Home >>
August 2010 >>
Sales and Use Tax: Don't Get Caught in a Game of 'Gotcha'
Attention to detail is critical when dealing with sales and use taxes, as personal liability can result even when conducting business as a corporation or limited liability company. The sales tax is an additional cost tacked on to purchases of tangible personal property and certain services. The use tax, however, is a compensatory tax paid directly by the purchaser when the seller doesn’t collect the sales tax.
Unfortunately, sales and use tax complexities are compounded in the construction industry. Sales of real estate typically are not subject to tax, but contractors are subject to tax on their purchases of tangible personal property that are subsequently incorporated into real estate improvements. Therefore, barring any special exemptions, both general contractors and subcontractors must pay taxes on the majority of their purchases.
Exemptions and Complexities
A tax exemption may be available in certain situations. Under the Supremacy Clause of the U.S. Constitution, states cannot impose tax on the U.S. government. In addition, most states provide an exemption for sales to themselves and their political subdivisions. Nonprofit entities also may be afforded an exemption.
But beware: While many states allow the contractor to act as an agent for the exempt customer, not all states allow the exemption to flow through. In other words, it’s possible that the exemption for materials will be allowed only if the exempt customer purchases the materials directly, as opposed to the contractor purchasing the materials.
Additional challenges may arise when the contractor is considered a manufacturer or retailer for a property. In these situations, the contractor is viewed as selling and installing tangible personal property as opposed to constructing real estate. For example, if a contractor builds cabinets that are to be incorporated into real property, it is possible for the contractor to be considered a manufacturer of cabinets.
Manufacturers are treated much differently than contractors. They do not pay tax on materials used, but they collect tax on the sale of the property. An exemption may be available for purchases of certain tools and equipment used in the manufacturing process that generally would not be exempt if purchased by a contractor. However, labor costs for manufactured property become part of the sales tax base, whereas construction labor generally is exempt.
The contractor also may be acting as a manufacturer or retailer if it sells tangible personal property outright, such as crushed rock or dirt. In these situations, the contractor likely will need to obtain a vendor’s license in order to collect sales tax from its customers.
Some states distinguish between capital improvements and real estate repairs. These states tend to treat real estate repairs as taxable services, requiring tax to be collected by the contractor on the entire sale amount. Capital improvements, on the other hand, are treated as construction contracts and generally are not taxable.
When a contractor conducts business in only one state, there are fewer, but equally significant, issues with which to contend. Purchases of tangible personal property for which tax was not charged by the vendor generally must be self-remitted to the state by the contractor. This applies to property incorporated into real estate, property consumed in performing construction, and the tools and machinery purchased or leased to be used in construction.
The Multi-State Environment
Because no exemption exists for the contractor when purchasing tangible personal property, tax must be paid to the state where possession of the property takes place. Once that property is moved to a second state and used in the performance of a construction contract, the contractor becomes liable for the use tax in the second state on the same property. A credit must be given to the contractor for sales tax legally paid to the first state to alleviate the double taxation.
Two issues commonly arise in this multi-state scenario. First, tax rates may differ between the two states. If the state where construction is occurring has a higher tax rate, additional use tax must be remitted to account for the rate differential. If the state where possession took place has a higher rate, an opportunity may have been lost. It is possible that by moving title transfer to the construction state, only the lower rate would apply. Some states provide an exemption to contractors when the property is earmarked for use in out-of-state construction contracts, but strict adherence to the specific state requirements must be met.
The second issue is whether the tax was “legally” paid to the state where title transfer occurred. In an attempt to simplify compliance, some contractors in a multi-state environment ignore the use tax issue in the state where construction is taking place as long as sales tax was paid to another state. However, if the title didn’t transfer in the other state, or if an exemption was available to the contractor, the tax would not have been legally paid. As a result, no credit would be available. And in the worst case scenario, the statute of limitations may have closed in the state where tax was paid, resulting in the inability to obtain an offsetting refund.
When considering all of these complexities, it is important to understand each jurisdiction’s unique rules and definitions. What may be considered real property in one state could be considered tangible personal property in another. The contractor may be treated as a manufacturer of certain property in one state, but a construction contractor with regard to the same property in another state. Errors in making these determinations can result in significant costs that the contractor is unable to recoup once it’s locked into a contract.
Additionally, it’s crucial to understand the “responsible person” recourse that states are beginning to assert with fervor. A responsible person is generally an individual with authority to make tax payments, but who chooses not to do so, or is responsible for the oversight of this area. Responsible persons can include owners, officers and employees.
Contractors run the real risk of personal liability if any owed tax cannot be recouped. In addition to being held liable for the tax, they may face civil and criminal sanctions.
States are stepping up auditing efforts as budget shortfalls continue to loom, and their enforcement power should awaken anyone who becomes lax about addressing tax matters. The complex nature of sales and use taxes gives rise to both errors and differing opinions. Now is the time to review these policies and procedures for accuracy. Don’t get caught in a game of “gotcha.”
![]()
Wednesday, February 8, 2012