By Lucian Khan, Of Counsel to McClellan Davis

This article discusses some of the complexities of the California sales and use tax law, as it applies to construction contractors. Pursuant to California Code of Regulations, title 18, section 1521, Construction Contractors, a construction contract is a contract to erect, construct, alter or repair any building or structure, project, development, or other improvement to realty. However, the tax consequences can vary depending on the type of property installed, how the property is installed, the type of contract you have, how the contract is billed, whether the contractor does any further processing before or after installation, and whether the contract is with the United States Government. When multiple contractors are involved, it is not always clear which contractor is responsible for the tax.

New House Construction

Sales Tax rules for Construction Contractors

Generally, Regulation 1521 classifies the property to be installed into three categories (materials, fixtures, or machinery and equipment), and also classifies construction contracts into three categories (lump sum, time and materials, and cost plus fee contracts). The general rule is that construction contractors are consumers of materials, which are items that lose their identity when installed, and become an integral and inseparable part of realty. Since the contractor is the consumer of materials the sale to the contractor in California (for a job in California) is a taxable retail sale, and the contractor may owe use tax for materials purchased outside California. However, under certain circumstances (not involving construction contracts with the U.S. Government) a contractor may be considered a retailer of materials, and will owe (more) tax on a marked-up price.

Fixtures are items which are accessory to a building or structure, that do not lose their identity when installed. Thus, a fixture is something that makes realty more functional. In contracts with the U.S. Government contractors are consumers of fixtures (owing tax on cost), and retailers of fixtures if the contract is not with the U.S. Government. However, where the contractor is the retailer, determining the amount on which tax should be reported can be difficult, if either the contract does not state the sales price of the fixture, and/or the contractor is the manufacturer, because manufacturing costs (e.g. labor, overhead, etc.) and reasonable profit is included in the taxable measure, and must be established in accordance with the regulatory guidelines.

Regulation 1521 specifically provides that construction contracts do not include contracts for the sale and installation of machinery and equipment. However, the regulation nevertheless defines such items as property to be used in the production, manufacturing, or processing of tangible personal property, the performance of services or other purposes, which is not essential to the fixed works of a building or structure, does not lose its identity when attached and is readily removable, without damaging the structure. Thus, machinery or equipment serve a purpose that is independent of the realty to which it may be attached. An example would be a drill press which is used in the manufacturing process. Although it may be attached to realty, it serves no useful function to the structure itself. Thus, removing the drill press will not diminish the usefulness of the structure in any way. A contractor is always the retailer of machinery and equipment, therefore, any sale to the U.S. Government would be an exempt sale, providing the contractor does not make any use of the property before transferring title. For sales of machinery and equipment which are not to the U.S. Government, determining the amount on which tax is due can be difficult, if either the contract does not state the sales price of the item, and/or the contractor is the manufacturer.

Disputes can arise in determining whether an item is a material (with tax on material cost but not labor), rather than a fixture (with tax on materials and labor, except for installation). Items such as non-electric signs, cabinets, counters and solar cells or panels can be considered either materials or fixtures depending on whether the item is prefabricated, before installation. There is also a special rule for electric signs (which are considered fixtures), but the amount on which tax is due may differ, depending on whether there is a stated price in the contract.
A contractor also needs to be aware that only labor to install fixtures or machinery and equipment, is not taxable. Any labor to fabricate or assemble fixtures or machinery and equipment (even at the jobsite), must be included in the amount on which tax is reported and paid.

In construction contracts with the U.S. Government, disputes can arise in determining whether an item is a fixture (with tax on cost to the contractor), or machinery and equipment (where the sale is exempt). Sometimes the lines can become blurred because an item may be classified as either a fixture or machinery or equipment, depending on unique circumstances. Where a contract includes all three items (materials, fixtures and machinery and equipment) the contractor must correctly distinguish between materials and fixtures which are consumed, and machinery and equipment that is resold, in an exempt sale.

A contractor owes tax on sales of materials to other contractors who will install the items sold, and also owes tax for any sales of fabrication labor on materials provided by other contractors. A contractor must also properly document any sales of fixtures, machinery, or equipment that are sold for resale, or shipped outside California. A contractor is a consumer of any tools or supplies used on construction jobs, with tax applying on the sale to the contractor.

Where a general contractor hires subs to perform different aspects of a construction job, determining the tax liability for each contractor can be difficult, because the various construction contracts must be examined separately. Problems can also occur when a contractor who consumes materials mistakenly makes a separate charge for sales tax, in an attempt to recover the tax as an item of cost.

A contractor doing a repair job can be either a consumer or retailer of the materials used, depending on how the contract is structured or billed. There are also special rules for contractors providing prefabricated buildings, factory built school buildings, factory built housing, and mobile homes.

When a landowner hires an out-of-state contractor (with no California ties other than the temporary jobsite), the landowner can be assessed use tax on any fixtures or machinery and equipment installed, if the contractor is not registered, and fails to pay the tax.

This article is just a sampling of the issues that can arise with construction contracts. It is not meant to be exhaustive of all matters that must be considered when performing a construction contract. The aforementioned issues, however, will help permit you to recognize the questions that should be examined at the time of bidding a job, and for sales and use tax reporting purposes.


McClellan Davis® offers a full spectrum of sales and use tax services and an initial free consultation.  You can set up an appointment by emailing or calling toll free at (855) 995-6789.  You can also reach Mr. Khan directly at  or by calling (916) 872-3078.   

Lucian Khan Esq.

Lucian Khan Esq.

Lucian Khan Esq. worked as a lead attorney, reviewer and supervisor in the California Department of Tax and Fee Administration’s (CDTFA), formally the Board of Equalization, Appeals and Settlement Divisions, for 22 years. He managed complex business tax appeals, specializing in nexus issues, construction contracts, leases, technology transfers and tax fraud. He also has extensive knowledge of audit techniques and procedures. Mr. Khan is currently working as Of Counsel with McClellan Davis, where he continues to focus on a variety of sales and use tax matters, ranging from compliance, audit management, appeals and settlement, across a broad range of industries. Email Lucian

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