Why Installation Contracts Can Create Sales Tax Liability Posted on Oct 04, 2016
In California, all contractors face the possibility of a sales tax audit by the Board of Equalization (“BOE”). If a contractor is audited by the BOE, the main documents the BOE will use to determine if unpaid sales or use tax occurred are the contractor’s residential and commercial installation agreements. Unpaid taxes, including fines, can be assessed for up to three years, so the BOE reviews the contractor’s customer files over the past three years. According to BOE regulations, contractors pay on a “use” tax basis if they quality as “lump sum” (fixed priced) contractors. They must pay on a “sales” tax basis if they qualify as “time and material” contractors.
Unfortunately, BOE’s regulations are ambiguous and seemingly contradictory in defining the distinction between “lump sum” and “time and material” contractors. At a high level, the distinction is one in which a lump sum contractor provides a “package deal” that sets forth a lump sum price. A “time and material” contractor requires payment of the actual cost plus any markup by the contractor for the actual cost of materials and labor needed to complete the work.
Many contractors think they qualify as lump sum contractors, but they do not because of how their installation agreements are written.
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During a sales and use tax audit, the BOE reviews the contractor’s installation agreements to determine if the contractor correctly classified itself as a lump sum contractor, and thus it was not required to remit sales tax. A three year statute of limitation applies to the BOE’s ability to collect taxes, so all contracts dating up to three years back will be subject to their review.
If the BOE determines the contractor should have been paying sales tax instead of use tax, the BOE will order the contractor to pay sales taxes and penalties on all jobs completed over the past three years.
The main factor that the BOE looks at during a sales and use tax audit is whether or not any installation agreements contain sections that break out costs for different parts or labor. The BOE has determined that a simple subsection in installation agreements including a cost break out which itemizes each item included within the total contract price is enough to trigger sale taxes obligations.
This means contractors should pay special attention to how their installation agreements are written. Any contracts that a contractor has with cost breakouts for components and/or labor could subject the contractor to liability for failure to remit sales tax. Of note, change orders and invoices that show price breakout by component after the agreement is signed do not disqualify a lump sum contractor. Tax law is arcane.