Construction contracts: multistate sales and use tax implications.
Contractors are generally subject to either a sales or use tax on purchases of tangible personal property affixed to real estate in the process of constructing, altering, repairing or improving such property. Construction firms, home improvement companies, brick, roofing, plumbing and electrical contractors and even wallpaperers are examples of taxpayers considered to be contractors in most states.
For each construction contract, several key issues arise: * The taxability of the particular transaction. * The cost base or "price" of the property subject to tax. * Whether the contract is exempt from tax under a special rule. * When does the transaction become taxable. * How is the contract taxed if construction takes place outside the state in which the contract originates.
Types of contracts
The general rule in most states is that a contractor is treated as the consumer of all the materials and supplies used in the performance of a construction contract. As a result, sales tax is generally due on the purchase of materials and supplies by the contractor. If the supplies are purchased without tax (e.g., outside the state of use or consumption), a use tax will generally be imposed at a subsequent date. In order to accurately determine how the contract is taxed, it is necessary to determine the nature of the contract being entered into.
There are generally three classes of contracts and five operational categories. The classes of contracts are lump-sum, time and materials, and cost-plus. Within these general classes, five categories exist: (1) Erecting and installing a building on land; (2) repairing and/or remodeling existing buildings; (3) selling buildings without installation (i.e., prefabricated buildings); (4) erecting, installing and leasing buildings; and (5) installing machinery and equipment. In some instances, the taxpayer does not in fact act as a contractor but instead is a servicer, a different set of rules (not addressed in this article) applies.
Price subject to tax
A construction contractor is generally treated either as a reseller or a consumer of tangible personal property, dictated by how the property is used to fulfill a construction contract. When entering into a contract to construct or improve real property, the contractor is generally regarded as the ultimate user of the property and must either pay a tax on materials used to fulfill the contract at the time of purchase or remit use tax to the taxing state at the time the materials are committed to the contract. The contractor generally cannot charge sales tax because the customer is purchasing real estate or an improvement to real estate, which is not a taxable purchase. The contractor may, however, pass the cost of the tax on to the purchaser as part of the contract price (sales tax will generally not be reflected as separately stated item on the contract).
For certain time and materials contracts, or when a contractor engages in resale activities, the contractor may have to collect and remit sales tax on the full selling price of tangible personal property transferred under the agreement. A contractor becomes a reseller when selling materials to another contractor, selling surplus materials not needed to fulfill a specific contract, or when it acts as a servicer and the materials are not considered to be incorporated into real property improvements.
Sales or use tax is generally based on the determined "sales price" or "fair market value" (FMV) of the materials used or consumed by the contractor. Most states define "price" to mean the finished goods inventory value of the item. Many states require the cost or value of installation to be included in the price, although some states will exclude labor costs if separately stated on an invoice, or if such labor is not in connection with original construction of real property. Similar rules apply to transportation charges; many states will look to the point at which title passes to determine if transportation charges should be included in the taxable base. When a contract involves both taxable and exempt items, research is generally required to determine which items are subject to or exempt from tax in a particular state.
Some states also tax the cost or value of equipment, tools, building forms, repair parts for equipment, and other items and supplies that do not become a component part of the structure but are consumed in the building process. For example, California defines materials to include "construction materials and components, and other tangible personal property incorporated into, attached to, or affixed to, real property by contractors in the performance of a construction contract and which, when combined with other tangible personal property, loses its identity to become an integral and inseparable part of the real property." California also taxes the sale of fixtures that are defined as "items which are accessory to a building or other structure and do not lose their identity as accessories when installed" (CAL. ADMIN. CODE tit. 18, R. 1521 (1991)).
Several states, including Georgia, Michigan, Maryland and Nevada, also tax fabrication labor for items constructed at a factory and delivered to the job site to be installed. Nevada defines fabrication labor as labor that results in the creation of tangible personal property or that is a step in a process that results in the creation of tangible personal property (NEV. ADMIN. CODE 372.380). In Michigan, costs incurred to modify or prepare tangible personal property for affixation or assembly are generally taxable, if such activities are considered to create a new product whose use is different from the article's original form, rather than the repair of a product that restores it to its original condition (which is considered a service). However, the amount subject to tax as fabrication labor is determined by whether the manufacturer-contractor of the product maintains an inventory of that item. A manufacturer-contractor who maintains an inventory of a product for sale at a list price must use the finished goods inventory value of the product as the tax base when the product is withdrawn from inventory and affixed to real estate. For contracts entered into after Mar. 31, 1939, a manufacturer-contractor who manufacturers, fabricates or assembles a product prior to affixing it to real property, but does not maintain an inventory, must use the materials cost plus the cost of all off-site labor (fabrication labor) as the basis for computing tax. However, labor to assemble or install the property at the jobsite is specifically excluded (MCL 205.92(f)).
Equipment brought into a state for use on a construction project may result in additional use tax liability in some states. For example, North Carolina law provides that "[c]ontractors are required to remit use tax at the applicable rate on the storage or use of motor vehicles, machines, machinery, tools and other equipment brought into this state for use in construction or repair work" (NCAC .2602). Various methods are employed by different states to establish the base on which the tax on equipment brought into a state must be calculated. For example, North Dakota use tax applies to the property's FMV at the time it is brought into the state. North Carolina requires the amount of tax to be calculated by multiplying the original purchase price by the duration of time used in the state and dividing by the total useful life (NCAC .2601). Normally, there is a credit given for sales or use tax previously paid to another state.
