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Construction Contractors as Consumers When Installing Property of Others

author photo of Jesse W. McClellan

In previous posts, my partner, Dan Davis, CPA, addressed how states tax installation charges and how states tax contracts with exempt entities. This article includes a related question: how states tax property that is being installed when title to that property is not held by the installing contractor and tax was not previously paid. For example, California generally considers a contractor to be the consumer of equipment and machinery which is furnished and installed under a contract with the U.S. Government, but the contractor will not generally be considered the consumer of such property if title is held by the U.S. Government at the time of installation. In some states, the installing contractor is considered the consumer of the installed property even when the contractor never takes title to that property.

In the majority of states, contractors are considered to be the consumers of materials that they furnish and install, which means tax applies to the contractors’ purchase price of such materials. When a contractor merely performs installation without furnishing the property installed, most states will not consider the contractor to be the consumer or “user” of the installed materials. (See Dan’s previous post regarding the taxability of installation charges.) If tax was not paid on the materials installed, most states will impose tax on the supplier or the purchaser of the materials. If the supplier lacks nexus with the controlling state and the purchaser is exempt from taxation, e.g., the U.S. Government, then the inquiry ends and no tax is collected on the installed materials. That’s not the case in all states, however.

Certain states consider the installing contractor to be the consumer of installed materials irrespective of whether or not the contractor ever held title to them. In those states, the installing contractor is liable for any tax not previously paid. To the extent the retailer or purchaser can be reached for the tax, the state will typically assert a dual obligation until one party or the other has satisfied the liability.

The states that consider contractors to be consumers of materials they install even if they never held title to such materials include, but are not necessarily limited to: Idaho, North Dakota, South Dakota and Tennessee.

When considering this issue in the context of a contract with the U.S. Government, the ability of a state to impose a tax based on the value of property owned by the U.S. Government is questionable at first blush, since the federal government is generally immune from state taxation pursuant to the U.S. Constitution. The issue was addressed by U.S. Supreme Court in United States v. Boyd (1969) 378 U.S. 39.

In Boyd, the Supreme Court considered the validity of a use tax levied by Tennessee on contractors performing work on behalf of the Atomic Energy Commission (AEC) at its Oak Ridge, Tennessee complex. The contract established that title to all of the relevant property and supplies would pass directly to the U.S. Government prior to installation, and that the items would be purchased using government funds. Therefore, title to the items at issue was held by the U.S. Government at the time the property was installed. Notwithstanding the government’s ownership, Tennessee taxed the contractors’ use of the property under a statute that imposed tax on the installing party, based on the cost or fair market value of the property installed, irrespective of ownership, provided such tax had not been previously paid. This law had been intended to eliminate the so-called loophole that permitted contractors to avoid tax on U.S. Government contracts.

The contractors and the AEC sued to recover the collected taxes, claiming that the collection infringed upon the implied constitutional immunity of the United States. The Tennessee Supreme Court upheld the collection, pointing out that the incidence of tax was upon the contractors, not the U.S. Government. The courted stated that the tax is “imposed upon the use by a contactor of tangible personal property whether title is in him or in another, and whether or not the other has immunity from state taxation,” adding that the “contractor’s tax was intended to be and is a tax upon the use per se by such a contractor.” The U.S. Supreme Court affirmed the decision, pointing out that the determining factor is the legal incidence of tax, and that the imposition of tax upon a private contractor is permissible even though the economic burden of the tax is ultimately borne by the United States.

Similar issues have since been brought before the Supreme Court with the same result, although the court now includes an additional balancing test to determine if the tax is permissible in some cases. Under the balancing test, the state must show that the benefits of the tax outweigh the economic burden.

In summary, it is well settled that states may impose a use tax on installing contractors, irrespective of whether or not the installing contractor ever held title to the property, and even if title is held by an exempt entity such as the U.S. Government. Therefore, it is important for contractors to recognize and consider their potential exposure when they perform construction labor on property owned or supplied by others. This type of exposure is not limited to contracts with the U.S. Government.

Sub-issues to consider include how the measure of tax should be established, and what products or services should be included in the measure of tax. Typically, the installing contractor’s contract will not identify the cost price of the property to be installed, and when the contractor is not providing the property, it may not be privy to such information. If the actual cost price cannot be obtained by the state during an audit, the auditor may establish the taxable measure from an estimate or from what it considers to be the fair retail selling price. Establishing the taxable measure in that manner creates the potential for an excessive audited value. The law is not always clear on how the cost price should be established: for example, is it the cost of the manufactured property to the supplier, or the selling price to the purchaser? The difference can be significant.

Issues also may arise as to what specific property and services are to be included in the taxable measure. For example, what happens if the supplier makes separate charges for testing the property after it transfers title to the purchaser - before or after installation, or for tools and supplies that are sold with the property, but not installed? States will typically seek to include such charges in the measure of tax, but if the services or supplies are not related to the installation performed by the contractor, is it appropriate to do so? These questions generally require a fact-intensive inquiry and should be considered by contractors when they are preparing bids or under audit.

