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Sales and use taxation of construction and real property transactions can be an area of great complexity that affects more than just contractors.
Whether you’re a tax professional who works for a construction company or for a business that enters into contracts with construction contractors, it’s very important that you understand the differences in how states can tax these transactions.
These sales tax pointers for both contractors and customers will help you untangle this mess. We’ll also examine one of the most important factors in real property transactions – the contract itself – and discuss some of the things you need to know from a sales tax perspective.
While the taxation of construction contracts varies from state to state, there are a few rules that generally apply across the states.
The taxation of a “lump sum” contract typically follows this treatment. A “lump sum” contract is a contract that does not distinguish between the charges for materials and the charges for labor.
Some states view the form of the contract as defining its taxability. “Separated” contracts may be taxed differently in some jurisdictions. A “separated” contract is a contract that separates the charges for labor and materials. Typically, separated contracts are either cost-plus contracts or time-and-materials contracts.
Since in separated contracts, the contractor is selling materials prior to incorporation into real property, they can be considered retailers of the materials and sales tax is collected on the selling price of the materials between the contractor and the customer. This amount includes the markup on the materials.
In some cases, a contractor may be deemed a retailer of certain items sold to customers.
An example of this would be if the contractor transfers items to the customer without incorporating them into real property. In this case, the contractor should collect sales tax from the buyer and remit to the appropriate authorities.
If the contractor has already paid tax on the items sold, the contractor is generally allowed a credit for the original tax paid. Examples include appliances and window coverings as these items retain their classification as tangible personal property.
For contractors and property owners alike, there are some best practices that should be followed when planning out a construction contract.
To correctly determine the application of taxes to a construction contract, the scope of the project must be specific and detailed. This specificity will determine the nature of the project as well as the financial terms.
The contract should clearly delineate what work is to be performed and what materials will be procured and installed to meet the contract’s requirements. Additionally, a well-written contract should address the tax responsibilities of both the contractor and the customer.
Florida previously issued guidance explaining how the terms of the contract dictate the tax treatment of the contract. In its technical advisement, the Florida Department of Revenue stated that if a contractor cannot provide an itemized list of materials and supplies at the inception of a contract, or the contract does not otherwise qualify as a “retail sale plus installment contract,” then the contract is usually categorized as a lump-sum contract, on which the contractor would not charge the customer sales tax.
In order to ensure that a construction contract results in the lowest tax costs, the customer’s tax professionals should be involved in the process during the bidding stage and communications with the contractor(s).
Depending on the type of project and/or location, there may be tax planning opportunities – such as enterprise zones – that need to be considered. For example, Washington state offers a sales and use tax exemption on the construction of corporate headquarters within a community empowerment zone. (Note: This exemption available through December 31, 2020)
The customer should never assume that a contractor is fluent with all tax planning opportunities related to their specific project or that they will bring tax minimization ideas to the customer’s attention.
It is also in the contractor’s best interests to be alert to tax planning opportunities that may apply to projects and/or discuss the topic with their potential customer during the bidding process. Being proactive and researching potential exemptions or credits can result in major cost savings for everyone involved.
Considering the taxability aspects discussed above, it is important that a contractor properly register for applicable tax types in each state where work is performed.
Many contractors incorrectly assume that they are always the “consumer” of the materials installed and used for projects. There may be situations that a state deems the contractor a retailer for which they need a proper sales tax registration to purchase applicable items for resale and to collect applicable sales tax.
From a customer perspective, the customer 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 the customer can result in unexpected audit risk.