You may be liable for your customer’s breach of contract – Wacky Tax Wednesday

We all know everyone makes honest mistakes, and that some folks do things they know they shouldn’t do. But did you know that if you’re in business in New York, you could be held liable for sales tax if your customer breaks a contract? Even if you’re honest and they’re unscrupulous?

In advisory opinion TSB-A-20(66)S, the New York Department of Taxation and Finance explains that the transfer of a tangible photograph is taxable when the transfer is permanent and occurs via tangible mediums (e.g., CD, negative, paper, or slide). However, if the transfer of a tangible photograph is temporary, for reproduction purposes, and payment takes the form of a royalty, the sale is generally exempt from New York sales tax.

To qualify as an exempt temporary sale, both of the following conditions must be met:

• The original photograph must be returned unaltered at the end of the contract
• Payment must take the form of a royalty, meaning it must be related to the continued exercise of the copyright rather than a lump sum

An example of this type of agreement would be when a news agency buys the right to reproduce a photograph in their journal during 2020. Once the calendar hits January 1, 2021, the agency can no longer use the photo; they must return it, unaltered, to the photographer, and cease to use any digital copies they may have made.

The taxability of an exempt transfer of a tangible photo for temporary use could be jeopardized if the customer does any of the following in breach of the contract:

• Retains possession of a tangible photo permanently
• Makes unauthorized alterations to a tangible photo
• Makes a digital copy of a tangible photo for subsequent use
• Grants reproduction rights to third parties without the photographer’s consent

The photographer may not realize a customer has done any of the above. Nonetheless, if a customer does hang on to a photo, alter it, copy it, or give a third party the rights to use it, it's the photographer who could suffer the consequences.

The New York Department of Taxation and Finance advised the photographer to charge a customer sales tax if that customer was found to have done any of the above. It also said the department could hold the photographer liable for sales tax that should’ve been collected if they discover any such unauthorized use, particularly if there’s “a pattern of such action.”

TSB-A-20(66)S concludes with this: "If Petitioner discovers that its customer is using the tangible photograph or archived image in such a manner as described above, then Petitioner should collect and remit sales tax from that customer on all consideration received for that commission. Alternatively, if the Department discovers any such use, then it may assess Petitioner for the sales tax Petitioner should have collected." 

You read that right: If a customer acts in breach of a contract, the photographer could be responsible for tax on a transaction they thought was (and that should’ve been) exempt. That’s something.

According to Scott Peterson, vice president of government relations at Avalara, “to expect a seller to collect a new or additional tax years after the transaction is a radical departure from the concept of sourcing.” But he suspects the state won’t have many opportunities to act on this because they’d likely uncover any such activity during an audit, years after the transaction. “Given the point of a statute of limitations is to place an end to the liability period, there will be very few instances when this could happen.”

That’s comforting. Still, the fact that the department has taken this stance is notable. 

It’s critical to understand how tax laws can affect your business because battles over sales tax liability can be long and expensive. Read more about tax enforcement efforts and how to successfully navigate them in Sales and use tax audits in 2021.