How to handle sales tax as a contractor

Sales tax is one of the most confusing parts of running a contracting business. The rules for contractors are different from the rules for stores, and they differ from state to state. The same kitchen remodel can be taxed three different ways depending on where the house is.

This guide:

• Explains the general concepts that apply across states
• Shows a worked example of how the same job comes out under different rules
• Lists the questions to answer for your own state

It does not give state-specific rules. Check your state's department of revenue, and talk to a tax professional, before you set up how you charge tax.

Why sales tax is different for contractors

Installed materials become part of the building

A store sells a product and charges tax on the sale. A contractor buys products, installs them, and often turns them into part of a building.

Once a tile is set in mortar, it is no longer a product you sold; it is part of the real property.

Four things decide who pays the tax

States answer the question "who pays tax on that tile, and when?" in different ways. The answer usually depends on:

• Whether the work is an improvement to real property (a new bathroom, a deck) or a repair or service to tangible property.
• Whether the state treats the contractor as the consumer of materials or as a retailer reselling them.
• Whether the state taxes the labor or service itself.
• How the contract is written: one lump-sum price, or materials and labor listed separately.

The two basic models for materials

Contractor as consumer: pay tax when you buy

In many states, a contractor doing improvements to real property is treated as the final consumer of the materials. You pay sales tax when you buy them, and you do not charge sales tax to the client on the invoice.

The tax you paid is a cost of the job, built into your price like any other material cost.

Contractor as retailer: charge tax to the client

In other states, or for some types of work, the contractor is treated as reselling materials to the client. You:

• Buy materials without paying tax by giving the supplier a resale certificate
• Charge sales tax to the client on the materials
• Send that tax to the state

Some states mix the two models

Some states use different models for different kinds of work, for example one for new construction and another for repairs. Others treat lump-sum and separated contracts differently. That is why the exact type of job matters.

Is labor taxable?

Labor on improvements is often untaxed

Many states do not tax labor on improvements to real property. Some tax certain services, including some repair, maintenance, installation or construction services. A few states tax a broad range of services.

Definitions decide which labor is taxed

If your state taxes some labor, the distinction often comes down to definitions: what counts as a repair versus an improvement, or installation versus construction.

Those definitions are where the state's published guidance for contractors is essential reading.

Worked example: one job, three tax treatments

Example: A small project has $2,000 of materials at cost and $3,000 of labor. You mark materials up 15%. The combined state and local sales tax rate where the job is located is 7% in this example.

Your state's rate and rules will differ.

Treatment 1: contractor pays tax on materials

You pay 7% tax when you buy materials: 2,000 × 0.07 = $140. Your materials cost is $2,140, and with your 15% markup that is 2,140 × 1.15 = $2,461.

Treatment 2: contractor charges tax on materials

You buy materials tax-free with a resale certificate, so your cost is $2,000, and with markup the materials price is 2,000 × 1.15 = $2,300. You charge 7% on the materials price: 2,300 × 0.07 = $161.

Same total for the client, different paperwork

The client pays the same total as in treatment 1, because 2,000 × 1.07 × 1.15 and 2,000 × 1.15 × 1.07 are the same number. What changes:

• Who sends the tax to the state
• How much: here $161 instead of $140, because tax is charged on your marked-up price
• What records you keep

Treatment 3: the whole job is taxable

If your state taxes this kind of work in full, labor included, and you buy materials for resale:

The checks: 2,300 + 3,000 = 5,300, and 5,300 × 0.07 = 371, for a total of 5,671.

Getting it wrong costs you either way

Same job, same costs: $5,461 or $5,671 to the client, and three different sets of paperwork. Getting the treatment wrong in either direction is a problem:

• Tax collected when it should not have been generally has to be refunded or sent to the state.
• Tax not collected when it should have been is usually owed by you, often with penalties and interest.

The sales tax calculator works out the tax and total once you know the rate and what is taxable.

Use tax

You owe use tax when no sales tax was charged

Use tax is the companion to sales tax. If you buy taxable materials or equipment without paying sales tax and use them in your state, you generally owe use tax to your state at the same rate. For example, an out-of-state online seller may not have collected it.

Report it on your sales tax return

If you are registered for sales tax, use tax is usually reported on the same return. If you are not, your state will have its own way to report it.

Resale purchases you use yourself owe it too

Use tax also comes up when you buy materials tax-free with a resale certificate and then use them yourself instead of reselling them. One example is a job where your state treats you as the consumer. In that case, you owe use tax on those materials.

