Trades involved in the construction industry have to abide by a complex set of rules if they are working on a building project in California, particularly if the contractors or subcontractors are from out-of-state.
Contractors in particular, have to be aware of how they invoice clients for materials procured for the project so that they are in compliance with California’s sales and use tax regulations.
Manufacturers must determine whether raw materials they purchase are to be used in creating a product or another purpose and if they are crossing California’s state line from other states. Purchases will also depend on whether or not the sale is subject to sales or use tax. Raw materials that are obtained outside the state may or may not be taxed, depending on what they are being used for and where the sale of the goods.
Service businesses also can be taxed based on whether or not the service was performed in California. There is more flexibility with the provision of “pure” services, whereas services provided as part of a sale, (e.g., training for a new software package) is considered taxable.
Before you sign any type of construction, manufacturing or service provider contract, give me a call. These types of contracts can get convoluted and if you are not careful, you will have the CDTFA knocking at your door to collect sales or use tax.
My firm has plenty of experience working with small businesses in California and helping them safely navigate the minefield of sales and use tax regulations.
Taxation of Construction Companies, Contractors, and Subcontractors in California
Businesses in the construction industry have various avenues through which they may be taxed as their transactions often involve the use of various personnel (contractors, subcontractors, suppliers, to name a few) and various types of property (all of the real, tangible and intangible varieties).
As with any transaction, the method of invoicing and wording of the contracts all can have an impact on what the state may ultimately deem taxable income. While a drafting and/or review of the contractual provisions by a trained attorney will best help you mitigate any risk of inadvertent tax underpayment, here are a few key points to keep in mind:
- Tax should not be stated as a separate charge, as doing so may prevent the contractor from being able to claim the tax as a pass-through reimbursement. You do not want to unnecessarily pay taxes on installation labor and other overhead costs simply by making a mistake in your invoicing process.
- The intention for which the parties entered the contract is what will govern its taxability. Therefore, the question of when title has passed from the customer to the contractor is important to determine who bears the responsibility of paying the applicable taxes.
- With some exceptions, contractors are responsible for remitting taxes for the cost of their materials. Cal. Code Regs., tit.18 § 1521 (b)(2)(A)1. California defines the word “materials” to mean “construction materials and components, and other tangible personal property incorporated into, attached to, or affixed to, real property by contractors in the performance of a construction contract and which, when combined with other property, loses its individual identity to become an inseparable part of real property.” Cal. Code Regs., tit.18 § 1521 (a)(4).
- Contractors may not purchase tangible property for resale unless they are in the business of selling such property. The CDTFA will aggressively pursue those who do not remit the proper use or sales tax and those who improperly use resale certificates. Therefore, contractors thinking of using resale certificates must be certain that their business activities warrant their use.
- The type of contract you enter into — whether it be a lump sum, time and material or cost plus a fee contract — will impact the timing and method for which you will calculate your tax liability.
- In general, contractors working on construction projects exclusively with the U.S. government do not have to register for a seller’s permit.
If you work in the construction industry, there will be many more details to take into account in carrying out your tax compliance plan. However, there is no need to guess or go off your memory regarding the various taxation rules.
Along with working with a professional, refer to the CDTFA’s Tax Guide for Construction Contractors. The CDTFA gives extensive information on the above mentioned topics as well as the topics of record keep, fixtures, district taxes, machinery and much more.
Taxation of Manufacturing Companies
Manufacturing: Manufacturers are involved in the creation of tangible products which may go through various steps of processing before they are ultimately sold to a retailer. In many instances, the product will be manufactured in one jurisdiction and sold in another. Here are some scenarios that manufacturers may encounter and the potential tax consequences for each of them in the California:
Purchases: Manufacturing companies must be aware that the taxability of any purchase that they make will depend upon the use of that item. In general, if a product is being purchased as raw material that will be used for the creation of a product, those raw materials will not be taxable. (Business Taxes Law Guide-Revision 2020, Article 3, Regulation 1525(b)). On the other hand, other materials purchased that will be used for purposes other than as raw material will generally be taxable.
