Key Sales and Use Tax Issues for the Construction Industry

Tram Le

Tram Le (tle@taxops.com) is a member of the SALTovation team at TaxOps and an adjunct professor at the University of Texas at Arlington. She writes about hot topics in state and local tax affecting business operations and growth strategies.

In this installment of Spreading SALTovation, Le examines sales and use tax issues in the construction industry, including classification of jobs, pricing and payment terms of contracts, the definition of a contractor, and exemptions for construction projects.

Copyright 2022 Tram Le.
All rights reserved.

Sales and use tax laws are complicated as applied to the construction industry, and tax responsibilities can be unique for every construction project. The classification of jobs and nature of work performed, the pricing and payment terms of the contract, the definition of a contractor, and applicable exemptions must be considered in properly managing sales and use tax responsibilities.

A contractor that manages projects in multiple states may have compliance difficulties because the sales and use tax laws are not uniform across the jurisdictions. A contractor must understand what materials and services are subject to tax by jurisdiction, when sales tax should be charged and collected from customers, applicable exemptions, and when to accrue use tax when purchasing materials and supplies from a vendor. It is important to distinguish between construction services for new construction, repairs, maintenance, or improvement to existing real property, and services to install tangible personal property.

Taxability

States have varying definitions of a contractor that affect the tax treatment of goods and services provided in a contract. Colorado’s definition is broadly written to include “any individual, partnership, firm, association, corporation, trust, estate or joint venture who performs construction work on real property for another party under the terms of an agreement.”¹ Alabama’s definition of a contractor includes specific activities and a dollar threshold. In Alabama, a contractor is “one who, for a fixed price, commission, fee, or wage undertakes to construct or superintend or engage in the construction, alteration, maintenance, repair, rehabilitation, remediation, reclamation, or demolition of any building, highway, sewer, structure, site work, grading, paving, or project or any improvement in the State of Alabama where the cost of the undertaking is $50,000 or more.”²

The contract type and terms, nature of work, and classification of the project may also affect the taxability of charges for materials and construction-related services. In many states, a contractor pays sales tax when purchasing materials, equipment, tools, supplies, and materials affixed to real property. The contractor is considered a user and consumer of goods used in completing construction contracts. In some cases, however, a contractor is considered a retailer selling materials or supplies to a customer and should obtain and provide an exemption certificate for goods purchased for resale.

Contract Types and Terms

In many states, the contract determines the status of the contractor and services provided for sales tax purposes. In Texas, a contractor is considered a retailer of materials and must charge and collect sales tax on materials charged to customers if the contract requires the contractor to itemize charges for time and materials. Texas requires a contractor who improves real property under a separated contract to hold a sales tax permit, collect sales tax from customers based on the contract price of the materials incorporated in the real property improved, and report and remit those sales taxes to the state.³ A separated contract has an agreed contract price in which charges for incorporated materials are separated out from labor charges. If the price of incorporated materials and labor are separately stated in any part of the contract or in a document that becomes part of the contract according to the terms of the contract, the contract is considered a separated contract. Merely adding the incorporated materials and labor charges together does not change the contract into a lump sum contract.⁴

Under a separated contract, a contractor is considered a retailer of the incorporated materials and taxable services and is required to collect sales tax from the agreed contract price of the incorporated materials and taxable services. On purchases of supplies, equipment, and materials that are not incorporated into the charges to the customer, the contractor is required to pay sales tax or remit use tax for items used and consumed in Texas.

On the other hand, a contractor who improves real property in Texas under a lump sum contract pays sales tax to suppliers on all purchases of materials, consumable items, equipment, taxable services, and other taxable items used in performing the contract.⁵ Lump sum contracts are defined as a contract with an agreed-on contract price in a lump sum amount in which charges for incorporated materials and labor are not separately stated. Under a lump sum contract, the contractor is considered the consumer of materials used and incorporated into the project and charges to the customer are not taxable.⁶

In Nebraska, a contractor can elect to be treated as a retailer or consumer of materials.⁷ As a consumer, the contractor pays sales tax on materials at the time of purchase or the contractor could purchase materials without tax and remit use tax on the materials used to affixed to real property. Therefore, the taxation of lump sum and itemized contracts will depend on how the contractor elects to be treated, either as a retailer or a consumer.

In Nevada and Alabama, a contractor is generally considered a consumer of all materials purchased for use under a contract and would be subject to sales tax on the purchase of all property.⁸ There is no distinction between how a contractor is taxed under lump sum and itemized contracts.