Resale and exemption certificates

A resale certificate covers only what you resell

A resale certificate lets you buy materials without paying tax, because you will charge tax when you resell them. It is only valid for purchases you actually resell in a taxable transaction.

Using one on materials you consume, where your state treats you as the consumer, can lead to back taxes, interest and penalties.

Keep every client's exemption certificate on file

An exemption certificate comes from your client to show the job is exempt. Clients who may give you one include:

• A church
• A school
• A government agency
• Another exempt organization

Keep a copy on file for every exempt sale. Without it, an auditor may treat the sale as taxable.

Questions to answer for your state

Before you set up how you charge tax, find answers to these questions in your state's guidance for contractors, or from a tax professional:

1. Do I need a sales tax permit or registration? (The guide to starting a contracting business covers the other registrations.)
2. On improvements to real property, am I the consumer of materials or a retailer?
3. Does that change for repairs, maintenance or installation of fixtures?
4. Is any of my labor or service taxable?
5. Does writing a lump-sum contract versus separately stated materials change anything?
6. Which local rate applies: where my business is, or where the job is?
7. How often do I file, and what records do I keep?

Read your state's guidance for contractors

Your state's department of revenue usually publishes guidance written specifically for contractors. It is worth reading in full once, and again when the rules change.

Local rates

Rates stack, so they change job to job

Sales tax rates often combine several rates, so the rate can change from one job to the next:

• State
• County
• City
• Special district

The job's location usually sets the rate

For jobs where you charge tax, rules usually tie the rate to where the work is delivered or performed, not where your office is. Check your state's rules. A job across a city line can have a different rate from the one next door.

Showing sales tax on estimates and invoices

Whatever your state's rules, be consistent on your paperwork:

• If you charge tax, show it as a separate line on the estimate and the invoice, with the rate. The client should see the same tax treatment on both.
• If you pay tax on materials and do not charge it, do not add a tax line. The tax you paid is part of your materials cost.
• If a client is exempt, get the exemption certificate before you invoice, and note the exemption on the invoice. An invoice generator or invoice template lets you show or leave out the tax line.

The invoicing guide covers the rest of what an invoice needs. The glossary entry on sales tax on materials gives the short version of the consumer-versus-retailer question.

Records to keep

Sales tax audits can look back several years, and the burden is on you to show why tax was or was not charged.

Keep these records by job

• Supplier receipts showing whether you paid tax on materials
• Copies of resale certificates you gave suppliers, and exemption certificates clients gave you
• Signed estimates and invoices showing how tax was handled
• Your filed returns and payment confirmations

File them so you can answer fast

Store them where you can find them by job and by date. An auditor's request that takes you a week to answer is a worse experience than one you can answer in an afternoon.

Common sales tax mistakes

• Copying another contractor's setup. Their state, trade or type of work may be treated differently from yours.
• Using a resale certificate on materials you consume. It saves tax today and creates a bill later.
• Forgetting use tax on online or out-of-state purchases where no tax was charged.
• One rate for every job. Local rates vary, and the job's location usually decides which applies.
• Spending collected tax. Money collected as tax belongs to the state. Move it to a separate account when the client pays.

Pricing with sales tax in mind

Tax you pay is part of material cost

If you pay tax on materials as the consumer, the tax is a real cost. Price materials at the cost you actually pay, tax included, before applying markup, the same way the pricing guide treats every other cost.

Example: In treatment 1 above, ignoring the $140 of tax would have priced the job $161 too low after markup.

Tax you collect is not profit

If you charge tax to the client, keep the tax out of your profit math: it is the state's money passing through your account. Set it aside when the client pays, so it is there when the return is due.

Sales tax in BuildWell

Set your rate once, change it per job

In BuildWell, you set your sales tax rate once in your settings. It applies on your estimates and the invoices made from them. You can change it on any single estimate, for a job in a different city or an exempt client.

Your state's rules decide what's taxable

BuildWell does not decide whether a job is taxable in your state. That is a question for your state's rules and your tax advisor.

Unsure? Ask the state in writing

If you are unsure about a job, ask before you invoice. Many state revenue departments answer written questions from businesses. A short written answer is worth more than a guess when an auditor asks why the job was taxed the way it was.

The short version

Sales tax for contractors depends on your state, the type of work and how the contract is written. In some states you pay tax on materials and charge none; in others you charge it; a few tax labor too.

To get it right:

• Find your state's guidance for contractors
• Answer the seven questions above
• Keep your certificates on file
• Handle tax the same way on every estimate and invoice