The Lump-Sum Versus Separated Dilemma in Texas Sales and Use Tax

One of the most common issues we see in the context of the contractor rules for Texas sales and use tax purposes has to do with whether a contract should be viewed as a lump-sum or separated contract. The difference can have significant consequences because the rules that apply to lump-sum contracts are largely polar-opposite to those that apply to separated contracts and vice versa. The consequence of mislabeling a contract or having the Texas Comptroller challenge a taxpayer’s treatment of a contract as either lump-sum or separated can have significant consequences.

As a general matter, a contractor performing work under a lump-sum contract, as defined in Comptroller Rule 3.291, is not generally required to collect tax from its customers on any part of the sales price but is required to pay tax on the purchase of materials, consumable items, equipment and taxable services that are either used by the contractor or incorporated into the customer’s property. See 34 Tex. Admin. Code § 3.291(b)(3)(A). By contrast, a contractor under a separated contract is required to collect tax on the charge for materials incorporated into the real property and taxable services sold to a customer but generally not on labor and may also purchase materials and the taxable services resold tax free. See 34 Tex. Admin. Code § 3.291(b)(4)(A), (C), (D). Also, as a general matter, a lump-sum contract is one where a charge to a customer is stated as a single amount, inclusive of all labor and materials, whereas a separated contract is one where the charges for labor and materials are separately stated. See 34 Tex. Admin. Code §§ 3.291(a)(8); 3.291(a)(13).

Disputes can and do arise between taxpayers and Texas Comptroller auditors over whether a contract should be viewed as lump-sum or separated. One such situation occurs where a taxpayer treats a contract as a separated contract and collects tax from its customer on at least part of the sales price, but the auditor views the contract as a lump-sum contract. In that instance, the auditor would assess tax on the materials purchased tax free without any reduction for tax collected from customers. See 34 Tex. Admin. Code § 3.291(b)(3)(A). The potential inequity in this result from an economic perspective should be quite evident as it effectively results in the State receiving tax on both ends of the transaction (i.e., the purchase and sale of materials). But the Texas Comptroller considers tax collected from customers to be a trust fund tax that must be either turned over to the State or refunded to customers if collected in error. See id. In some cases, however, it may be possible to offset the amount of tax assessed on purchases by the amount of tax remitted by the contractor to the Texas Comptroller for the sale of materials, including for instance, (i) where the contractor’s customer assigns its right to refund to the contractor, (ii) the contractor first refunds or credits amounts collected in error to its customer or (iii) where the contractor can show that it did not in fact collect the amount of tax paid to the Texas Comptroller from its customers (i.e. the contractor paid the tax itself).

Another such situation occurs where a taxpayer treats a contract as a lump-sum contract, but the auditor claims the contract is in fact a separated contract. In that instance, the auditor would assess tax on the sales price for the materials but should reduce it by the amount of tax erroneously paid on the purchase of those materials. See 34 Tex. Admin Code § 3.291(b)(4)(C). Essentially, the taxpayer would owe additional tax on the markup of the materials charge. See id. While this may not be as egregious as the former scenario, it could still result in a substantial assessment. Arguably, if there is a question as to whether a contract should be viewed as either lump-sum or separated (and no tax has been collected by the contractor from its customer), treating it as a lump-sum contract may create the least amount of potential exposure.

The effect of having the State challenge the treatment of a contract as either lump-sum or separated can be quite significant from a tax perspective. Many contracts for the improvement of real property are large-dollar transactions negotiated with only small profit margins, especially in highly competitive markets. When an auditor assesses tax at a rate of up to 8.25%, the resulting amount if upheld cannot only be quite large but can also reduce or possibly even eliminate a contractor’s profit entirely. Likewise, a buyer who receives an assessment may be faced with a substantial additional amount owed to the State with little to no recourse against a contractor.

Because Texas Comptroller auditors tend to take positions most favorable to the State, there is a high likelihood that if a contract can be viewed in a manner that results in an assessment, that is how the auditor will want to construe it. But just because an auditor views a contract in one particular manner does not mean he or she is correct. Construing a contract often involves complex questions of both fact and law.

For these reasons, legal counsel often is and should be involved in challenging the State’s characterization of legal documents including contracts and particularly when questions arise as to whether a contract should be viewed as lump-sum or separated. The earlier in the process that legal counsel becomes involved, the more likely they can help develop and implement a legal strategy that provides the greatest likelihood of success. Perhaps equally important, legal counsel should be involved in drafting the contracts to avoid or at least minimize the likelihood of these issues arising in the first instance.

Whether you or your client are in the process of drafting a contract or want to challenge an assessment or refund claim denial by the Texas Comptroller, our dedicated team of highly experienced legal professionals stand ready to provide the appropriate legal representation and services.

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.