North Carolina bakers recently won a battle against the N.C. Department of Revenue for confusing sales tax governance, but the war over the legal definition of “prepared foods” may have just begun.
In an unprecedented decision, North Carolina legislators passed the Small Business Tax Protection Act that exempts bakeries from some back tax bills. The act is intended to protect small businesses from certain sales and use tax assessments, require the Department of Revenue to document certain verbal advice given to taxpayers, allow taxpayers to rely on documented verbal advice from the Department of Revenue, and to give the Secretary of Revenue more discretion in resolving sales and use tax disputes concerning small businesses.
The landmark legislation stems from problems retail bakeries and other small businesses started experiencing in 2003 when North Carolina stepped up audits of businesses to collect sales tax. La Farm Bakery, Cary, N.C., was among the many bakeries caught in the crossfire over whether they should be charging the grocery store tax, which is 2 percent, or the prepared foods tax, which is 7.75 percent.
In 2005, La Farm was slapped with a $150,000 bill after undergoing a state audit. The bakery had been collecting the 2 percent the state had originally instructed them to collect since they opened their business in 1999.
“Being somewhat naive at the time, we were actually excited about the audit because our business was doing great and we had kept excellent records,” said Missy Vatinet, owner of La Farm Bakery. “But when our bookkeeper called me in hysterics during the audit, that's when things came to a screeching halt.”
Even after the audit, Department of Revenue officials told Vatinet on several occasions that her bakery products only required the 2 percent grocery tax, but they would not put their words in writing. The debate was whether or not bakery products should be classified as a “prepared food,” which is defined as food that is sold hot or heated by the retailer, mixed or combined by the retailer, or sold with eating utensils provided by the retailer.
The Department of Revenue representatives were telling the taxpayers one thing, but its auditors were taxing another. After years of legislative debates and with N.C. Sen. David Hoyle's backing, the Small Business Tax Protection Act has finally passed. North Carolina bakeries that were audited were awarded back the majority of the audit money collected with interest. Bakeries that make 80 percent of their baked products on premise and do not offer utensils to customers will be able to reduce their sales tax back to 2 percent beginning Jan.1, 2009.
“With the help of one of the most influential senators, Sen. David Hoyle, assembly members were able to craft a bill to protect those small businesses caught in the cross fire,” Vatinet said. “He really went to bat for us. Hoyle and legislators protected and demanded a culture for North Carolina that respects its hard working small businesses.”
Despite this victory for N.C. bakeries, another discrepancy has surfaced. The legislation allows some retail bakeries to charge equal sales tax with grocery stores, but others still do not qualify for the lesser tax because they offer utensils to customers, which puts them in the higher “prepared foods tax” category of 7.75 percent. Because of this loophole, customers are charged a higher tax rate in the retail bakery where the bread is made than if they purchased the same bread that bakery wholesaled to a grocery store, which only has to charge 2 percent.
The resolution in North Carolina may become an issue in other states that are also participating in the National Streamlined Sales Tax Project (NSSTP) that introduced the definition of a prepared food and allows state legislators to include or exclude bakery products among a lengthy list of possible exemptions for prepared foods. Minnesota bakers experienced a similar issue with a “bread tax” that was eventually repealed in 2002.
“Prepared food is a now a legal term for states to tax more,” said Jerry Ray, owner, Mickey's Pastry Shop, Goldsboro, N.C. By the prepared food definition, the ingredients in a bakery product are alone considered “food.” However, flour, sugar and yeast can't stand alone as a food. “These items cannot be eaten or ingested for taste or nutritional value. Nobody buys and consumes the ingredients I use,” Ray added.
Further, many bakeries are adding coffee and café offerings to their product lines, pushing bakery product sales to less than 80 percent of their business. The issue could become a national one because states that comply with the NSSTP must view bakery items as a prepared food. For now, North Carolina bakers are getting their money back and have a clearer definition of their sales tax law as well as a friend in one of their state senators.
“The larger problem of taxing a higher prepared foods sales tax for products made by artisan bakeries on their premise still exists,” Vatinet said. “In the interim, I highly suggest all retail bakers get their sales tax details in writing. That's my $150,000 advice.”