In Mississippi, a contractor is considered a retailer and subject to a 3.5 percent tax on the contract price if the total contract price or compensation received for nonresidential construction activities exceeds $10,000. A contractor is required to apply for a material purchase certificate before beginning work and does not pay sales or use tax on the purchase of materials or services.⁹ Otherwise, a contractor would generally be considered a consumer and must pay sales tax on the purchase of the materials.

Nature of Work and Services Performed

A contractor’s sales tax responsibilities are also affected by the nature of the work and services performed under the contract. A contractor’s services are generally not taxable unless enumerated as taxable. Construction projects may include work to construct, erect, extend, alter, repair, maintain, or improve real property or structures. Further, these projects commonly require a contractor to convert tangible personal property to real property. States have differing rules on classifying whether a contractor is installing tangible personal property or making a real property improvement. A contractor may perform both taxable and nontaxable services and must understand each state’s treatment and know what services are subject to sales tax.

In North Carolina, a contractor is considered a user or consumer of materials purchased and is required to pay sales tax at the time of purchase if making capital improvements and the contract is considered a “real property contract.”¹⁰ North Carolina includes the following activities and services as real property contracts: new construction, reconstruction, or remodeling; work that requires a permit under the state building code; or installation of underground utilities, depreciated capital equipment or fixtures, roofing, septic tanks, plumbing, electrical, commercial refrigeration, irrigation, sprinkler systems, or other similar systems, heating or air conditioning units or systems, and free-standing gas or electric appliances such as stoves and refrigerators. Other real property services include landscaping, painting and wallpapering, and replacing or installing roads, driveways, parking lots, patios, decks, and sidewalks. Repair, maintenance, and installation of tangible personal property is taxable, with the contractor considered a retailer who must charge tax on labor and materials.¹¹

Services in North Carolina are taxable unless the contract is considered a real property contract. A contractor of construction projects that include taxable maintenance, repair, and installation services worth less than 25 percent of the value of the overall job can treat the whole job as a nontaxable real property contract. If the job is more than 25 percent taxable services, the contractor can collect tax on the amount attributable to the taxable services.¹²

Ohio taxes individual services that a construction contractor performs on real property. Those services include repairing, installing, washing, or storing tangible personal property; landscaping or providing lawn care services; conducting building maintenance or janitorial services; and removing snow. For services that involve a transfer — such as the sale, installation, or repair of tangible personal property — the taxability of the work performed depends on whether the property remains tangible personal property or is incorporated into real property. A contractor must charge sales tax as a retailer in Ohio on the transfer of tangible personal property to real property that retains its character as tangible personal property after installation. The installation of carpet, padding, and related materials and appliances typically are considered the installation of items that remain tangible personal property.¹³

However, when tangible personal property is transferred and incorporated into real property, a contractor is considered a consumer of the tangible personal property and pays tax on materials at the time of purchase. Ohio defines real property to include land and all buildings, structures, fixtures, and improvements on the land. Improvements are permanent additions, enlargements, or alterations to buildings or structures that would have been considered a part of the building or structure had they been included in the original construction of the building.¹⁴

Fixtures are items of tangible personal property that become “permanently attached or affixed to the land or to a building, structure, or improvement, and that primarily benefits the realty and not the business, if any, conducted by the occupant on the premises.” For the property to be considered incorporated into real property, the tangible personal property must be permanently attached or affixed to real property, primarily benefit the realty, not the business run by the occupant; and title to the tangible personal property must transfer to the owner or lessee of the premises.¹⁵

In Texas, a contractor is defined as those who make real property improvements on or repairs, restores, maintains, or remodels residential real property and performs new construction on residential or nonresidential real property.¹⁶ A contractor’s labor charges are not subject to sales tax. Services that are provided to or on real property must result in altering a building or the land to be considered real property improvements. The following are considered nontaxable real property improvement services in Texas:

1. erect, construct, alter, or repair any building or other structure, project, development, or other permanent improvement on, under the surface of, or to real property, whether fee or leasehold;

2. furnish and install property becoming a part of any building or other structure, project, development, or other permanent improvement on or to such real property, including tangible personal property, which after installation becomes real property by virtue of being embedded in or permanently affixed to the land or to a structure constituting realty and which property after installation is necessary to the intended usefulness of the building or other structure; or

3. alter the land surface of real property by such means as creating roads, earthen dams, and stock tanks. However, mining or timber operations do not, in and of themselves, constitute improvements to realty.¹⁷

If the services under the contract do not result in altering a building or the land surface, those services are not considered real property improvements and may be considered taxable repair or remodeling services. Repair has been defined as “to mend or bring back real property that was broken, damaged, or defective as near as possible to its original working order.” Remodeling is the rebuilding, replacing, altering, modifying, or upgrading of existing real property. Remodeling would likely include repainting or partial demolition of an existing building and generally not be considered a real property improvement.

