Construction Contractor Sales Tax Issues: Some Do’s and Don’ts
Growing up, I wanted to be an architect. I loved thinking about design, engineering and building functional art. So, when I broke into state tax planning, I especially enjoyed working with contractors.
As it turns out, construction is also one of the more unique and fascinating industries when it comes to state tax. In most states—Minnesota, North Dakota, Iowa and Wisconsin included—contractors are principally considered to be service providers for purposes of sales and use tax. As such, the contractor, rather than the real property owner, consumes the materials incorporated into real property and must pay sales tax, or accrue and remit use tax, on its purchases of such materials.
When I work with clients on either sales and use tax planning or controversy matters, the sales and use tax structure facing contractors frequently prompts a number of unanticipated challenges. With that in mind, I wanted to highlight a few basic do’s and don’ts for these companies:
DO recover sales tax paid; DON’T itemize it!
While the tax liability related to purchases of materials falls on the contractor, the contractor is permitted to pass the economic impact of that liability on to its customer by marking up the charge for materials.
What a contractor cannot do, however, is itemize any charge for sales tax, or make any “sales tax included” notation on the invoice. A property owner seeing such a notation and aware that their purchase of real property improvements is exempt from sales tax could potentially file a tax refund claim with the state, which may create audit risk and potential class action exposure for the contractor.
DO consider available exemptions; DON’T assert an exemption without substantiating paperwork!
Although the sales tax treatment of the construction industry is unique, there are plenty of tax exemptions worth exploring. Some are generally applicable, such as exemptions for materials used in improving real property owned by government instrumentalities or exempt organizations. Others are state- and situation-specific, such as Minnesota’s exemptions for qualified low-income housing projects and for reconstructing properties damaged by significant fires.
But before asserting any exemption, companies must ensure that they satisfy all documentation requirements. I frequently see this become a major issue for contractors performing work for exempt organizations in Minnesota, where the state taxing authority has adopted guidance requiring specific contractual language appointing the construction contractor as a “purchasing agent” for the exempt organization, among other very specific requirements, before allowing the contractor to assert the exempt organization’s sales tax exemption.
DO engage in retail activities; DON’T forget to pay use tax as required!
Although the discussion above has focused on the treatment of contractors as service providers, numerous states recognize that a contractor may also operate as a retailer (e.g., through the provision of a materials-only contract, or by selling tangible personal property at a showroom or online). When acting as a retailer, the “ordinary” rules of sales and use tax apply: The contractor-retailer purchases tangible personal property from its suppliers exempt from sales tax as purchases for resale and collects sales tax from its customer, barring any exemption, at the time of sale.
In these situations, it is important for a contractor-retailer to maintain inventory integrity. The contractor-retailer must track which purchases were made for use in construction projects versus those purchased exempt for resale. Any inventory purchased exempt for resale that is consumed by the contractor in improving real property will be subject to use tax.
To be sure, there are plenty of interesting state-specific nuances around what qualifies as an “improvement” to “real property” and how a construction contract’s structure affects sales and use taxability. Anticipating the more fundamental issues and assembling required documentation beforehand can make the next audit a much smoother and more successful one.