There has been some confusion among construction contractors recently about the California State Board of Equalization’s (“Board” or “SBE”)position on the application of sales tax to materials provided by a construction contractor working under a time and materials (“T&M”) contract. The confusion stems from an unclear “Summary of Application of Tax for Construction Contractors” table that was attached to a February 8, 2012 letter sent to licensed contractors throughout the State, and comments made to some contractors by SBE agents who claimed that contractors owed sales tax any time they added mark-up to materials on a T&M job. Even the regulation that governs the application of sales tax to construction contractors—Regulation 1521—is not a model of clarity regarding what is and is not taxable on T&M contracts.
On May 3, 2012, the SBE’s Tax Counsel issued a Legal Opinion Letter that clarifies the application of the sales tax to materials provided by construction contractors in the course of performing T&M work. While the letter is only an opinion based on assumed facts and is not binding, it does tell contractors the current thinking at the SBE on the issue. View a copy of the letter.
In summary, the Opinion Letter states that as long as T&M contractors do no enter into agreements that “explicitly provide for the transfer of title to the materials prior to the time the materials are installed” and also do not calculate sales tax on the marked-up value of the materials and then bill their customers for that sales tax in addition to the materials and mark-up, the T&M contractor is a consumer of the materials and is not required obtain a sellers permit or pay sales tax to the state. That means for most contractors doing T&M work under typical construction contracts, the contractor pays sales tax reimbursement to the retailer when it purchases the material, and its sales tax liability for those materials ends there.
The sales tax law is complicated, and the Board’s Legal Opinion is limited to the facts recited in the letter. Keep in mind also that the Legal Opinion addresses only the sales tax applicable to “materials.” Materials are things that lose their identity when incorporated into the work— like concrete, asphalt, lumber, drywall, stone, brick and block, etc. The tax rules are different for “fixtures”—things that keep their identity after installation, such as air conditioning units, water heaters, light fixtures, sinks, faucets, and bathtubs. Contractors are considered to be “retailers” of the fixtures they supply to customers and are required to pay sales tax on the transfer of fixtures. Finally, the application of sales tax depends on the language of the contract documents for each transaction. While most T&M contracts do not “explicitly provide” for the transfer of title to materials prior to installation, there are some exceptions. For example, some contracts allow for the contractor to bill early for payment for “materials on hand” securely stored on site but not yet installed. In some cases those early payment provisions also provide that the owner takes title to the material as soon as payment is made. The unintended consequence of this type of clause could be to turn the T&M contractor into a retailer of materials, so contractors should review contracts carefully to avoid this unintended tax exposure.