Are Product Misclassifications Causing You to Overpay or Underpay?

In the world of tobacco excise tax, the rules are complex, and the line between a product falling into a specific category, like Other Tobacco Product, or Cigarette, isn’t always obvious, making product misclassification errors common.

Each of these errors has consequences: sometimes you’re overpaying tax, and sometimes you’re underpaying. Either way, your team is exposing the business to compliance risk. Misclassification erodes margins and puts you on shaky ground with the Department of Revenue.

The Cost of Overpaying

When product attributes like type, price, and quantity are wrong, businesses can end up taxing items they don’t have to. For example, classifying a cigar cutter or lighters as a taxable tobacco product means you’re paying excise taxes you never owed in the first place.

Take this real-world example: a gas station chain mistakenly applied the tobacco excise tax to lighters. Month after month, they were sending in payments that weren’t required. The result? Money that should have stayed in the business, gone.

What is the real problem with overpaying? It’s usually invisible. Unlike underpayment, the Department of Revenue likely won’t alert you. Those dollars are gone unless you catch the mistake and act, and by then, you’ve already sacrificed valuable capital.  You may have the option to amend or file for a refund, but either option carries an extra burden and can lead to lengthy reviews.

Here’s why overpaying is such a costly issue:

1. Poor Cash Flow Management

Overpaying excise tax is essentially giving the government an interest-free loan. You don’t get charged a penalty, but you forfeit the use of that money in your own business. That means:

• Less cash available for day-to-day operations.
• Missed opportunities to invest.
• Reduced financial flexibility in a market where margins are already tight.

2. Recovery Is Time-Consuming

While it may be possible to recover overpaid taxes, the process isn’t quick or easy. Businesses must:

• File a formal claim for excise tax refunds.
  • Jurisdictions have different ways of filing.  It could be via an amended tax return, a refund claim form, or a letter to the jurisdiction.
• Provide documentation that supports the claim.
• Wait weeks, or sometimes months, for processing.
• Potentially respond to multiple rounds of inquiry before an approval or denial is issued.

That’s valuable time and administrative effort your team could be spending on higher-value, like analyzing new legislation or working on other taxes in the business.

According to Tobacco Tax Refund, on top of paying excise tax on non-taxable products, you may also be eligible for a refund if you delivered tax-paid products to another state or your tobacco products were lost, destroyed, or became unfit for a sale.

3. Statute of Limitations

Refund claims don’t last forever. There is a statute of limitations and taxpayers generally have:

• Three to four years from the date the return was filed, or should have been filed.

Check with each jurisdiction for an exact statute of limitations. If you miss that window, your right to a refund disappears. Many businesses don’t realize they’ve been overpaying until it’s too late to recover those funds.

The Risk of Underpaying

On the flip side, underpayment creates a different kind of headache, one that comes with risk exposure.

If a taxable product is misclassified as the incorrect category or exempt, you’re under-collecting and under-remitting excise tax. That might seem small at first, but it snowballs. When an auditor finds it, you’re looking at:

• Back taxes owed (sometimes years of them).
• Interest and penalties on top of the tax owed.
• Reputational risk with the Department of Revenue.

For businesses in the tobacco supply chain, one audit can wipe out months, or even years, of margin.

See other potential triggers of tobacco audits, here.

Why These Mistakes Happen

The complexity of the tobacco excise tax makes errors almost inevitable when relying on manual processes or outdated systems. Common challenges include:

• Similar products, different rules: From rolling papers and vape cartridges to cigars, smokeless tobacco, and accessories, products that seem similar on the surface can be taxed in various ways. Without precise classification, even a small coding error can lead to significant overpayments or dangerous underpayments.
• Changing regulations: As legislatures catch up to evolving product trends, E-cigarette and alternative tobacco definitions evolve.
• Multiple systems: Product data in POS, ERP, or spreadsheets often doesn’t match. Without consistency, misclassifications slip through. In fact, A recent study found that nearly 94% of spreadsheets used in business applications have critical errors that can impact business function and decision making.
• High-Volume Complexity: Distributors and retailers with thousands of SKUs face a sheer volume challenge. Even if most items are correct, a handful of misclassified products across multiple jurisdictions can add up to significant tax exposure.

The Solution: Automated Tax Determination Software

The way to avoid both overpaying and underpaying is automated tax determination. Instead of spending countless hours interpreting statutes to determine how each product in your catalog needs to be taxed in every jurisdiction you do business, A tax determination software leverages common product attributes and interprets the jurisdictional rules to assign the correct product category and determine the appropriate taxation per jurisdiction.

Here’s what that means in practice:

• Possible Reduction of Overpayments: Non-taxable products (like lighters, cases, and certain accessories) are flagged instantly, so you never remit unnecessary tax.
• Risk Mitigation: Every taxable product is mapped and taxed correctly, protecting you from penalties and audit findings.
• Up-to-Date Audit Trails. With transparent documentation of how each tax decision was made, you can show regulators clear proof of compliance, reducing disputes and audit stress.
• Margins Protected: Accurate tax treatment ensures you only pay what you owe, keeping more revenue in your business while maintaining full compliance.

This analysis is intended for informational purposes only and is not tax advice.  For tax advice, consult your tax adviser. See the full disclaimer here.