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Contractors as Both End Users and Retailers - California

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In the previous blog post we discussed states that unequivocally regard construction contractors as consumers (end users) of the materials and fixtures they install. In this installment, we’ll look at California, which treats contractors as consumers of materials but retailers of fixtures. We’re featuring California because it provides what may be the clearest example of the consumer/retailer concept in action.

We’ve previously defined materials as items that lose their individual identity when incorporated into real estate, such as nuts, nails, and screws. Fixtures are items that remain readily identifiable after installation, such as sinks, light fixtures, and water heaters. A third category, machinery and equipment, encompasses installed units that will be used directly in operating the property owner’s business.

In consumer/retailer states, contractors are expected to report sales tax on the retail prices of some or all of the fixtures they install, just as if they were selling those fixtures over the counter. They remain consumers with respect to materials they install, however, and they’re expected to either pay tax to their vendors when they purchase those materials or report use tax measured by their costs on their sales and use tax returns. California law incorporates these approaches with respect to all installed materials and fixtures; other states make additional distinctions. (Machinery and equipment, the third category of installed property, is always treated as sold at retail when transferred pursuant to a construction contract.)

With tax law being what it is, “retail price” is not always a number that a logical interpretation might suggest. In California, the retail price of a fixture can vary according to the form of the contract. Under a lump-sum construction contract (where only a total price is stated, with no breakdown of fixtures, materials, labor, or tax), the retail prices of any installed fixtures are actually considered to be equal to the contractor’s costs. Thus, for most practical purposes, the tax treatment of fixtures and materials installed under lump-sum contracts is similar, so that lump-sum contractors may buy all such items tax-paid and furnish and install them without incurring further liability. (Exception: if the contractor self-manufactures a fixture that it then installs, the measure of the tax due on that fixture is the price that the contractor would have paid to an outside vendor for a similar unit that was already manufactured. If similar fixtures are not normally sold to contractors in a completed condition, alternative costing methods are provided in California Sales and Use Tax Regulation 1521(b)(2)(B). Note that this provision does not apply to manufactured materials, such as sheet metal ducts and tubing, which remain taxable only on the costs of their component parts.)

Under a California time and materials contract, the retail price of any fixture that is furnished and installed is the greater of the cost of the fixture or the price stated for the fixture in the contract. Any materials provided under the contract remain taxable on their costs.

For example: assume that a time and materials contract specifies “materials” of $1,800 and labor of $2,000. The stated “materials” actually include fixtures that cost the contractor $1,000 plus true materials that cost the contractor $200. A quick computation tells us that the contractor marked up his materials and fixtures by 50 percent in the contract. (The costs of $1,000 plus $200 = $1,200; $1,200 plus 50 percent of $1,200 equals $1,800.)

The measure of sales and use tax due for this contract is (a) the retail price of $1,500 for the fixtures ($1,000 plus the 50 percent markup), plus (b) the $200 cost of the materials, for a total of $1,700. Assuming an 8 percent tax rate, the tax due would be $1,700 X .08, or $136. (The $2,000 charge for labor is not a factor in computing the tax because installation and repair labor are nontaxable in California.)

If the contract had specified materials of $1,800, labor of $2,000, plus sales tax of $144 (.08 X $1,800), the entire $144 tax would be due to the state. Once a contract calls out a specific figure for sales tax (even on materials), the higher of the specified tax or the tax measured by the costs of the materials becomes the amount due.

Some states allow exemptions for property purchased to fulfill contracts with state and local governments and/or nonprofit entities, but California has no such provisions. The state has enacted special rules for construction contracts with the U.S. government and its instrumentalities. Since California is prohibited by the U.S. Constitution from taxing sales to the United States, the state has declared that contractors are consumers of fixtures that they install under U.S. government contracts, even though the same contractors are considered retailers of fixtures they install for anyone else. Making contractors the consumers (end users) of such fixtures allows the state to shift the incidence of the tax from the United States (constitutionally exempt) to the contractor (eminently taxable).

