Between federal laws, the taxing jurisdictions of the 50 states and the District of Columbia, and countless local jurisdictions, contractors and construction companies face unique tax challenges. However, with minimal planning and a proactive approach, unwanted tax consequences can be avoided.

Considering that tax reform was a priority of the new administration’s campaign, economists believe substantial changes will be made this year to corporate and personal income tax rates. Given the likelihood of reform, it is important to consider the potential tax changes in relation to the business’ legal formation (e.g., Corporation, LLC, etc.), which could yield benefits given the expected decreases to the corporate and individual tax rates.

If tax reform occurs, contractors may want to consider which legal formation is most suitable while also considering other business needs, such as legal liability protection, ownership structure and raising capital.

Can a Contractor Benefit From Multi-jurisdictional Income Distribution?

When contractors work in multiple states, their income is generally apportioned among those states using one or more apportionment factors, including sales, property and payroll. States’ apportionment methodologies vary, which presents a planning opportunity. For example, irrespective of property and payroll, limiting sales in single sales factor states reduces the apportionment factor. Similarly, limiting payroll and property in three factor apportionment states can dilute the apportionment percentage regardless of sales into that state. Consequently, the amount of taxable income can be shifted to more favorable states.

Additionally, some states require contactors to source receipts based on the “cost of performance” method. Accordingly, contractors based in cost of performance states that perform jobs in multiple jurisdictions should consider performing certain services (e.g., design, assembly or fabrication) at their facilities versus the jobsite in another state, thereby reducing the amount of sales sourced to the other state. In bifurcating the receipts between states, contractors may be able to benefit if the tax rates differ by performing permissible services in jurisdictions with a lower tax rate.

It is important to caution that some states impose a gross receipts type of tax in lieu of an income tax. Unlike an income tax, which is levied against a contractor’s taxable income, a gross receipts tax is levied against the specific receipts derived from the state. For these states, apportionment planning does not offer any benefit.

Ultimately, a full multi-jurisdictional income apportionment and distribution analysis is complicated, and other factors need to be considered, so contractors should seek consultation from experienced tax professionals.

When Must the Contractor Pay Sales Tax or Self-assess Use Tax?

Excluding a few exceptions, most states do not impose sales tax on the sale of contractors’ services; however, materials and supplies purchased by contractors for the jobsite are generally taxable unless eligible for an exemption. Contractors are generally considered the consumers of the materials and supplies used to fulfill their construction projects.

While it is usually easiest to pay sales tax to the vendor upon purchase, contractors that operate in different states or purchase in bulk for various jobs may consider a direct pay permit in lieu of paying the sales tax. The contractor is then responsible for self-assessing use tax when those purchases are put into use. Additionally, when purchasing or drop-shipping goods in one state for use in another, contractors must remit use tax to the jurisdiction where the goods are used.

Also, when a prime contractor leverages the services of subcontractors, the prime contractor should understand the state’s requirements. Generally, subcontractors are subject to the same rules as the prime contractor and are the consumers of the materials. However, some states require the prime contractor to withhold a percentage of payment to the subcontractor and pay it to the state to cover the subcontractor’s sales and use tax liability; others specifically make the prime contractor liable for subcontractors’ tax liability. Finally, many states require an out-of-state contractor to post a bond for the total sales tax due on materials used in the state.

How Does a Contractor Properly Withhold Income Taxes on Employees or Owners?

Proper classification of employees and independent contractors is very important, as misclassification could lead to hefty federal and state fines. The IRS considers behavior, financing, and the degree of control and independence of the worker to determine whether the worker is an employee or independent contractor. Contractors’ considerations should include who maintains control over the work performed and who determines how the work will be done. If the answers to these questions are “the contractor,” then generally the individual should be treated as an employee, and income taxes must be withheld.

In addition to federal withholding requirements, contractors must withhold state income tax from the employee’s wages in his/her resident state, as well as in all states where the employee performs services. Further, a pass-through entity may be required to withhold state income tax on nonresident owners. Some jurisdictions permit pass-through entities to file composite tax returns, which allow the entity to pay the state income taxes on behalf of electing nonresident partners or members.

What About Credits and Incentives Available to Contractors?

A frequently missed benefit includes tax credits and incentives that state and local jurisdictions offer to encourage growth and community improvement. For example, most states allow contractors to take advantage of historical preservation credits to restore historic buildings that are generally listed on the National Register of Historic Places or located within a historic district.

Additionally, similar to the federal Work Opportunity Tax Credit, many states give contractors credits on wages paid to individuals of designated employee categories, including unemployed veterans, food stamp recipients, supplemental security income recipients, designated community residents, ex-felons and others.

Invoicing Considerations

Depending on the type of project, separately stated invoicing may be more beneficial than lump-sum. Moreover, when invoicing materials separately for repair, maintenance or installation projects, contractors should consider the tax consequences of marking up prices of materials because the markup may be taxable.

Exempt Customers. States typically provide sales tax exemptions to certain government, non-profit or otherwise qualified projects. Some states allow the exempt entity’s status to flow through to the contractor while others limit the use of such exempt status to only certain aspects of a job, if any. Contractors should ensure they request and retain any necessary exemption certificates and consider the state’s specific procedures for purchasing materials.

Job Classification. States may determine taxability of materials and services based on whether the job is for new construction, residential, commercial or improvements to existing property. For example, Connecticut imposes sales tax on construction services performed on existing commercial or industrial property. Consequently, when starting a new job, contractors should review the state’s rules to determine if any exemptions exist as a result of the classification.

In an industry where profit margins can be modest, some advanced tax planning can go a long way to prevent unwanted costs, make bids more competitive and protect contractors’ profits.

John Cavanaugh is senior manager, Megan Lee is manager and Danielle Panariello is associate of RSM US LLP, Washington, D.C. For more information, visit rsmus.com.