In the previous article 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.