Contractors: Are You a Victim of the Infamous Texas Sales and Use Tax "5% Test"?

Among the many administrative rules and policies that taxpayers must often contend with is the Texas Comptroller’s 5% test. It comes up in different contexts and, when an auditor mentions this test, it often results in an assessment of Texas sales or use tax. Generally, the so-called 5% test creates a presumption of taxability when both taxable and nontaxable items are sold for a single charge. The threshold for its applicability is quite low at 5%, making it easy and convenient for the Texas Comptroller to invoke it. But there may be a legitimate question in many cases as to whether the Texas Comptroller can properly apply it and whether its application contradicts existing case law.

At a very general level, the Texas Comptroller’s 5% test provides that where taxable and nontaxable services are provided for a single (i.e., lump-sum) charge the entire amount is presumed taxable if the taxable portion exceeds 5% of the total price. See, e.g., 34 Tex. Admin. Code §3.357(b)(3). The burden then lies with the taxpayer to show the percentages of the total charge that relate to taxable services and to nontaxable services. See id. §3.357(b)(9). In practice, what this often means is that if the Texas Comptroller’s office believes any portion of a single charge includes some level of taxable services, they will generally assess tax on the entire amount and leave it up to the taxpayer to prove the amounts attributable to nontaxable services.

The 5% test exists in several different areas of the Texas Comptroller’s administrative rules, but most notably for contractors, in the context of improvements to real property that include both taxable and nontaxable work (e.g., a contract that includes both new construction and remodeling work). See 34 Tex. Admin. Code §3.357(b)(3). The potential difficulty with this rule for taxpayers, however, is evident in how it has been applied. For example, while the Texas Comptroller may consider the installation of a new pipeline to be new construction, the point at which it connects to an existing pipeline the Texas Comptroller views as nonresidential repair and remodeling. See, e.g., Comptroller Ltr. Rul. 202104045L (April 21, 2021). As such, if these amounts are not separately stated, the entire amount could be presumed taxable by the Texas Comptroller under the 5% test. See id. While this presumption can be overcome through documentation, in many cases it can be difficult or time consuming for taxpayers to show what portion of a total charge pertains to different aspects of a project, and disagreements with the auditor can often arise.

There is at least a question as to whether the Texas Comptroller can create a presumption where one is not provided for in the Texas Tax Code, especially where it might contradict established case law. Texas case law has generally stated that ambiguities in law regarding the taxability of services are resolved in favor of taxpayers. In one case, for example, the Austin Court of Appeals stated that where an issue concerns the taxability of services, viz, “whether a taxpayer is subject to tax in the first instance … [court’s] apply ‘an ancient pro-taxpayer presumption: The reach of an ambiguous tax statute must be construed ‘strictly against the taxing authority and liberally for the taxpayer.’ In other words, a tax must apply unequivocally.” Allstate Ins. Co. v. Hegar, 484 S.W.3d 611,616 (Tex. App.—Austin 2016). By creating a presumption of taxability using such a low threshold, such that it is satisfied essentially automatically in practice, there may be a question as to whether this 5% rule undermines this “pro-taxpayer” judicial presumption of nontaxable services.

In addition, there may also be a question as to whether the underlying activities should be viewed as separate services for Texas sales/use tax purposes or as part of a single overall service. In such instances, the “essence of the transaction” test created by Texas courts may apply. Under that test, the taxability of a single charge that includes both taxable and nontaxable items focuses on the essence of the transaction – was the essence of the transaction a taxable or nontaxable service? In one case, for example, the Houston Court of Appeals [14th District] held that online bill pay services provided by a taxpayer to bank customers were not taxable as data processing services because, to the extent data processing services were included, they were ancillary to the nontaxable bill pay services. See Hegar v. CheckFree Services, 2016 WL 1576414 (Tex. App.—Houston (14th Dist.) 2016, not pet.).

In different situations, therefore, legitimate questions may exist as to whether the Texas Comptroller’s 5% test, which focuses on percentages rather than the essence of the transaction, contradicts the above line of cases. For example, should a contract for the installation of new pipeline that includes connection to an existing pipeline be viewed as a single contract for a new pipeline with the connection work being simply ancillary work under the essence of the transaction test and therefore potentially nontaxable if billed on a lump sum basis?

Notably, a recent decision by the Texas Supreme Court calls into question the application of the Texas Comptroller’s rules in district court litigation and could therefore also become relevant in this context. In particular, the Texas Supreme Court recently noted that “The very first section of the Comptroller’s rules … limit[s] the matters subject to the rules to ‘contested case proceedings that may be referred to the jurisdiction of [the State Office of Administrative Hearings.]’”. See GEO Group, Inc. v. Hegar, 709 S.W.3d 585, 590 (Tex. 2025). The Court went on to state that a taxpayer suit brought after all administrative remedies had been exhausted cannot be referred to the State Office of Administrative Hearings. See id at 591. While the full extent of this holding’s application remains to be seen, it could signal a potential strategic benefit to filing a lawsuit in district court when the applicability of a Texas Comptroller rule, such as the 5% test discussed above which is set out in several Comptroller rules, is at issue.

The Texas Comptroller’s use and application of the 5% test can cause significant issues and potentially result in unexpected tax assessments for taxpayers under audit. Taxpayer should be aware of the Texas Comptroller’s use of this test and that there may be a legitimate question regarding the many instances where the Texas Comptroller relies on the 5% test to assess Texas sales or use tax.

If you have questions regarding the information disclosed or on any other State tax related matter, please contact David Colmenero at dcolmenero@meadowscollier.com or Alex Pilawski at apilawski@meadowscollier.com. To contact them by phone, please call 214.744.3700.