Contractors face complex issues when dealing with sales and use taxes and the impact the taxes may have on the organization. Missteps can lead to unexpected audit results with significant tax assessments, resulting in a major influence on financial statements. What should a contractor consider, that will help minimize the tax effect and a negative aspect to profits?
State-specific tax treatments and requirements
Most states have a general rule that contractors are consumers of the materials used to fulfill their construction contracts. Under the rules, the contractor would pay sales tax directly to the vendor or remit use tax on the purchased materials. This “general rule” applies when the contract is construction related to real property. However, since nothing is “easy” in the tax world, each state has specific laws.
Some states have certain construction exemptions, other states may charge tax on the construction services provided. Contractors can also be viewed as retailers or manufacturers, which alter the dynamics of the taxability of the type of activity performed.
Thinking of the potential tax impact starts at the beginning of the project. When bidding, understand and reach an agreement with the customer - discuss the true nature of the project and the taxes involved. What should be considered?
- What is the nature of the project?
- What type of contract will be issued?
- Are there any tax exemptions that can flow through from the customer to the contractor?
Whether the project is for the construction of real property, or the installation of tangible personal property is ruled by each state’s tax laws. States may consider the manner of affixation and permanence, whether property becomes “permanent” or merely a “fixture.” Differing state rules could result in different tax exposure even though the contracts could be identical, but performance of the contract occurs in various states.
Impact of contract type on taxes
Tax treatment can be affected by the type of the contract. “Lump-sum” contracts do not separately state charges for materials, labor, overhead, and similar charges. Under a lump-sum contract, the contractor is treated as the end consumer of materials incorporated into real property. The contractor is responsible for paying tax on all materials. “Time and material” contracts itemize charges for material, labor, supplies, and other charges. States will treat time and material contracts as sales of tangible personal property with installation. Under time and material contracts, materials are purchased and transferred to the customer as nontaxable sales for resale, but then the contractor would need to collect tax on the property installed.
Flow-through exemptions
Flow-through of exemptions from customer to contractor are dependent on each state and can cause significant tax issues for a contractor. Most states will not allow contractors to use a customer’s exempt status to make tax-free purchases of materials. Sometimes the exemption could be limited. There may be a requirement of pre-approval for using exemptions and specific documentation to gain use of an exemption. Exemptions that may exist, but not necessarily apply to a contractor, include non-profit entities, educational sites, hospitals/healthcare facilities, places of worship, and governmental projects. Each state must be analyzed to see the applicability of a specific exemption.
Overall, contractors are primarily responsible for sales and use taxes and must ensure their contracts cover this often-overlooked expense. Although tax can rarely be charged directly to a customer, there is nothing to prevent a contractor from billing a customer to cover the tax associated with materials. The tax is merely a cost of doing business.
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