Most industries are taxed on the sale of goods or services. The customer is usually responsible for paying the tax while the business has to collect and remit the sum. In contrast, states tax construction contractors based on the materials they consume during a project.
This is because, in most states, when a contractor is performing work on real property, the contractor is deemed to be the final consumer and must pay sales tax upon those purchases. Accordingly, in most states, as a purchaser of construction services, you would not owe any sales/use tax on the contract price.
In the early days of sales tax, states applied the tax to tangible personal property (because real property was already taxed with property taxes). Services were not taxed. Therefore, construction historically has generally not been taxed because it was deemed a service. However, for construction and other service providers, they still owe sales or use tax on the tangible personal property used in performing those services.
This seems rather clear on its surface. A contractor is the end user of the tangible personal property because when the contractor finishes the job, the tangible personal property (nails, sheet rock, lumber, etc.) has transformed into real property.
Unfortunately, though, just paying sales tax on purchases does not begin to cover the multitude of activities contractors perform.
In addition to contract jobs on real property, contractors sometimes act as retailers of fixtures or other tangible personal property such as furnaces, water heaters, cabinets and air conditioners. Construction contractors will usually have questions over the different sales tax treatment depending on the types of contracts, such as cost-plus, fixed-price, time and materials.
There are further complexities regarding contract work with federal and state governments, churches and not-for-profit organizations. And then the distinction between real property and tangible personal property contracts is not always clear. Things also become more complex when you have projects in multiple states, as each state has unique regulations.
A contractor must always consider the impact of sales tax on purchases when making a bid. This can be challenging when you face constant competition and the bid price is a major criteria for winning a contract. But you also have to be very careful to accurately estimate the tax cost of the materials incorporated in the job so you don’t end up losing money. If state law requires it, you’ll need to be careful to bill the sales tax on the overall job.
While the guidelines just provided are applicable to the majority of states, it is important to remember that there are always exceptions. States are responsible for their own tax laws, so each state has unique technicalities and exceptions to be mindful of.
For example, it’s worth paying attention to whether regulations apply to residential or commercial projects. Some states will make that distinction. Others won’t.
One notable exception to the above guidelines is gross receipts tax, which is a tax on the total revenues of the company. To explain how these types of exceptions affect contractors, we’ll take a look at Arizona, which has a unique gross receipts tax.
Arizona has a gross receipts tax called the Transaction Privilege Tax. In many ways, it operates like a sales tax in that it is billed separately. But technically speaking it is a tax on the seller, not the buyer. The differences become very apparent when you consider how the tax impacts construction.
In Arizona, “Prime Contractors,” purchase their construction materials free of tax. Why? Because the Prime Contractor must pay a “Transaction Privilege Tax” (TPT) on 65% of the gross receipts on their contracts, a tax that is passed on to the building owner in much the same way a sales tax is passed on to a purchaser.
At first glance, the TPT on contractors may seem simple enough. But if a contractor performs maintenance, repair, replacement or alterations (MRRA) work for the owner of real property, or the owners of improvements to real property, that contractor becomes a service contractor, not a prime contractor. As a consequence, instead of buying their building supplies free of tax like a prime contractor and paying tax on 65% of their gross receipts, a service contractor pays tax on the building materials when they buy them.
You can quickly see how this could be confusing. First, a contractor has to know what is included in MRRA and what is still modifications that are prime contracting. Second, contractors could be a prime contractor or subcontractor to a prime on one job, and a service contractor on another job. In these cases, the prime contractor inventory and service contractor inventory must be accounted for separately.
Other states imposing special taxes upon contractors in addition to a general sales tax include Mississippi and South Dakota.
While state taxes can be confusing and difficult to navigate, there are some strategies construction contractors can use to get their tax expenses under control.
Each 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.
In order to ensure that a construction contract results in the lowest tax costs, the customer’s CPA or state tax consultants should be involved in the process during the bidding stage and communications with the contractor(s).
They can help you get in writing who will be responsible for the sales tax on the construction materials. Typically, as a contractor you would need to pay sales tax on the materials you purchase for the project. But you may be able to position yourself as a reseller who charges sales tax to the end customer.
If shifting this tax responsibility to the client is not possible, you can account for your sales and use tax expenses in the bid price. This prevents unexpected tax liability from turning a profitable project into a loss.
Your project may also qualify for incentive programs that exempt or offset sales and use taxes that fall under statewide initiatives. (For an example of the kinds of opportunities out there, see Washington’s incentive programs1.)
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