Whether repair or remodeling services are taxable depends on whether the work is performed on residential versus nonresidential properties. Residential property is defined as “property that is used as a family dwelling, multifamily apartment or housing complex, nursing home, condominium, or retirement home.” The term includes an apartment complex’s common areas; however, hotel lobbies and common areas are not included. Nonresidential property is not specifically defined in Texas.¹⁸ Therefore, property that does not fall within the definition of residential property is considered nonresidential property. When a contractor is performing repair or remodeling work on nonresidential real property, the contractor must obtain a sales and use tax permit and collect tax on the total sales price to their customers.

New construction work performed on residential and nonresidential property in Texas is not taxable. Texas defines new construction services as “all new improvements to real property including initial finish out work to the interior or exterior of the improvement.” New construction includes the addition of new, usable square footage to an existing structure.¹⁹ In some cases, it may be difficult to distinguish between new construction work and repair or remodeling. For example, any work performed after the initial finish out work to the interior or exterior of a structure would likely be considered remodeling even if the space has not been used or occupied. Work that adds new, usable square footage such as expansion of building space would be considered new construction.

Texas enumerates the following work as taxable real property services: landscaping and lawn care; garbage removal or collection or other solid waste (other than hazardous waste); building or grounds cleaning, janitorial, or custodial services; pest control services; and the surveying of real property. Although other construction-related services may include maintenance services on real property, these are not taxable in Texas. Maintenance services are defined as “scheduled, periodic work that is necessary to sustain or support safe, efficient, continuous operations, or to prevent the decline, failure, lapse, or deterioration of” operational and functional improvements to real property.²⁰

In many instances, repairs or replacements of items performed to improve real property will be considered maintenance if the work is done as part of a scheduled, periodic program. For instance, if the repainting is maintenance and scheduled to prevent deterioration of the surfaces and performed on an ongoing basis, the work is likely considered maintenance and not subject to tax in Texas. Otherwise, repainting could be considered taxable repair or remodeling services if the work does not fall within the definition of maintenance services.

To determine whether construction or construction-related services are taxable in Texas, the first step is to determine whether the service is a contract to improve real property. If so, the next step is to determine if the improvement is repair or remodeling of an existing structure or new construction, and whether the project relates to residential or nonresidential property. Additionally, it is important to distinguish work performed as maintenance that is not taxable from taxable real property services and repair or remodeling services.

When taxable services (for example, commercial repair or remodeling) and nontaxable services (new construction or maintenance services) are performed under the same contract in Texas, and the taxable portion exceeds 5 percent of the overall charge, then the contract must separately identify taxable and nontaxable labor along with the charges that apply to each, or else the entire contract would be considered taxable services.²¹

Construction Project Exemptions

Sales tax exemptions may also apply to construction projects. When a contractor is considered a retailer and is reselling materials and taxable services to a customer, a valid and complete resale certificate must be provided at the time of purchase. Additionally, customers such as government and nonprofit organizations may be exempt from sales tax. The exemption requirements based on the purchaser status vary from state to state. Therefore, a contractor must know the specific rules and required documentation need to exempt a sale from tax. For example, Colorado provides an exemption for organizations that have been certified exempt under IRC section 501(c)(3). To qualify for an exemption, purchases must be billed to and paid directly by the organization or agency. Payment without a purchase order or by personal check or personal credit card disqualifies a purchase from exemption even if the purchaser is later reimbursed.²²

In some states, when the contract is for a government agency, a contractor may purchase materials and supplies for the customer and is not required to pay tax. In those instances, timing of when an exemption certificate is required and is used to purchase goods, that is, before or during a project, will affects whether there is a valid exemption.²³ In other instances, the exemption might apply to specific activities or time periods. In Ohio, a construction contractor may purchase materials or services that will be incorporated into real property qualifying for property tax exemptions until one calendar year after the construction is completed.²⁴

A contractor selling taxable goods and services has the burden of proving that a transaction is properly exempted. Therefore, the contractor must understand and obtain all required information and ensure that proper forms and payment methods are provided to protect both parties from a sales tax audit.

Reducing Risk

In many states, a contractor will be considered either a consumer or retailer with varying tax responsibilities. To reduce the risk of under- and or over-collection and remittance of sales and use tax, a construction contractor must understand the tax implications for the nature of the services or project, terms of the contract, and rules that apply in the state where it is working. This includes everything from knowing how goods will be used, what services are subject to sales tax, which exemptions are applicable, and how to characterize the activities performed. Failure to comply with the various sales and use tax responsibilities could result in significant tax assessments, penalties, and interest.