FEATURE ARTICLE, OCTOBER 2004

TAX ISSUES CONTRACTORS SHOULD KNOW ABOUT
Increased audit activity could mean a decreased bottom line for contractors.
Dan Bartholet

Bartholet

State budget deficits are affecting contractors’ bottom lines — maybe without them being aware of it. According to the Center on Budget and Policy Priorities, some 30 states are projecting budget deficits for fiscal year 2005 for between $39 billion and $41 billion.

These deficits are causing state and local governments to increase audit activity, and, as a result, it is becoming increasingly important for contractors to consider state and local tax rules when bidding and performing construction projects.

Understanding Basic Tax Issues

State and local taxing authorities impose a variety of taxes. Typically, these include income, sales and use, withholding, unemployment, real and personal property taxes. Because the rules related to the imposition and administration of these taxes vary between the states and localities, compliance difficulties and audit issues often arise.

Contractor License

Most states require contractors to be licensed before performing any in-state activities. The type of licensure required often varies between the states. For example, a certification license in Florida authorizes a contractor to work statewide with no county licensure required. In contrast, a Florida registration license allows the company to provide contracting services only in the county where it is registered.

As part of the licensing process, the applicant may be required to pass a contractor’s examination. Some states will waive the exam requirement if the contractor is licensed in another state. In addition, states often require the contractor to post a surety or cash bond for certain construction projects.

Corporate Income, Franchise and Excise Tax

Many states impose a tax on the income received from construction services performed in the state. This tax is imposed on the income apportioned to the state, which is generally determined via a three-factor formula. The calculation of a state’s corporate income tax begins with the business’ federal taxable income. This amount is modified and then apportioned to the state based on the three-factor formula. The resulting state taxable income is then multiplied by the state tax rate to determine the tax liability. However, certain states provide special rules for calculating the factors used to apportion a contractor’s income.

Some states, such as Mississippi and South Dakota, base the tax calculation on the contractor’s gross receipts. In these states, the contractor is not allowed a deduction for the cost of the property sold, the cost of materials used, the cost of services or labor, or any other expenses or losses. Generally, the tax on gross receipts can be passed to the customer.

In addition, states may also impose a franchise or net-worth tax based on the company’s issued capital stock, paid-in surplus and retained earnings. As with corporate income taxes, franchise or net-worth taxes are apportioned to the state based on the three-factor formula.

Sales and Use Tax

Most states consider contractors the consumers of all tangible personal property used in the performance of real property contracts. As the consumer, the contractor must pay the state and local sales or use tax on such items. Generally, these taxes may be passed onto the customer in the contract bid price.

Mississippi is one of a handful of states in which contractors are not taxed as consumers of items used in fulfilling real property construction contracts. Instead, contractors are treated as retailers who purchase materials tax free for resale and collect tax on the basis of their gross receipts. In Nebraska, contractors may choose from three methods of paying sales and use tax. The contractor can be treated as a retailer, as a consumer, or as a consumer that maintains a tax-free inventory of materials and fixtures.

The taxability of purchases by contractors who have contracts with exempt organizations or governmental units also varies by state. In Minnesota, contractors may be designated as the purchasing agent for the exempt entity or governmental unit, allowing the contractor to purchase building materials tax free. For the purchasing agent designation to be valid, however, the contract with the exempt entity or governmental unit must contain certain provisions. Likewise, in South Dakota contractors with governmental units may be designated as purchasing agents, exempting purchases of materials from tax. As in Minnesota, the South Dakota law requires that the contract with the governmental unit contain specific provisions appointing the contractor as purchasing agent.

State Withholding/Unemployment Tax

Most states that impose an individual income tax require contractors to withhold income tax on the wages of employees that perform services in the state, but a number of states engage in reciprocal agreements allowing the contractor to elect the state of withholding.

In addition, contractors must fulfill unemployment insurance filing requirements unless the state participates in a reciprocal coverage agreement that allows the contractor to elect the state of unemployment insurance coverage.

Tangible Personal Property Tax

A property tax may be assessed on supplies and equipment brought into a state or purchased in state to perform construction services. For some states, the length of the contract period may determine whether a property tax is imposed. In Nebraska, for instance, equipment and supplies brought into the state will be assessed if the contractor has possession of the items in the state for more than 6 months.

When contractors bid on a construction project, they need to keep in mind the various state and local taxes with which they have to comply. And contractors should consult a local tax professional if they have any questions about how a particular tax may affect them.

Dan Bartholet is director of state and local taxes in the Minneapolis office of Grant Thornton LLP.

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