Part 1 – The Sales Tax ABCs for Contractors and Taxable Service Providers
In this month’s issue, we introduce the first part of a four-part guide about contractors, taxable service providers and related services. Part 1 covers terminology and the taxability of real property improvements in Texas, and provides basic principles for determining the taxability of new construction and real property repair, remodeling and restoration.
Who are Contractors and Taxable Service Providers?
If you perform new construction; residential real property repair, remodeling, maintenance, restoration; or nonresidential real property scheduled and periodic maintenance, you are a contractor.
If you repair, remodel or restore nonresidential real property, you are a taxable service provider.
Am I Making a Real Property Improvement or Installing Tangible Personal Property?
The first step in understanding your tax responsibility is to determine whether an item is incorporated into the real property, a real property improvement, or remains tangible personal property (TPP) after you install it.
To determine if an item is incorporated into the real property, you must consider the following questions:
- Is the item annexed (or connected) to the real property?
- Is the item fitted or adapted to the real property?
- Was the item intended to become a permanent part of the real property?
Note that the third question is considered the most important, with the first two being evidence to support it. Generally, if you would damage the real property, the item or both when removing the item after installation, the item has been incorporated into the real property.
If, in light of the three questions, the item is incorporated into the real property, then you are providing a real property improvement and are considered either a contractor or taxable service provider.
For example, creating a retaining wall is a real property improvement because the materials used in building the retaining wall are intended to remain in the wall permanently.
Examples of real property improvements include:
- garage door openers
- kitchen cabinets
- building materials (such as wood, brick, concrete)
- ceiling fans
- hardscaping (such as retaining walls, ponds, sprinkler systems, etc.)
If you are not incorporating TPP into the real property, then you are delivering or installing TPP and must collect sales and use tax on the total price (including installation labor, materials and all related charges) for the TPP.
For example, attaching a television to a wall mount in a residence is installing TPP because the television is not intended to be a permanent part of the real property. The owner is likely to remove the television and take it with them when selling the home.
Other examples of installing TPP are freestanding appliances (refrigerators, dishwashers, clothes washers and dryers), televisions, telephones and computers.
What Type of Property Am I Working On?
Once you have determined that you incorporate TPP into real property, you must determine what type of property the work is being performed on: residential or nonresidential.
Residential property is a building used as a residence, not as a business. Property next to and connected to those buildings is also residential property.
Residential property includes family homes, multifamily apartments or housing complexes (including homeowner and tenant common areas), condominiums, nursing homes and retirement homes.
Nonresidential (commercial) property is property without facilities for people to live in. It includes buildings and other improvements built into, or affixed to, the land such as office buildings, shopping centers, industrial parks, bridges, hotels, motels, etc.
What Type of Contract Can I Use?
You must take into consideration the type of contract you use to determine your tax responsibilities. You can use either a lump-sum contract or a separated contract. Your tax responsibilities are different for each one.
Lump-sum contracts are also known as “one-fixed-price” or “turn-key” contracts. You bill your customer one amount for both labor and incorporated materials instead of separately stating them. Separated amounts on invoices issued to the customer will not change a lump-sum contract into a separated contract unless the terms of the contract require separated invoices.
Separated contracts are also known as “time and materials” contracts. You bill your customer by separately stating labor and incorporated material charges. As long as you state the charges for the incorporated materials and labor separately, it does not matter if the charges are added together and the total is provided. Cost-plus contracts are considered separated contracts if the cost of labor is separately stated from the cost for incorporated materials.
Your contract with your customer has priority over any bids or invoices you provide them. For example, if you have a lump-sum contract to perform residential repair work for your customer, separated bids or invoices will not change it to a separated contract. If there is no written contract, then the written bid determines the tax responsibilities. If there is no written contract or bid, then the written invoice determines tax responsibilities.
What are Incorporated Materials, Consumables and Equipment?
As a contractor or taxable service provider, you use incorporated materials, consumables, and equipment to complete your construction projects. Knowing how to classify the items you use will help you understand if you must pay sales tax.
Incorporated materials are items that are incorporated into, and become a part of, any permanent real property improvement such as construction items (brick, drywall, mortar, lumber), central air conditioning units, lighting fixtures, electrical receptacles, flooring (tile, wood, carpet), paint and shingles.
Consumables are non-reusable, single-use (nondurable) items used for construction projects such as non-reusable drop cloths, disposable latex gloves, barricade tape, electricity, natural gas, chalk or non-reusable concrete forms.
The following are not consumables: machinery, equipment, incorporated materials, durable items, office supplies or rented (or leased) items.
Equipment is any item you use that is not an incorporated material or a consumable item. Equipment includes tools (screwdrivers, hammers), machinery (lathes, saws, drills) and accessories, or repair or replacement parts for machinery.
