Basic Concepts 

The contracting industry, which encompasses several occupations such as construction, roofing, masonry, maintenance, and more, is projected to grow faster than the average of any other occupational industry from 2023 to 2033.1 But working as a contractor presents its own special set of challenges when it comes to sales tax. Due to these challenges, the contracting industry is among the most frequently audited industries, according to a 2021 study conducted by Avalara and Potentiate.2

One of the most confusing aspects of sales tax for a contractor is if and when you need to charge sales tax on your labor and materials. Sales tax laws vary significantly by state, and the rules for contractors can get particularly complex. In this blog post, we’ll be looking at the basic sales tax considerations that contractors face, and how to stay on top of your sales tax obligations as a contractor. 

Sales Tax on Materials 

As a contractor, you will likely have contracts that require you to both provide a service and supply physical materials, like tools or lumber, known as tangible personal property. Sales tax generally applies to those items of tangible personal property, since most states consider the contractor to be the final consumer of those materials. However, there is an important exception for real property.

Real property is tangible personal property that is incorporated into a building or structure. The test for whether tangible personal property becomes real property is generally whether or not the property can be easily removed, or if it has become an integral and permanent part of the structure or building. An example of tangible personal property becoming real property is installing drywall into a building. Removing the drywall would damage the building, since the drywall becomes a permanent part of the structure. When you are buying materials that will be incorporated as a permanent part of the building or structure, you may be able to purchase these items exempt from sales tax. 

Sales Tax on Labor 

Most business owners understand that services are generally  exempt from sales tax. However, this can be a dangerous assumption for a contractor. While it is true that most states do not impose sales tax on services, some contracting services may be taxable while others are not. Even further, your role as the contractor and your customer may impact the taxability of the service. If your customer is a government agency, for example, you may be able to purchase certain items tax exempt. 

Sales tax laws can further differ by locality. As a contractor, you will have nexus in the state where you are performing the work, even if you are not physically located in that state. That means that both state and local tax laws apply, and you should be aware of state, city, and county level regulations. 

An example of differing state laws for contractors is charges for labor related to repairs or maintenance. The service of repairing a broken window or fixing a leaky faucet may be considered a taxable service in some states, and a nontaxable service in others. Usually, taxability depends on whether installation was involved, if tangible personal property was purchased to make the repair or perform the maintenance, and whether the tangible personal property was incorporated as real property during the repair or maintenance.3

Types of Contracts 

Another important consideration that can impact taxability is the type of contract between the contractor and the customer. There are two common types of contracts used: a lump-sum contract, and a time and materials contract. 

A lump sum contract is an agreement between the contractor and customer for a single price that includes both materials and labor. This type of contract may also account for the contractor’s overhead costs. With this type of contract, most states consider the contractor to be the end consumer and the party responsible for paying sales tax at the time of purchasing any taxable materials for the contract. The customer is usually not responsible for the sales tax due. 

In a time and materials contract, however, the contractor separately states the charges for labor and materials on the invoice. That way, the contractor can pass along the cost of sales tax to the customer for taxable goods or services, with a valid resale certificate.  

Subcontractors

Subcontractors have their own sales tax considerations, but their obligations generally depend on the agreement with the contractor. In some cases, the contractor may elect to take on the sales tax responsibilities themselves. In other cases, the subcontractors may need to pay the sales tax when applicable. Alternatively, a contractor could supply the subcontractor with the materials needed for the job, having already paid any applicable sales tax for those materials. 

For subcontractors, it is crucial to set forth clear expectations regarding the sales tax responsibilities at the beginning of the contract. 

Conclusion 

Although sales tax laws can always vary by state, the contracting industry is one particular industry in which sales tax laws change drastically by state. For example, South Dakota imposes a 2% excise tax on all contractors, despite exempting constructing services generally.4 Illinois, on the other hand, does not impose sales tax on labor or materials, as long as the materials are incorporated into the structure as real property.5

The vast differences in requirements for contractors by state can lead to mistakes, penalties, audits, and stress as a business owner. As always, it’s best to have an experienced tax professional on your side who can help you understand all of your obligations as a contractor. 

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1 https://www.bls.gov/ooh/construction-and-extraction/

2 https://www.avalara.com/blog/en/north-america/2021/10/can-your-business-spend-less-on-sales-tax-compliance.html

3 https://answerconnect.cch.com/topic/92752bfc7c76100091a6d8d385ad169402/installation-and-repair-and-sales-tax

4 https://dor.sd.gov/businesses/taxes/contractors-excise-tax/#:~:text=A%202%25%20contractor's%20excise%20tax,services%20or%20reality%20improvement%20projects

5 https://tax.illinois.gov/questionsandanswers/answer.149.html