Sales tax is notoriously complex for construction contractors and others in the industry that provide a combination of goods and services with varying tax outcomes. Each state has its own rules that apply to real property contractors and Texas is no exception. We discuss the key questions to ask yourself or your clients to understand the potential taxability of transactions related to the construction or repair of real property. Then, we explore some common pitfalls and issues our sales tax professionals see in construction businesses that could lead to an audit or assessment from the Texas Comptroller’s Office.
4 Questions That Could Affect Your Sales Tax Obligations as a Contractor
The general rule for contractors in Texas, similar to other states, is that you are the consumer of all materials and equipment used in your work. With some exceptions, you do not generally charge and collect sales tax from customers for the equipment or consumable items used on a job under Rule 3.291(b). Instead, you usually pay sales tax to your suppliers for all equipment and materials when purchased but may need to directly pay tax to the state if your vendor does not charge sales tax.. Charges for the labor of your contractor services can be taxable in Texas depending on the issues explained below, which may also require you to register for a sales tax permit.
1. What Type of Property Are You Servicing?
Texas contractors must properly identify the type of property they are working on and how its status will impact the sales tax outcome. There are two property distinctions to track: (1) real property versus personal property and (2) residential property versus nonresidential property.
Texas defines real property under Administrative Code Rule 3.357(a)(10) as land including structures and improvements that are embedded into or permanently affixed to the land. When disputes exist about whether property is personal or real, Texas courts use a three-factor test to classify the property for sales tax purposes:
- The mode and sufficiency of the annexation to the real property (either real or constructive).
- The adaptation of the item to the use or purpose of the real property.
- The intent of the party who annexed the personal property to the real property
Services to repair, remodel, maintain, and restore tangible personal property are generally taxable in Texas under Rule 3.292.
The taxability of a contractor’s labor charges further depends on the second distinction: whether the property is residential or not. Contractor services performed on residential real property are not usually subject to sales tax. The Texas Administrative Code Section 3.291(a)(12) defines residential real property to include the following:
- Family dwellings
- Housing complexes
- Multifamily apartments
- Nursing homes
- Condominiums
- Retirement homes
- HOA- or apartment-owned swimming pools, laundry rooms, and other common areas for tenants’ use
Residential real property does not include hotels or other facilities that are subject to the hotel occupancy tax. In comparison, contractor services to repair, remodel, or improve nonresidential real property are generally subject to sales tax.
2. Is the Contractor Service for a Sales Tax Exempt Organization or Tax Exempt Purpose?
If a contractor’s work on nonresidential real property is for an exempt organization, then you may not need to charge sales tax for their labor. Instead, you must receive a completed exemption certificate from the organization, whether it is a government agency or nonprofit. Contractors can verify the tax-exempt status of their customers through the Texas Comptroller’s office.
Additionally, contractors can use a resale exemption certificate for completely consumed materials or taxable services performed at the jobsite. All other tangible property used for an exempt organization project is subject to sales tax, including machinery, equipment, accessories, repair or replacement parts, office supplies, furniture, and computers.
Texas also provides sales tax exemptions on contractor labor when the real property repair or improvement is for a certain purpose. For example, Texas exempts labor charges to repair nonresidential property damaged by a declared natural disaster. The contract must separately state the labor charges from the amounts charged for incorporated materials. Another sales tax exemption exists for labor charges to repair or remodel nonresidential real property that increases the capacity in the production unit of a petrochemical refinery or chemical plant under the guidelines of Rule 3.362.
3. What Type of Contractor Service Are You Providing to Nonresidential Real Property?
The type of contractor service provided for nonresidential property could also affect your sales tax obligations in Texas. Texas generally classifies these services into several categories with the following sales tax consequences for labor charges:
- Maintenance: Charges for maintenance services are not taxable. These are services for real property that are not broken and are necessary to keep the property in good working order by preventing deterioration. Maintenance services must be scheduled and periodic and must be shown through a contract or another form of documentation. See Rule 3.357(d)(2).
- Repair, Restore, or Remodel Services: These are taxable services in Texas under Rule 3.357(b)(2) and contractors must obtain a sales tax permit to collect owed tax from customers and remit it to the state.
- New Construction: New construction labor is not taxable and includes, building new structures, completing unfinished structures, and providing initial finish out work to the interior or exterior of a structure. See Publication 94-116.
- Other Real Property Services: A contractor may also provide other real property services that are taxable under Rule 3.356, such as surveying or landscaping work.
A project could involve a combination of taxable and nontaxable real property services. If these services are provided for a single charge and the taxable services are more than five percent of the total charge, then Texas presumes the total charge is subject to tax. However, a contractor can overcome this presumption with documentation that shows the allocation of the contract price among taxable and nontaxable services. See Rule 3.357(b)(7)-(9).
4. What Type of Contract or Invoice Methods Are You Using: Lump-Sum or Itemized?
A final issue that could impact your sales tax obligations as a contractor is the method you use to document your transactions with customers. The Audit Division of the Texas Comptroller’s Office has a hierarchy that applies to the controlling documents for determining the sales tax obligations of parties under a real property contractor service transaction. As stated on page 5 of the Audit Procedures for Contractors and Repairment (April 2017), the following order of authority applies: the written contract, a written bid, or the written invoice.
A contract is either lump-sum or separated, depending on whether a single price is charged for all labor and materials or if separate prices are given. Contractors who use a separated contract are retailers of the materials incorporated into the real property and must collect sales tax from their customers. See Rule 3.291(b)(3)&(4). However, contractors can purchase materials from suppliers using a resale exemption or can claim a credit for tax-paid materials. Contractors using a lump-sum contract are still consumers of materials and cannot charge customers sales tax. The contracting method is most critical in transactions where the labor is not taxable, such as new construction or work on residential property.
Issues That Could Complicate Your Sales Tax Compliance and Increase a Risk of Audit
The different factors that impact a contractor’s sales tax obligations in Texas means there are many potential pitfalls that could lead to unintended exposure. Consider the following challenges that could create additional risk for an audit or assessment from the Comptroller’s Office:
- Charging and over-collecting sales tax on lump-sum contracts for new construction or residential property projects.
- Failing to pay use tax on materials purchased with a resale certificate but not sold to a customer.
- Purchasing equipment and unincorporated property with a resale exemption certificate.
- Not separating charges for taxable and nontaxable labor. For example, a project involving both new construction and repair work of nonresidential property.
- Purchasing materials and equipment out-of-state and not paying use tax when consumed in Texas.
Schedule a Meeting with a Sales Tax Professional Today
If you have concerns about sales tax compliance as a real property contractor in Texas, our team of professionals may be able to help. We provide a variety of sales tax services for businesses in the real estate construction industry, including management of audits, representation in administrative appeals, and general consulting. Contact us today for help with a notice from the Texas Comptroller’s Office or another issue with your or your client’s sales and use tax compliance.