because tax was already charged on the actual (discounted) sales price.

Applying this to the agency's specific items:

• Competition tapes are taxable to the agency. They are never resold to the client, so the resale exemption doesn't apply. They also don't qualify for the manufacturing/quality-control exemption, because that exemption only covers equipment used in the actual production process -- not the pre-production, research-and-development-like phase where competition tapes are used.
• In-house dubs that become nonbillable are not additionally taxable, because the agency already paid tax on the audio/visual supplies when it bought them.
• Out-of-house dubs purchased for resale that end up sold to the client for less than cost (or destroyed) are not taxable, following the same "already taxed on actual sales price" logic.

The letter also encloses a chart classifying a long list of other "nonbillable" line items (gifts, travel costs, freelance costs, faxes, postage, storage, telephone, typesetting, etc.) as either taxable to the agency when acquired, or non-taxable, based on the same resale-versus-consumption analysis.

What this means for you

Advertising and marketing agencies

Track whether an item purchased on a client's behalf is actually resold/billed to that client. If it's resold (even at a loss), no extra tax is due beyond what was charged on the actual billed price. If it's never resold -- given away, used internally, lost to error, or consumed by the agency itself -- the agency owes use tax on it because the resale exemption doesn't apply.

Businesses using outside creative/production vendors

Materials used in the pre-production or "creative development" phase (like competition tapes used for quality control before production begins) are treated like research and development, not manufacturing -- so they don't get the manufacturing exemption even if they are short-lived and essential to quality.

Accountants and tax professionals

The key distinction in this letter is resale versus consumption: (1) items resold to a client, even below cost, are taxed only on the price actually billed; (2) items never billed/resold to a client are taxed to the agency as if the agency were the end consumer, because the resale exemption no longer applies.

Common questions

Q: If we buy an item for a client but end up not charging them for it, do we owe tax?
A: Yes. If a taxable item purchased under a resale exemption is never actually resold to the client, the agency owes tax on it, per this letter.

Q: If we resell an item to a client at a loss, do we owe extra tax on the loss?
A: No. According to this letter, no additional tax is due on the difference between cost and the discounted price charged to the client, since tax already applies to what was actually billed.

Q: Are competition tapes used for creative quality control exempt as manufacturing equipment?
A: No. This letter states the manufacturing exemption only covers equipment used during actual production, not the pre-production/research-and-development-like process where competition tapes are used, and the tapes are never resold to the client.

Q: What about dubs (audio/visual copies) that go unbilled?
A: Per this letter, in-house dubs that become nonbillable are not additionally taxed because tax was already paid on the underlying supplies; out-of-house dubs sold to the client for less than cost (or destroyed) are also not taxable.

Source

• STAR search: https://star.comptroller.texas.gov/search?doc_type_code=L&tax_type_code=SST
• Opinion: https://star.comptroller.texas.gov/view/9605252L

Original ruling text

May 22, 1996

Dear **:

Thank you for your letter of May 3, 1996 further explaining nonbillable

expenses.

You described "nonbillable" entries as follows:

** may purchase some of the same items for our day-to-day

operations. However, if they are appearing in our nonbillable accounts, it is

because our clients need or demand these items or services, and we are unable

to bill them for those expenses. We specifically track these items-on a client

level-so we are able to identify the expenses we are unable to bill. As with

any other business or industry, our objective is to keep these expenses as low

as possible.

If you buy goods or taxable services for your clients and cannot or do not

resell those items, the agency will owe tax on those items. To eliminate

confusion, let me explain how sales tax works. All purchases of personal

property are taxable unless specifically exempted in the law. For example, the

tax law provides an exemption for goods purchased for resale. Under this

provision, a department store may buy dresses, jewelry, shoes etc. for resale,

but not hangers, racks and other fixtures. And it may not claim a resale

exemption when purchasing boxes, sacks and tissue to wrap its customers'

purchases.