What Type of Work Do I Perform?
The type of work you perform for your customer is a primary factor in determining your sales tax responsibilities. You can perform new construction, repair, remodeling, restoration or maintenance work on residential or nonresidential real property.
New construction means building all new improvements to either residential or nonresidential property, and includes adding new usable square footage to a property or performing the initial finish-out of an existing building before its initial occupancy or use.
The initial finish-out refers to completion of the interior or exterior of an unfinished residential or nonresidential real property improvement so that it meets an owner’s or lessor’s requirements.
Some new construction examples are:
- constructing a new shopping mall
- building a new home
- building a new school
- performing the initial finish-out of a space (such as installing fixtures, drywall, cabinets, etc.) that has never been occupied in a strip mall
- adding new square footage (such as a new room) to an existing home or building
- installing a new sprinkler system in a lawn
- paving a new parking lot
- constructing a new commercial building
- building a new playground
- expanding an existing one-story building from 2,000 square feet to 3,000 square feet
- adding stories to an existing building
- completely demolishing an existing residential or commercial building down to the slab and constructing a new building in its place
Hardscaping is a real property improvement and the first installation of hardscaping (such as retaining walls, ponds, lawn sprinkler systems, etc.) is new construction.
Repairing, Remodeling or Restoring Property
Repairing property means mending or bringing the broken, damaged or defective real property back as near as possible to its original working order.
Remodeling or restoring property means rebuilding, replacing, altering, modifying or upgrading the existing real property.
Some examples of repairing, remodeling and restoration work are:
- partial demolition work
- any work done after the finish-out of an existing residential or commercial building
- fixing a leaking faucet
- fixing a fence
- unclogging a toilet
- remodeling a bathroom, kitchen or office
- replacing a roof
- replacing carpet or flooring
- replacing a central air conditioning unit
- replacing part of an existing parking lot
- repairing an existing retaining wall
Each of the following scenarios provides a summary from the contractor’s or service provider’s point of view and explains their tax responsibilities.
The labor for new construction is not taxable. The incorporated materials are taxable. The person or entity responsible for paying the tax depends on the type of contract used.
As a contractor, you can bill your customers using either a lump-sum or a separated contract. Your tax responsibilities are different for each one. If your customer provides the materials, then you are providing labor only. You’re not responsible for tax on the materials.
Under a lump-sum contract, you do not collect sales tax on materials or labor from your customer. You are the consumer of all items purchased to perform the work. You are not a seller.
Under a lump-sum contract, you must:
- pay sales or use tax on consumable supplies, tools and equipment used to do the work;
- pay sales or use tax to your suppliers on the incorporated materials at the time of purchase; and
- accrue and pay tax on materials bought tax free, either removed from your inventory or bought outside of Texas.
For items bought tax free, you must accrue state and local use tax based on:
- the jobsite location if the items are delivered directly to the jobsite from outside Texas; or
- the location where the items are first stored.
Use our Sales Tax Rate Locator to search for sales tax rates by address. In addition, for exempt contracts tax may not be due on incorporated materials, consumables and certain taxable services. See the “Contracts with Exempt Organizations” section in this article.
Under a separated contract, you are the seller of the incorporated materials. You must collect tax on the incorporated materials billed to your customer, but there is no tax due on labor.
Under a separated contract, you must:
- pay tax on consumable supplies, tools and equipment used to do the work;
- give Form 01-339, Texas Sales and Use Tax Resale Certificate (PDF), to sellers instead of tax when buying:
- incorporated materials and
- subcontracted taxable services resold to the customer to complete the job; and
- collect from your customer:
- tax on the incorporated materials;
- Form 01-339 (back), Texas Sales and Use Tax Exemption Certificate (PDF), instead of sales tax on the incorporated materials, if an exemption applies; or
- Form 01-339, Texas Sales and Use Tax Resale Certificate (PDF), on the incorporated materials, if you are performing a subcontract for a general contractor who is working under a separated contract.
You will collect local sales taxes based on the tax rate at the jobsite location. Use our Sales Tax Rate Locator to search for sales tax rates by address. In addition, for exempt contracts, tax might not be due on incorporated materials, consumables and certain taxable services. See the “Contracts with Exempt Organizations” section in this article.
If you perform both lump-sum and separated contracts, and do not know at the time of purchase which type of contract you will use the incorporated materials under, you may purchase the materials tax-free for resale by issuing Form 01-339, Texas Sales and Use Tax Resale Certificate (PDF) and placing them in a tax-free inventory. You then must:
- charge sales tax on them, or accept a resale certificate if you subcontract to a general contractor working under a separated contract, if you are working under a separated contract; or
- accrue use tax on them when you remove them from inventory to perform a lump-sum contract.