About the Author: Jesse W. McClellan, Esq. is a former state sales and use tax auditor, licensed attorney, and the managing partner of McClellan Davis, LLC, a firm that offers a full spectrum of sales and use tax services. Learn more about him by visiting his author bio page. Learn more about McClellan Davis at salestaxhelp.com.

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Comments

4 Responses to Construction Contractors as Consumers When Installing Property of Others

  • Posted by Gregory on December 20, 2015 4:38pm:

    What happens globally? Do States routinely exempt purchases by manufacturers and processors fulfilling Federal Contracts?

    Are there some State decisions such as with Missouri addressing the expenses of testing?

    ...and the munitions list, what about the manufacture of munitions on the Federal Munitions list?

    I'd simply like to comment on Contracts and Contractors dealing with the Federal Government.

    The Federal Government seeks the lowest bidders.

    When the lowest bidders know the State's approach to Federal Contracts, such as with State and other exempt entities projects, then the sales people bidding on those jobs would most certainly have some need to know the particulars of their customers' cost considerations, correct?

    Around these parts, Federal Contract fulfillment is specifically exempt, and so is just about everything to make munitions. Does Tennessee reject manufacturing and supply of military bases to contractors and sub-contractors? Where are those instances?

    Missouri has several military bases, and just about anything to anywhere to the Federal Government can avail itself to exemption, exception.

    So, why is Tennessee such a rogue State?

    • Posted by Author photo of Jesse W. McClellanjessemcclellan on December 22, 2015 3:11pm:

      Gregory,

      Thank you for your post, you pose some interesting thoughts. I'll respond, to the extent I can, roughly in the order you presented your thoughts and questions.

      First, as a general concept, it is necessary to recognize that states, absent a specific exception established by Congress, are not permitted to impose tax on the U.S. Government (USG). The key to taxing transactions or projects with the USG, is to place the incidence of tax on the provider/seller. In that case, the courts have held with relative consistency that the tax is permissible, and that the economic burden on the USG, in itself, is not sufficient to invalidate the tax. In some cases, including Indian reservation cases, the state will also have to show that the interests of the state's taxation, outweigh any burden created by the tax.

      With that backdrop, "purchases" by manufacturers and processors of equipment, machinery and/or items that will be incorporated into such products, for resale to the government will generally be considered an exempt purchase for resale. (Subject to the general rule that items that are not incorporated into the finished product are considered to be consumed by the manufacturer.) "Sales" by manufacturers and processors to the USG, absent a specific federally established exception, are generally exempt under federal immunity principles. There is a bright-line rule for tax which is imposed on the purchaser. In that case, when the purchaser is the USG, tax will not apply (absent a special federal exception). The questions generally arise where a contractor is performing a contract on behalf of the USG and the law treats the contractor as the "consumer" of the products used and/or installed in performing the work.

      There are decisions that address testing, but I'm not aware (or can't recall) if such decisions exist in Missouri.

      To the extent a state treats a contractor as the consumer/user of installed property, notwithstanding title, the installing contractor certainly would want to know 1) if tax was paid on the property to be installed, and if not, 2) the cost of such property. That would enable the contractor to account for the tax obligation in its bid.

      Tennessee, like all states, cannot tax sales to the USG provided the incidence of tax falls on the USG. TN does, however, hold a contractor responsible for tax on the cost of property installed in the performance of contracts - irrespective of whether the products are provided by the contractor or a third-party - as explained in my post and addressed in Boyd. Other states do the same, but most will not tax property that is owned by the USG at the time of installation.

      Another issue to consider is one of agency. If the contractor/seller/purchaser is acting as an agent of the USG, typically federal immunity will apply. That issue has been the subject of several court cases, and the outcome typically turns on whether the taxpayer is truly considered to be an agent. Perhaps a topic for a separate post...

  • Posted by Terance on December 16, 2015 5:29am:

    I am looking into federal construction projects. Can the government issue tax exempt forms for contracts worked on federal grounds for a federal build in Puerto Rico?

    • Posted by Author photo of Jesse W. McClellanjessemcclellan on December 22, 2015 2:21pm:

      Terance,

      Puerto Rico, while a territory of the United States, operates under its own constitution which I have not studied. Federal immunity from tax within the incorporated states stems from the U.S. Constitution. Thus, the fundamental rules for Puerto Rico may differ. With that said, it is my understanding that Puerto Rico currently provides an exemption from SUT for sales and services provided to the U.S. Government (and it will provide the same exemption/exclusion under its pending VAT system). If you would like me to review the matter in more detail on your behalf, please feel free to contact me at jmcclellan@salestaxhelp.com

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