Contractors can confidently focus on the projects at hand if they have been proactive in resolving multi-state tax issues early in the bidding process.
Contractors must keep track of many state tax compliance issues on a daily basis. By being proactive and resolving multi-state tax issues with clarity early in the bidding process, management can confidently focus on the projects at hand. The difficulty in resolving the issue is that, in reality, multi-state tax encompasses many issues.
What is nexus?
Nexus is defined as a substantial connection to a state that allows the state to tax a taxpayer. Often sales tax nexus is confused with income tax nexus. Income tax nexus has the protection of Public Law 86-272, which protects taxpayers from paying net income based taxes if their only activities in a state are the solicitation of sales. Since sales tax is not based on net income, the mere solicitation of sales in a state can create sales tax nexus if the solicitation is substantial.
Each state has its own nexus guidelines. Having a physical presence in a state (permanent or temporary) usually suggests a substantial connection to a state. But physical presence can be complicated because it can be created by third parties acting on a company’s behalf. For instance, the use of subcontractors is considered a physical presence for the general contractor in the state where the work is being performed. For contractors, if they have a job in a state, they most likely have nexus and a sales or use tax filing obligation.
Taxability
Multiple tax issues must be considered when contractors strategically expand to other states or simply take the occasional job across the state line. One of the mistakes contractors make related to sales and use tax is to try to use their home state’s rules when expanding to new states. Each state’s rules and regulations are unique. Research should be done before a bid is completed since pricing the job correctly up front ensures an accurate bottom line on the project.
A few common methods of taxing construction activities are discussed below to help contractors understand the basics when researching taxability in new states.
Contractor as consumer
In some states, contractors are viewed as the end consumer of all materials purchased in the construction of real property. This means that all purchases of tangible personal property made by a contractor will be taxable, such as building materials, equipment, and consumable supplies. Since sales or use tax is paid on the materials, most states will not tax the invoice for the actual construction of the building. Under this scenario, most states will allow contractors to include sales tax as a material cost in their bids but they will not allow the invoice to separately state a line item for sales tax to the customer.
Contractor as retailer
Some states treat contractors as retailers of the building materials and labor they sell when constructing a building. In these states, the contractor can purchase building materials tax-free for resale and will be required to charge tax on the material cost to the end consumer. The taxability of the labor will depend on the state.
Contract type
Some states use a taxing method which is a hybrid of the two methods above, where the type of contract determines the taxability. If the contract is a lump-sum contract, usually the contractor as a consumer method applies and tax is paid by the contractor when purchasing materials and not charged as a separate line item to the customer.
If the contract separates charges for materials and labor, usually the contractor as a retailer method applies since states view the transactions as selling the materials and selling labor to install the materials. In this case, the contractor purchases materials tax-free for resale and charges tax to the customer, but the taxability of the labor portion depends on the state.
Subcontractor relationships
A contractor’s role (as the general contractor or the subcontractor) also determines how taxes are applied to a transaction. In some states, the contractor and subcontractor are treated separately, and each determines tax liability based on the contract type. In other states, the general contractor determines how to apply tax, and the subcontractor’s services are purchased for resale.
In evaluating sales tax, auditors look at the legal form of the project. It is critical to document the project to match the tax treatment, so that all contracts and invoices line up and support the tax position being taken.
Flow-through exemptions
Flow-through exemptions create a lot of problems when contractors are audited by the state. The most common issues we encounter involve the contractor not having a properly completed exemption certificate on file. In most states, the certificate has to be completely filled out to be valid, which includes all the purchaser and seller information complete with signatures and dates.
If auditors don’t see a completed certificate, in most cases they will tax the entire transaction, and it is up to the contractor to prove the exemption exists. The auditor’s presumption is that all transactions are taxable unless sufficient evidence is provided to prove otherwise. Unless you receive a properly completed exemption certificate from the customer or general contractor, you must pay tax when purchasing tangible personal property.
Manufacturing
Most states allow exemptions for manufacturing equipment. The exemptions vary with each state but can consist of purchases made by a contractor on behalf of the customer, such as electrical materials dedicated to machinery and equipment (not for the general purpose of the building), purchases of the equipment itself in some cases, and pollution control equipment that may be installed during the construction process.
The general rule is to pay tax when purchasing tangible personal property or charge tax when selling tangible personal property unless you receive a properly completed exemption certificate from the customer or general contractor. In most cases you can request a refund or credit if tax is overpaid.
Governments
Most states provide some type of exemption for construction contracts for state and local governments, and the federal government is almost always exempt from tax. When dealing with government contracts, always obtain an exemption certificate if possible, or keep records to confirm that the contract is with a governmental entity.
Nonprofits
Everyone assumes that nonprofits are always exempt from tax on purchases, but that is not always the case when dealing with construction contracts. Some states will not allow the exemption to pass through to the contractor.
The general rule is to pay tax when purchasing tangible personal property or charge tax when selling tangible personal property unless you receive a properly completed exemption certificate from the customer or general contractor. In most cases, you can request a refund or credit if tax is overpaid, so if you are uncertain about the tax laws in a specific state, be conservative.
Moving equipment
Use tax usually gets overshadowed when discussing sales tax, but use tax can cause issues when transporting equipment across state lines. Most equipment used by contractors, such as excavators and lift trucks, will be subject to sales tax when purchased but can still be subject to use tax in other states and even other cities within the same state when moving to perform a job.
The use tax obligation occurs when the equipment is used in a jurisdiction where sales tax was not paid on the equipment or sales tax was paid at a lower rate than the rate in the current jurisdiction. In the case of a rate differential, use tax could be due based on the cost of the equipment multiplied by the rate differential. Jurisdictions will usually give a credit for tax paid and legally due in other jurisdictions, which is why rate differential is important to take note of when entering a new state or locality. Generally, if the rate in the new location is lower than the rate paid when the equipment was purchased, no use tax will be due.
Bidding issues
Personnel involved in bidding jobs do not always understand the concepts behind multistate sales tax. This becomes an issue if the bid and ultimately the contract do not treat sales tax correctly.
If a bid separates out all of the charges, but the contract is for a lump-sum amount, the bid might not have accounted for tax, and most lump-sum contracts do not allow you to separately state a line item for tax. That means the contractor will most likely pay the tax or negotiate with the customer to increase the lump-sum amount. Neither situation is good for business. On a large project, a mistake like this can be well over six figures, and a contractor will not be able to pass it on to the customer.
How we can help
CLA professionals provide a wide range of resources that contractors need to work on projects in different states. We understand the construction industry as well as multi-state tax issues. Because of the wide variety of state tax issues, contractors must do the research up front to determine their tax responsibilities. Sales tax rates average between 6 and 8 percent, and can create a huge tax liability under audit if the contractor is not correctly paying or collecting tax.