During the last recession, state tax departments saw a decrease in revenue and struggled to create new cash flows to replace what was lost due to taxpayer income reductions. States responded by increasing their audit activity to replace the lost revenue. Most states pursued sales and use tax audits as there was a greater likelihood of audit findings with related penalties and interest.
States pursue audits based on several factors. One of the factors involved with each state’s selection method will generally include the complexity involved with compliance. States realize the more complex the industry, the more chance of a mistake, an oversight, or an incorrect position, and a greater likelihood of a substantial tax finding.
Which bring us to the construction industry. The construction industry tends to have very complicated fact patterns that have the potential of producing very different results for sales and use tax based on:
- The individual states involved with the construction contract, the location of any purchase and the location of the project;
- The role of the contractor (sub-contractor v. general contractor);
- If the contract involves a residential or commercial project;
- The type of contract (lump sum v. time and material);
- The ultimate use of the material involved and a determination if the material has become incorporated into the project;
- The services involved (carpeting, tiling, landscaping, etc.); and
- The fact that state tax codes and/ or pronouncements are often ambiguous and do not provide complete guidance.
In the majority of states, construction firms do not have to collect sales tax on the services they provide. Instead, construction contractors are generally treated as the consumer of supplies and materials used in construction projects and have to pay sales or use tax at the time of purchase. This results in the contractor not having to submit sales tax upon the sale of the finished construction. In most cases this will be an advantage, because any markup you charge to your customer on the materials, supplies and labor, will not be subject to sales tax.
This result could change, however, if the installation of any item does not become part of the real estate, and remains personal property after installation. If there is a determination that the construction involves personal property then the contractor may need to withhold sales tax on the completion of the contract. Personal property can include appliances, machinery and equipment, light bulbs, draperies, clean rooms and locker rooms. The distinction between incorporation into real estate and personal property can often be unclear and will be different depending on the state.
A few states, such as Arizona, Indiana and Texas, treat construction contractors as resellers that purchase materials solely for resale to an end user, and the state does not require that the contractor pay sales tax when purchasing materials. Further complicating these situations, however, is that you can have a different outcome based on the determination of whether the contract is a lump-sum contract or time and material contract.
Contractors should generally keep in mind that there may be an opportunity to use an exemption certificate. Whether you qualify for any exemption will depend not only on the type of contracts that you negotiate with your clients, but also the type of clients (non-profit, governmental, etc.).
Contractors can reduce their audit exposure by managing their sales and use tax liability and learning the rules before entering into a contract. Contractors should understand the sales tax costs of doing business in each state to ensure they are building these costs into their pricing. As seen with the last recession, states are specifically aggressive with their audit activity when companies are in a position that they can least afford it. If you are in the construction industry and looking for further understanding of some of the specific rules for each state as applied to your business please contact us. We can work together to reduce this exposure.