Best Practices for Construction Contract Planning

Construction projects can be massive and overwhelming endeavors for property owners. The projects entail a slew of decisions and require clear and frequent communication with the project contractor. 

Before any construction project can even make it off the ground, you must first plan and execute a contract. Construction contracts are the foundation of not just the physical planning but also tax planning for the project. The property owner, as the customer, should include and engage their tax personnel in the contract planning process from the bidding stage onward. 

Depending on the type of project or the location of the project, special tax planning opportunities may be available. The property owner should be confident that their construction contract helps them take advantage of potential tax savings and clearly defines each party’s tax responsibilities. 

For contractors and property owners alike, there are some best practices that should be followed when planning out a construction contract. We will focus on best practices from the property owner’s perspective in this article since it is more likely that your company will be on that side of the contract if you’re not in the construction industry. 

Lump Sum vs. Separated Contracts

There are two types of general construction contract structures: lump sum and separated or itemized contracts. Lump sum contracts do not distinguish between the charges for materials and the charges for labor. Separated contracts separate material and labor charges. Typically, separated contracts are either cost-plus contracts or time-and-materials contracts. 

In many states, the structure of the contract can have an impact on the taxability of the transaction.  A lump-sum construction contract generally imposes tax liability on the contractor. In states that follow this type of tax treatment, the contractor is required to pay tax on materials incorporated into the real property purchased for the project. This may be advantageous because any markup the contractor charges the property owner/customer on materials or labor won’t be subject to sales tax. The contractor won’t itemize or show tax on the invoice, but that doesn’t mean they’re not passing the tax along because it’s in the total cost (or should be!) 

In a separated contract, the contractor is “selling” materials prior to incorporating them into real property for the project by listing them on the invoice. In some states, contractors may be considered retailers of the materials in this type of contract and are able to purchase tangible personal property for resale. Sales tax is collected on the selling price of the materials between the contractor and the property owner/customer. This amount includes the markup on the materials. 

Exemptions for Construction Projects

If the project qualifies for some sort of usage, entity or incentive exemption, you want to identify the exemption opportunities up front. An exemption identified after the fact generally results in no savings when related to construction contracts, particularly in a lump sum fixed fee contract. 

If you qualify for a tax exemption as the property owner/customer, whether it’s a manufacturing exemption or because you are an exempt entity, you need to determine if your exemption can “flow-through” to the contractor. Not every state permits this treatment for every type of exemption. 

If the exempt organization purchases materials directly that will be used for construction projects, these would typically be able to be purchased tax-free (assuming the state exempts sales directly to the exempt organization). This would be the approach if a flow-through exemption is not allowed in the state where the project is. Otherwise, the contractor would be deemed the purchaser and tax would apply to all the materials incorporated into the project.

However, in states where the flow-through exemption is allowed, the contractor can make purchases on the property owner/customer’s behalf by providing the property owner’s exemption documentation to their supplier along with appropriate language on their purchase agreements which stipulate the job the materials will be used on. For example, in Illinois, exempt entities that have been issued a sales tax exemption identification number are granted flow through exemptions on contractors’ purchases. 

Out-of-State Contractor

From the property owner/customer perspective, the property owner should always require proof of proper registration from the contractor as part of the contract process. Allowing a non-registered or not properly registered construction contractor to perform work for you can result in unexpected audit risk. 

States generally require contractors to be registered, bonded, and insured in order to protect in-state customers. For example, in Massachusetts, an out-of-state contractor must register as an “Out-of-state Contractor” with the Department of Revenue and submit a Guarantee Bond Form for any project valued at $20,000 or more. In Mississippi, contractors without a physical location in the state are required to prepay the taxes due or bond all contracts over $10,000. Additionally, it’s critical to be aware of state requirements even when working on a federal project. Washington determined that a company working on a contract with the federal government was required to pay Washington use tax for a turbine rehabilitation project. Under Washington tax law, because federal contractors may not impose sales tax on the federal government, federal contractors are required to pay use tax on the value of the materials and tangible personal property used for the government contract. 

As a property owner/customer, if your contractor is not required to be registered in your state, you want to ensure that the appropriate bond is in place to protect you. If the proper registration hasn’t happened, the tax that otherwise would be the responsibility of the contractor can shift to the property owner. 

Get the Best Sales Tax Outcome

If you’re the property owner/customer for a construction project, you should never assume that a contractor is fluent with all tax planning opportunities related to your specific project or that they will bring tax minimization ideas to your attention. This is especially important when using an out-of-state contractor! 

It’s best to be fluent yourself so you are well-prepared to influence the sales tax outcomes of your construction contracts moving forward!