As briefly alluded to above, services are generally sales tax exempt in California. The only exceptions are fabrication labor (labor that results in a functional change to tangible personal property) and services that are regarded as an integral part of a sale. In other states, some or all construction services are specifically included in the sales tax base. We’ll begin to address such services in the next installment.

So does this post help you understand how (and why) California treats construction contractors as both consumers and retailers?

Your comments and questions are not only welcome - but greatly appreciated! Please use our COMMENT section below.

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Comments

15 Responses to Contractors as Both End Users and Retailers - California

  • Posted by Bob on January 18, 2016 10:39am:

    If a paving contractor also produces asphalt does he have to pay taxes on in-house materials installed on a project under a lump sum contract?

  • Posted by Brett on April 29, 2015 2:24am:

    I have been looking for an article like this for almost 3 months. The law is so ambiguous that I have called the BOE on three different occasions and everyone has told me something different and that everyone else wrong. These people are CA States own tax experts and they still down understand the law. After really analyzing the sale and use tax law, I came up with my own definition which matches what you said in your article. I really am glad I found it, Great write up!
    We are a specialties subcontractor with lump sum contracts, retail sales, and most of our vendors are out of state.

    • Posted by Author photo of Dan DavisDan Davis on April 29, 2015 5:47am:

      Brett,
      I appreciate the kind words. Unfortunately, the BOE people who handle telephone questions from the public aren't really experts - they're compliance people with a general but fairly superficial knowledge of sales and use tax law. Since this is true not only for California but for most other states as well, one should never rely on oral answers from a tax agency employee; if you intend to rely on an agency response, always get it in writing. (I suspect you already know this, but I'm emphasizing it for our other readers.)

  • Posted by christine on November 25, 2014 2:36am:

    We are a manufacturer. We typically sell wholesale and therefore do not collect tax. All our California customers supply us with a sellers permit. However, we were approached by a contractor who would like to buy whole sale. Our product is not a permanent fixture - it's a temporary window shade. The contractor does not have a sellers permit; therefore, we are applying sales tax to the order. However, they've indicated they are excluded from sales tax due to a contractors license. I'm not finding anything on the CA state website to support this. Can you help?

    • Posted by Author photo of Dan DavisDan Davis on November 25, 2014 3:56am:

      Christine,
      You are correct in charging them sales tax, and in fact you're required to do so under these circumstances. Holding a contractor's license does not exclude anyone from paying the tax.
      Regards,
      Dan

  • Posted by paul on October 17, 2014 3:37am:

    Hi Dan, good article. So if I'm understanding correctly, if I buy materials (and pay tax on them) to build cabinets, which I then install, I in turn have to charge my customer tax again on the cabs I fabricated? It is a lump sum contract. Thank you.

    • Posted by Author photo of Dan DavisDan Davis on October 17, 2014 8:15am:

      Hi Paul,
      I'm assuming you're a California custom cabinet builder and installer. (By "custom cabinet builder," I mean that more than 10% of your total direct costs of labor and materials are incurred beginning with the time you start affixing the cabinet to the wall and thereafter. If 90% or more of those costs were incurred in building the cabinet prior to affixing it, you'd be regarded as making a prefabricated fixture, and different rules would apply. Most cabinet makers qualify as custom builders.) Subject to that stipulation, if your contract is lump-sum, you should not charge your customer tax on the materials. You're regarded as a consumer of those materials, and the only tax due is on your materials costs. Since you've already paid tax to your vendor, you have no further liability.

      • Posted by Marc on November 1, 2014 6:00am:

        In other words, if I'm a custom cabinet maker and installer. I should be paying my sales tax as a consumer when I purchase materials needed to make the cabinets? Does this mean I am not liable to collecting further sales tax from my client. Preferably I would like to pay my sales tax to vendors and not have to be liable to collect sales tax from my client if I'm contracting the job as a "lump sum." Also, what if I ship my cabinets to any of the other states where I'm not physically conducting business? How do I handle a situation like that since I'll be selling the cabinets but not installing them?