Alterations: Whether or not taxes may be paid for the alteration of a product will depend in part on whether the alterations are being done for a consumer who has already purchased and used the item or whether they are being done for an entirely new item. While alterations for used items are not subject to taxation, alterations of new items are. (Business Taxes Law Guide-Revision 2020, Article 3, Regulation 1524(b)).
Resale Certificates Seller’s Permits: Resale certificates are used for businesses who plan on purchasing any taxable items for resale to avoid double taxation on that item. Seller’s permits are necessary for businesses selling or leasing taxable, tangible personal property.
Their applicability to manufacturers will depend on what types of products are being created and what they are used for when sold. For example, some manufacturers may not sell finished products that are ready to be sold to consumers at retail stores.
Rather, such manufacturers may be in the business of selling components of products to other manufacturers who eventually piece the finished product together.
If your business provides manufacturing services of this variety, it most likely will not need to obtain a seller’s permit. On the other hand, if you are selling manufactured items directly to retailers, a seller’s permit will be necessary. In situations where a retailer is purchasing from a manufacturer, the manufacturer can collect a certificate of resale from the retailer.
By doing so, the manufacturer seller will not owe taxes on the sale and instead, the sales tax will be properly collected by the retailer when the item is sold to a consumer.
Exemption for Manufacturing and Research and Development Equipment
In California, manufacturers may take advantage of partial use and sales tax exemptions on certain qualifying tangible personal property used within their business.
Although the exemption has various criteria for qualification, machinery and various devices used to control machinery may qualify for the exemption.
The current exemption percentage is 3.9375 percent. To learn more about which entities and items qualify for the exemption, closely review the guidelines provided by the CDTFA .
Taxation of Service Companies in California
For out-of-state services companies, the answer to the question of whether their work will be considered taxable will be entirely dependent on the jurisdiction in question, as certain jurisdictions will tax some types of services while not taxing others.
In general, California limits the imposition of sales and use taxes to transactions that involve the use or sale of tangible personal property. Furthermore, whether you will owe taxes on services can depend on whether you are purely providing a service or if you are providing a service that is incidental to a tangible good you are selling.
California will impose taxes on on-of-state service providers, even when none of the services were performed from within the state or were accompanied by the sale of tangible property.
The law also addresses various other scenarios to determine whether a corporation, profession, business, sole proprietorship or other entity owes California taxes.
If your services business is conducted in any manner within the state or with a California entity, you will need to work with an attorney to determine the applicability of the law to your specific scenario.
With or without exchanging a tangible item with another person or entity in California, if you derive income from within the state, you can expect that California may have a law in the books to allow for the taxation of that income. (18 CCR § 17951-4(c)).
Services Accompanied by the Use or Sale of Tangible Property
Sometimes, services are provided in conjunction with the sale of a tangible product. For example, an office desk may be sold and assembled for the customer for an additional fee. The “true object” test is one of a few tests commonly applied across various jurisdictions to determine whether a service can be divorced from the tangible property by which it is accompanied.
The “true object” test aims to answer the question as to whether the service is incidental to the receipt of the tangible property or otherwise. The CDTFA defines the “true object” test to be an inquiry as to whether the purpose of the transaction is to receive the service or a tangible item produced by the service with which it is accompanied. (Business Taxes Law Guide, Annotation 515.0020).
Why Are Out-of-State Companies Taxed in California?
California loves to collect sales and use taxes and manufacturers, contractors and service businesses are not wholly exempt. However, some circumstances may qualify a business for tax exemption, for instance, if the materials or production are being used for R&D purposes.
Further complicating the tax issues is if personnel or raw materials come from out-of-state. In those cases, the seller may be subject to sales and use tax. Another variable is at what point in the supply chain that the title passes from the manufacturer or contractor to the consumer.
The same out-of-state tax rules apply to service businesses. Taxation depends on where the service was performed and whether or not it was in conjunction with the purchase of a product.
As you can see, taxation on these industries is complicated. That is why it is important to have an experienced attorney review any contracts you plan to sign. I can help you figure out whether or not the transactions are subject to sales and use tax and at what percentage.