How Sales & Use Tax Applies to Construction Contracts with the United States Government
Generally speaking, the United States Government is immune from state taxation under the Supremacy Clause of the United States Constitution. Courts have ruled that states are precluded from taxing activities where the incidence of tax falls directly upon the federal government, its agencies, and instrumentalities. But what about construction contracts with the federal government where the contractor is the party that is providing and installing items on behalf of the federal government?
This article uses California as an example to briefly explain how tax applies to construction contractors in general and to contractors that perform work on behalf of the federal government.
Overview of California Law for Construction Contractors
The primary legal authority in California for sales and use tax as it applies to construction contractors is California Code of Regulations, title 18, section 1521.1 A construction contract includes a contract to erect, construct, alter, or repair any building or structure, project development, or other improvement to real property. The application of tax can vary based on the type of contract, i.e., lump sum, time and material or cost plus a fee and it also will vary based on the classification of the items installed, i.e., materials, fixtures or machinery and equipment. As especially relevant for this article, the law draws distinctions between United States Government (USG) contractors and all other contractors (Non-USG). Non-USG contractors who furnish and install are generally considered to be consumers of “materials,” retailers of “fixtures” and retailers of “machinery and equipment.”2 Non-USG contractors may act as retailers of materials under a single contract if the contract is properly formed. Consumption of materials is generally considered to occur when materials are earmarked for a particular job, prior to installing them, with tax due on costs. A retail sale of fixtures is generally considered to occur at the time of installation, with tax due on the retail selling price.
Notwithstanding the foregoing overview, as discussed below in more detail, even though tax does apply in general, there are circumstances under which sales and use tax will not apply to materials or fixtures installed under USG construction contracts.
Specific Rules for United States Construction Contractors
USG contractors that furnish and install are typically considered to be consumers of materials and fixtures. Consumers must pay sales or use tax on the cost of the items consumed, and retailers owe tax on the “sales price” of fixtures.3 The law limits the circumstances under which a USG contractor may be considered the retailer of materials and fixtures, which is distinct from other contractors. (Cal. Code Regs., tit. 18, § 1521.) The distinction between consumer vs. retailer is important under USG contracts because sales at retail to the federal government are exempt from tax. (Rev. & Tax. Code § 6381; Reg. 1614; Howell, In re (1984) 731 F.2d 624, 628-629.)
As the consumer of materials and fixtures furnished and installed, either sales tax is imposed upon a contractor’s vendor, or if sales tax is not applicable, any applicable use tax is primarily imposed upon the USG contractor. Thus, technically speaking, the incidence of tax is upon the vendor or contractor, not the federal government. As such, the application of tax to a USG construction contract does not violate federal government immunity from taxation, even if the economic burden is borne entirely by the federal government. (United States v. California (1993) 507 U.S. 746; United States v. New Mexico (1982) 455 U.S. 720.)
Because California treats USG contractors as retailers of machinery and equipment, the sale of those items are exempt from tax if the transaction is structured and supported in accordance with Revenue and Taxation Code section 6381 and Regulation 1614.
In summary, tax typically does apply to standard contracts with the federal government and considering the size of some federal contracts, it can be a costly mistake to assume that it does not. It is strongly advised to consider the sales, use, and excise tax implications prior to issuing a bid.
Can a Contractor Legally Avoid Tax on a Federal Contract?
Although tax typically does apply to contracts with the federal government, in most states, there is a way to structure the transaction to legally avoid the application of sales or use tax. Doing so requires careful planning to address the manner in which items that will be incorporated into the project will be purchased, how title to goods will transfer to the federal government and other related factors.
Each contract is unique so the specifics of how to avoid the application of tax to a contract with the federal government are not addressed here in detail, but understanding your options to avoid tax can make a significant difference. With sales and use tax rates in many states reaching as high as 10 percent, an informed contractor stands to significantly increase its profit margin, or significantly decrease its bid-price to increase the chances that it will be awarded the contract, if it structures the transaction to legally avoid tax on its federal contracts.
If you would like to have a consultation on your construction contract, please contact us firstname.lastname@example.org or 855-995-6789.
The information presented in this article is not intended to be legal advice and should not be treated as such. Every transaction is unique and requires the advice of competent legal counsel to determine your best options.
1 All references to Regulations are to the California Code of Regulations, title 18, unless otherwise noted.
2 Materials include items which, when installed, lose their identity to become an integral and inseparable part of real property. Fixtures include items which are accessory to a building or other structure which do not lose their identity when installed. Machinery and equipment include property intended to be used in the production, manufacturing, or processing of tangible personal property. (Cal. Code Regs., tit. 18, § 1521.) These distinctions are important for properly determining the application of tax.
3 The “sales price” of completed fixtures installed under a lump sum contract is considered to be the cost to the contractor under certain circumstances. Thus, a properly formed contract for the installation of completed fixtures in California can reduce the amount of tax due.