        • Posted by Author photo of Dan DavisDan Davis on December 16, 2014 7:01am:

          Marc,
          I apologize for the delay in responding.
          As a California custom cabinet maker and installer who is contracting on a lump-sum basis, your best approach is to pay tax to your vendors (as a consumer) when you buy materials to make the cabinets. As long as you're installing these cabinets and not selling them "over the counter," you will not be liable for charging CA sales tax or collecting it from your customers.
          With respect to CA, you owe no sales or use tax on your shipments of cabinets to customers in other states if you're just shipping them out of state by common carrier. As long as you have no physical presence in the other states (which means you don't deliver into those states in your own vehicles, install the cabinets, or hire third parties to install them), you won't have any sales or use tax obligations to those states either.

  • Posted by Jennevieve on October 1, 2014 5:38am:

    We are a lump sum contractor and only charging our customer sales tax on the cost of fixtures. How do we show that on our invoice? It seems this would tell our customer how much the cost of materials is - which is not helpful!

    • Posted by Author photo of Dan DavisDan Davis on October 1, 2014 7:12am:

      As a California lump-sum contractor (which means your contracts stipulate only a lump-sum amount, with no breakdown for labor, materials, fixtures or tax), you're best off just showing lump-sum amounts on your invoices as well. For instance, if you're sending out a billing for a 20% progress payment, just invoice 20% of the lump-sum total, without a breakdown. If you're invoicing the whole amount at once, stick to the lump-sum total without breaking out fixtures, labor, tax, etc. Of course, you'll need to report tax on the costs of your fixtures and materials to the Board of Equalization (unless you've bought them tax-paid), but the customer doesn't need to see the amount of the tax.

  • Posted by Jon on December 11, 2013 8:11am:

    I am a contractor of maintenance services for a large company (our customer) and we employ subcontractors on a time and materials basis for specialty work outside our expertise (i.e.. HVAC repairs). My company passes the cost of any subcontracted repairs onto our customer and we would like to know if we should be charging the tax for installed equipment or materials by the subcontractors directly to our customer and using a resale certificate with the sub or is the sub responsible for collecting the tax from us and paying it for materials they have installed?

    • Posted by Dan on December 16, 2013 5:20am:

      In California (and most other states) you should show subcontract services as a lump-sum line item in your contract, bid, or invoice. You'd just call it "Subcontract services," "Subcontract - HVAC," or something similar. Subcontractors are responsible for paying the tax on the materials they install, and you should not issue resale certificates to them.

  • Posted by Ian on November 15, 2013 12:50pm:

    Hello, I have a quick question on sales tax. I use a flat rate for my labor services so that is straight forward and I understand fully, but when I buy parts at (retail) not under my sellers permit and am charged sales tax do I also charge sales tax on my resale price? i.e. If I buy a part for $50+tax do I then sell that part for say $65+tax or is it just the profit that is taxed ($15) I have just been taxing my total profit minus biz expenses since labor is not taxed on it own.

    • Posted by Author photo of Dan DavisDan Davis on November 16, 2013 6:30am:

      I'm assuming that (a) you normally bill parts like a retailer, i.e. charging for parts at retail plus tax on the retail amount, and (b) this treatment is appropriate in your state (as it would be in the great majority of states). In that case, you'd charge tax on the full retail price ($65 in your example) and then claim a deduction on your sales tax return for the amount on which you paid tax to your vendor ($50). (The deduction would be classified as "tax-paid purchases resold.") However, just charging and reporting tax on your profit produces the same result and should not create any additional liability - it just throws a little more complexity into a potential audit scenario. (The tax should apply to the total markup of $15, without reduction for business expenses.)

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