Local taxes are due based on the jobsite if you remove the items to perform the work under a separated contract. Local taxes are due based on the location where your inventory is stored if you remove the materials to perform work under a lump-sum contract.
Residential Repair, Remodeling, Restoration and Maintenance
Labor to repair, remodel, restore or maintain residential real property is not taxable. Materials incorporated into the real property are taxable. The individual or entity responsible for paying the tax depends on the type of contract used. The taxing responsibilities for residential repair, remodeling and restoration are identical to those for new construction. See the “New Construction” section in this article.
Nonresidential Repair, Remodeling and Restoration
When you repair, remodel or restore nonresidential real property, you are a taxable service provider. Any restoration, repair or remodeling work done after the initial finish-out of an existing nonresidential (commercial) building is taxable.
The total charge for both labor and materials used to repair, remodel or restore nonresidential real property is taxable. It makes no difference whether you use a lump-sum or separated contract to bill your customer.
If your customer provides the incorporated materials, then you are providing labor only, which is taxable. You are not responsible for the tax on incorporated materials, your customer is.
Tax is due on the entire charge to your customer, and you must:
- pay tax on consumable supplies, tools and equipment used to do the work;
- give Form 01-339, Texas Sales and Use Tax Resale Certificate (PDF), to vendors when buying incorporated materials and subcontracted taxable services resold to the customer; and
- collect from your customer:
- tax on the total charge;
- Form 01-339, Texas Sales and Use Tax Resale Certificate (PDF), if you are performing a subcontract for another service provider; or
- Form 01-339 (back), Texas Sales and Use Tax Exemption Certificate (PDF), instead of sales tax if an exemption applies.
The tax you collect is based on the tax rate at the jobsite location. Use our Sales Tax Rate Locator to search for sales tax rates by address. In addition, for exempt contracts, tax may not be due on incorporated materials, consumables, and certain services. See the “Contracts with Exempt Organizations” section below.
Contracts With Exempt Organizations
An exempt organization is an entity that is either exempt under state or federal law or approved by our office to be exempt from Texas sales and use tax. Be aware, though, that some exemptions only apply to specific types of exempt entities.
Federal, state and local governments are automatically exempt from Texas taxes.
Many non-profit organizations have been granted Section 501(c) exemption status by the Internal Revenue Service (IRS), which is a federal entity. This Section 501(c) status does not automatically grant the organization tax exemption in Texas.
To be recognized as exempt from Texas sales and use tax, these organizations must apply to the Comptroller’s office for exemption on purchases necessary for an organization’s exempt purpose. You can verify an organization’s exempt status using our Texas Tax-Exempt Entity Search.
Be aware that certain exemptions are available for projects performed for certain Section 501(c) and other nongovernmental exempt organizations. The work you perform, though, must be related to the exempt organization’s primary purpose. If the job is unrelated to that purpose, then the associated exemptions are invalid.
When you do work for an exempt organization, you must get proof showing the contract is exempt. For a qualifying nongovernmental exempt organization, this is a Form 01-339 (back), Texas Sales and Use Tax Exemption Certificate (PDF). For a governmental entity, a written contract or purchase order is also acceptable documentation.
When your contract is with an exempt organization, and you have received proof of exemption from the entity, you can give your suppliers your own exemption certificate referencing the exempt contract and listing yourself as the purchaser instead of paying sales tax on:
- incorporated materials;
- consumables that are essential to the job and completely used up or destroyed after one use at the job site; and
- taxable services performed at the job site that are integral to completing the job and specifically required by the contract.
For example, a city hires you to repair a city road. You can give an exemption certificate instead of paying tax for taxable items incorporated into the road (such as concrete, asphalt, etc.) and on certain types of consumable items you use to complete the job (such as barricade tape).
If your customer provides the materials, then you are providing labor only. You are not responsible for the tax on the materials.
You must pay tax on items you use to provide your services such as machinery, equipment, accessories or repair and replacement parts for your equipment and machinery used at the job site, office supplies, furniture and computers.
Note, your machinery and equipment are specifically excluded from the exemption discussed above. For example, if you need to rent a backhoe to complete the road job, you owe tax on the backhoe rental. This is true even if the exempt entity reimburses you for the tax.
In conclusion, to properly apply and collect or pay the appropriate taxes, contractors and services providers should analyze their transaction by answering five key questions:
- Am I installing tangible personal property or improving real property?
- What type of property am I working on?
- What type of work am I performing?
- What type of contract do I have with my customer?
- Is my customer exempt from sales and use taxes?
This month’s article presented general terminology and tax treatment of real property improvements. In next month’s issue, we will break down demolition services as they relate to contractors and taxable service providers.