The law defines personal property to include processing and fabrication

activities, such as film processing and the creation of pictures, paintings or

logos.

Certain service transactions are also subject to sales and use tax. Under

certain circumstances, taxable services may be purchased for resale.

Keeping that concept in mind, an agency will owe tax on goods and taxable

services when those items are purchased unless an exemption is applicable.

If an agency buys a taxable item for resale and does not resale it but gives it

to a client, then the agency owes tax on that item. On the other hand, if an

agency buys a taxable item for resale to a client and charges the client less

than cost, the agency does not owe tax on the difference, which is the net loss

booked to "nonbillable."

In your letter you argue that "competition tapes" are not taxable to the agency

because they are used to service your clients and that because you are not

billing your clients for the total cost the agency incurred, these items would

be considered a "nontaxable nonbillable" expense. Additionally, you believe

that competition tapes are a necessary and essential material used to achieve

quality control. In your explanation you pointed out that if you waited until

the actual production process to use competition tapes, it would be too late to

affect quality control. Next you pointed out that these tapes definitely have a

life of six months or less.

The competition tapes are taxable to the agency. They are not resold to your

clients. Therefore, the resale exemption is not applicable. The tapes may be

necessary and essential to the creative process and have a useful life of less

than six months. However, they do not qualify for the exemption provided for

manufacturers because that exemption only extends to equipment used during the

actual manufacturing process. The exemption specifically excludes equipment use

in research and development. The tapes are used in the pre-production creative

process-the process that takes place before production begins is similar to

research and development.

You also discussed dubs.

If an in-house dub becomes nonbillable, we would not accrue additional tax

since we paid tax on the Audio/Visual supplies at the time of purchase. If an

out-of-house dub could not be billed to our client (e.g., we ordered too many),

we would not be billing our client the total cost GSD&M incurred, resulting in

a net loss. Therefore, this would be a nontaxable item.

I agree. In-house dubs that become nonbillable are not taxable because you pay

tax on audio/visual supplies when you buy them. And out-of-house dubs purchased

for resale and sold for less than cost or destroyed are not taxable.

I have attached your chart of taxable and nontaxable nonbillables. Please let

me know if you have any questions. My number is 463-4614.

I have forwarded your offer to help produce a brochure to clarify the tax

responsibilities for advertising agencies. Thanks for your help and patience.

Sincerely,

Adina Whittemore

Tax Policy Division

List of "Non-billable" Items Description

gifts - Taxable to the agency when acquired

travel-airfare - Non-Taxable

travel-mileage - Non-Taxable

travel-auto/taxi - Non-Taxable

travel-meals - Taxable to the agency when acquired

travel-misc. - Taxable to the agency when acquired

agency error - Non-Taxable

competitive creative - Taxable to the agency when acquired

in-house development - Non-Taxable

donations - Non-Taxable

dubs (nonbillable-tax on tapes) - Tapes are Taxable to the agency when acquired

dubs out of house purchased for resale (Sales amount to client represents discounted sales price) - Non-Taxable to agency when acquired but taxable to client when billed

faxes (phone bill is taxable) - Non-Taxable

freelance (this amount represents the discount of the sellling price) - Non-Taxable

freelance-creative (this amount represents the discount of the sellling price) - Non-Taxable

freelance-media (this amount represents the discount of the sellling price) - Non-Taxable

int meetings (internal meetings) - Non-Taxable

legal fees - Non-Taxable

Mac time - Non-Taxable

media errors - Non-Taxable

new business - Taxable to the agency when acquired

over estimate - Non-Taxable

postage/freight - Non-Taxable

production - Non-Taxable

research - Non-Taxable

stats - Taxable to the agency when acquired

storage - Non-Taxable

story board (produced in house) - Non-Taxable

telephone - Taxable to the agency when acquired

typesetting (out of house) - Taxable to the agency when acquired

copies - Taxable to the agency when acquired

misc. - Taxable to the agency when acquired & Non-Taxable