Contracts with exempt entities
Some of the largest construction projects are entered into with tax-exempt entities: U.S., state or local governments, charitable and religious organizations, and nonprofit educational institutions or related organizations. Although such entities are generally exempt from sales or use tax on materials and supplies used in their exempt functions, less than one-half of the states extend exempt status to a contractor who enters into a construction contract with an exempt organization. A few states allow an exempt organization itself to purchase construction materials on a tax-free basis and permit the contractor to enter a service-only contract. Other states impose tax on the contractor even if the exempt entity purchases the materials directly, since the contractor is considered to be the consumer of the installed materials. Many state statutes provide limited exceptions for the passthrough of exempt status.
Some states [Colorado, for example) exempt building materials used in the construction of property for exempt religious, charitable and governmental entities. Other states specifically deny this exemption. Nevada goes so far as to specify that the exemption is denied "regardless of the fact that a contractor might purchase the tangible personal property he is going to affix in the name of the entity" (NEV. ADMIN. CODE 372.200). Because of such varied rules, it is essential that each state's rules be reviewed before a contract bid is submitted.
When liability attaches to a
For contractors that must pay sales tax at the time of purchase, there is little question as to when the tax liability arises. For contractors that initially purchase materials and supplies on a tax-free basis, the question of when use tax must be remitted differs from state to state. Many states require the contractor to remit he tax as materials are committed to the fulfillment of the contract. (The withdrawal from storage or transportation to a job site generally constitutes such a commitment.) It is generally not permissible to wain until the construction contract is completed before reporting and paying applicable use tax.
Many states impose a sales or use tax on materials merely stored in the state if their ultimate use will be taxable. In Michigan, storage is defined as the "keeping or retention [of property] in this state for any purpose after losing its interstate character" (MCL 205.92(c)). This is typical of a general requirement that to be taxable the property must come to rest in the state, and not simply be in the state temporarily. Kentucky law, for example, specifically excludes from use tax the keeping of tangible personal property in the state for the purpose of subsequently transporting it outside the state for use outside the state (KAR 30:190, Sec. 3(3)). Conversely, Pennsylvania has no interim storage exemption; a construction contractor storing property in the state is required to pay sales or use tax to Pennsylvania, even the property will subsequently be used to perform a contract in another state. Maine provides a refund for taxable materials later removed from inventory, if the contractor's records are adequate to trace the purchase and sale of materials and the state of destination does not levy a tax. Similarly, Utah allows an exemption from use tax for property purchased outside the state that is also intended for ultimate use outside Utah, provided the purchase of the specific materials in question can be traced through the interstate commerce channel (Admin. Rule R865-21-12U).
Contracts for construction in
All states that impose a sales or use tax on contractors require a contractor to pay tax on materials used on jobs performed within the state. This is true whether the materials and supplies originate from within or without the state. Some states also require that sales or use tax be paid on materials removed from inventory within the state and transported to a job site outside the state. States that impose a use tax on the storage of materials within a state generally require the use tax to be remitted when materials are taken from inventory and shipped to a destination outside the state. As noted, almost one-half of the states impose such a tax on storing goods in the state. Also, many states require a contractor to post a bond to cover the liability for sales or use tax for construction contracts within their state.
In many cases, whether an item shipped from one state to another is subject to tax in a particular state depends on where title transfers. Material picked up by or delivered to a customer in the storing or origination state for transport by the customer outside of the state is generally deemed to have been sold in the origination state. However, if the goods are shipped by common carrier and title passes in the destination state, the goods are generally exempt from tax in the state in which the shipment originates.
Most states allow a credit against use tax imposed on tangible personal property brought into the state for any sales or use tax paid in another state. If the rate imposed by the other states is lower, the difference must usually be paid in the state into which the property is brought. Exemption or credit is generally not granted if the first state does not have a sales or use tax or does not itself allow a reciprocal credit. One exception is Virginia, which allows a credit without requiring reciprocity (VR 630-10-29(A)). If credit is granted, it is normally dependent on the tax being legally imposed by the first state in which the tax was paid. Reciprocity varies from state to state and must be examined independently with respect to any two states. Note that reciprocity may or may not extend to local taxes, which may be imposed independently of a state's general sales and use tax.
The proper determination of a contractor's state sales or use tax liability requires careful analysis, and may occasionally be reduced through careful planning. For instance, the sales tax on contract materials can frequently be reduced through the use of a purchasing subsidiary located in a low tax or not tax state. Similarly, it may be possible to reduce the tax liability on equipment used in other states if the equipment is owned by a leasing subsidiary that remits use tax on the lease payments attributable to a period during which equipment is used in the taxing state, rather than on the entire value of the equipment.
If there is a single principle applicable to sales and use taxes as they apply to construction contractors with multistate activities, it is what every state has a different set of rules and regulations. The many exceptions to the general rules can either save or cost clients substantial amounts, and must be carefully investigated in each state in which a construction contractor is doing business.
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|Author:||Best, Cynthia C.|
|Publication:||The Tax Adviser|
|Date:||Dec 1, 1992|
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