11.12.2013 State and Local Tax Issues in Construction
BY: STEPHANIE LIPINSKI GALLAND
Every business has an accountant or finance resource. This resource spends 150% of his or her time handling the cash flow, paying the bills, and filling out the requisite federal income tax returns. What is usually missing is time to focus on state and local taxes and the issues that arise out of working in multiple locations with different tax rules and regulations. The time to think about tax issues are before you bid on the projects. Keeping tax issues in mind will result in a bid that more closely reflects the tax costs of the projects and will generally reduce any tax surprises that can create tax expenditures two or three years after the project completion.
Federal Tax Issues
Construction companies generally file only one federal income tax return for all related companies. Federal taxation issues concerning expense deductions (cost associated with materials, tax payments and credits) and income recognition are ones to be considered.
State Income Tax Issues
State income taxation requires one return for each state. Simple? Not really. On the state level, some states provide that companies may be able to “combine” the activities of all related entities and apportion the income to the various states. (Virginia, North Carolina) Some states require that only the company that does business in that state files an income tax return (Maryland, New Jersey). Determining which state requires which type of filing requires knowledge of that state’s law and regulations. Thinking that you can just file a return in the state where you home office is located, waiting until another state finds you and then trying to use a credit for the tax you paid to your home state can result in denials of those credits and penalties and interest for failure to file the correct returns in the correct states. Also, a failure to file leaves the statute of limitations open in those states, and the states can go back to the first date you started to do business in those states. The reality may be that you will be precluded from going back to your home state and get that refund for the taxes you paid to the home state. This is painful, especially if you thought you could use some of that tax paid to offset the taxes you will have to pay in the other state. Knowing when to file and how to file can save money in the long run.
One other issue that comes up under the “income tax” area involves those states that have adopted a different type of tax based on the gross receipts or income of a company – Ohio with its Commercial Activity Tax, Texas and its Margins Tax, Washington State and its Business Occupations Tax. These taxes require a specific knowledge of the taxes and how they apply to income derived from activity in those states.
Sales and Use Tax Issues
Sales and use taxes apply in every state but five: New Hampshire, Oregon, Montana, Alaska and Delaware. Each state has the ability to determine which transaction or use of tangible personal property is subject to the tax and if an exemption applies and how. A transaction may be exempt from the tax in one state and subject to the tax in a neighboring state. Add to this that there is a federal prohibition on sales in “interstate commerce,” and a company that has a central purchasing function may end up with a huge state tax liability in one or more states. Some more confusing questions add to the fun: “Is the underlying activity construction, maintenance or repair?”; “Is the underlying activity for the federal or state government?”; “Is the underlying activity new construction?”; “Is the contract with a nonprofit, not government?”; “Are there incentives or exemptions that can be utilized?”
A general rule in the area of sales and use tax is that contractors are consumers of all tangible personal property or taxable services that they use or consume in performance of their underlying contract. This taxing regime is generally based on the fact that the prime contract is not subject to sales or use tax. This position also prevents cascading of tax within the contract.
The rule in Virginia is that a contractor is deemed to be the user or consumer of all tangible personal property or taxable services furnished to him or by him in connection with the real property construction contract. This rule includes reconstruction, installation repair or other contract. This also includes any tangible personal property that is incorporated into the real property and “loses” its identity as tangible personal property. An example is tiles that are laid into concrete. Virginia deems that the placement of the tiles into the concrete changes the tiles from tangible perusal property into real property by the fact that the tiles cannot be removed from the concrete with damaging them and rendering them useless. The contactor is deemed to have “used them” in the performance of the construction contract and must pay the sales or use tax on the tiles.
North Carolina follows the Virginia rule in that contractors are deemed to be the consumers of all tangible personal property that they use in the performance of their contract and must pay tax to their suppliers on the purchaser of the tangible personal property.
North Carolina does have one difference form Virginia in that they have a classification of “retailer contractors.” These retail contractors are contractors that sell the actual building materials, equipment and fixtures to the underlying consumer or building owner and then enter into a contact with the same underlying owner to construct, build or alter or repair the structure and will also install the materials. The retail contractor can purchase the materials and fixtures at retail cost and provide the underlying retailer with a “Streamline Sales and Use Tax Agreement Certificate of Exemption and not pay tax on the transaction. The effect of this rule is that the retailer contractor must then submit either the sales tax it bills and collects from its underlying buyer/consumer or pay the use tax to the state on the retail price when the retail contractor uses the materials or fixtures itself in performance of the contract. As you can see, this may get complicated.
In sales and use tax, the type of contract and how it is written, the person or entity for which the construction is being done, and how the underlying materials are being acquired all come into play in determining the underlying tax liability. An example: If the activity is “new construction” and being done for a commercial owner, the contractor will generally have to pay tax on the materials and services used in performance of the construction. BUT, if the activity is “new construction” and the ultimate owner is the federal government, a carful drafting of the contract may allow the contractor to use “tax free” materials in the construction. The difference may be whether the exemption enjoyed by the underlying owner can “flow through” to the purchase of the materials.
Other issues in the area of sales and use tax include the use of direct pay permits, “green” incentives, manufacturing exemptions, use of fabricated materials, purchases between affiliated companies, real property or tangible personal property classifications and use of subcontractors.
In both Virginia and North Carolina, property tax comes up in the area of construction contracts as to both the building and the machinery and tools used in the project. Some localities impose a property tax on transient construction property such as large equipment and work trailers. Other localities may impose a property tax on a building where title has not passed, but the underlying building is fairly completed. In Virginia, if a county imposes the machinery and tools tax, having machinery and tools in that county on the lien date could subject the contractor to the tax.
Having vehicles in a locality on the lien date could also expose the vehicles to that county’s “car tax.”
Local License Taxes
Local license taxes are a stealth tax, and this issue is coming up more frequently in this time of economic stress. As localities look for more funding they are taking a good look at companies that are “doing business” in their jurisdictions and not paying the local business tax. This is true especially if the underlying contract is with the locality to build a locality building. This is not the “contractor’s license” but a separate tax on the privilege of doing business in that place. This tax applies even if the work is being done on a base or fort that is located in the locality. NOTE: most states are now making it a requirement in their contracts to build a state-owned building. The requirement is buried in the boilerplate language of the contract – “Contractor warrants that it is in full compliance with all state and local laws and regulations.” This means that you have to register to do business in that locality.
Contract language, while not a tax, can determine the taxability of the project. As noted above, structuring the contract to clearly determine who is buying the materials, when and where; who gets the incentives or exemptions; how subcontractors can be used; the type of contract (time and materials, cost plus, etc.); and the use of multiple contracts for the actual construction versus construction and provision of elements not considered real property, can help manage the sales and use tax and property tax liabilities.
In Virginia and North Carolina, neither state will allow the liability of the sales tax to be waived. If the contractor is doing real construction and consuming the underlying materials in performance of the contract, the sales tax cannot be passed along as a separate line item in the construction contract.
As noted above the pitfalls to an unwary contractor can causer the contractor to be liable for unforeseen taxes that can take a contract from profitable to unprofitable quickly. A clear understanding of state and local level tax laws and regulations prior to drafting the contract can give a contractor the edge to price the contract at the correct price and reduce liabilities later.