Who is Subject to the Texas Sales and Use Tax Contractor Rules and Why Does it Matter?

Taxpayers are often surprised to learn they may be subject to the “contractor” rules for Texas sale and use tax purposes and sometimes learn of this only after hearing from a Texas Comptroller auditor. Before one can consider the implications of the “contractor” rules in Texas, which can be technical and complex, one must necessarily understand who is subject to those rules. In addition to avoiding the many potential pitfalls, understanding whether and how these rules apply can also provide the necessary ammunition for potentially challenging an assessment of tax or refund claim denial.

As an initial matter, it may come as no surprise that the “contractor” rules apply to “contractors.” A “contractor” at a very general level is defined by Texas Comptroller Rule 3.291(a)(3) as a person who makes an improvement to real property in the context of either (i) new construction work, (ii) residential repair or remodeling work, or (iii) maintenance. Each of these terms is likewise defined in the Texas Comptroller’s Rules, and these definitions do not always track the general industry understanding. See 34 Tex. Admin. Code §§ 3.291(a)(3). As an example, the term “maintenance” is limited to work that is performed on a “scheduled” and “periodic” basis, which are terms that are also specifically defined. See id. § 3.357(a)(7). Some of these more nuanced concepts are considered more fully in future blog posts we will provide in this series. Suffice it to say that each of these concepts has engendered considerable litigation, given that in many instances there are legitimate questions as to whether a particular taxpayer’s work falls within one or more of these terms.

While persons falling within the above definition of a “contractor” are clearly subject to the “contractor” rules, there are persons who perform similar work but are expressly excluded. Perhaps the most evident are persons who perform “nonresidential” (i.e., commercial) real property repair and remodeling work. See 34 Tex. Admin. Code §§ 3.291(a)(3); 3.357. Likewise, persons who provide “real property services” as defined by statute are similarly excluded from the contractor rules as they are subject to a separate set of rules. See 34 Tex. Admin. Code §§ 3.291(a)(3); 3.356. In addition, a person who sells and installs tangible personal property, but does not install it in a manner that renders it an improvement to real property is generally excluded from the definition of a contractor. See 34 Tex. Admin. Code §§ 3.291(a)(6); 3.347(b). In these three instances, 100% of a taxpayer’s charge for their services is generally considered taxable. See id §§ 3.356(b), 3.357(b)(2); Tex. Comptroller Tax Policy News (Aug 2018) Access No. 201808031N. By contrast, part or all of the amount charged by a “contractor” may be nontaxable, depending in part on whether a contractor bills on a lump-sum or separated basis. See 34 Tex. Admin. Code § 3.291(b)(3), (4). These are all necessarily general concepts, as there are exceptions that apply in certain instances.

So, consider if you will some potential implications of failing to properly apply the “contractor” rules. Among other things, if a taxpayer were to collect tax on a lump-sum charge to a customer but did not pay tax on its purchase of materials when in fact they should have done the opposite under the contractor rules, they would be faced with an assessment of tax on purchases with no offset for tax collected from customers in the event of an audit. This may occur, for example, where a taxpayer believes they are engaged in repair and remodeling work when in fact they are performing new construction work, or where a taxpayer believes they are selling and installing tangible personal property when in fact they are making an improvement to real property. It could also occur where a taxpayer believes they are providing a real property service when in fact they are engaged in new construction work. There are many other situations with potentially similar consequences as well.

To further complicate matters, there are instances where a taxpayer may be performing work that only partially falls under the contractor rules. For example, the Texas Comptroller has taken the position that, while laying new pipeline may qualify as new construction work, connecting the new pipe to an existing pipe constitutes repair and remodeling work. See, e.g., Comptroller Ltr. Rul. 202104045L (April 21, 2021). Where the latter is taxable, the Texas Comptroller has also adopted the infamous “5% rule”, under which a single charge for both taxable and nontaxable work is considered fully taxable if the taxable portion of the charge is not separately stated and exceeds 5% of the total charge. See 34 Tex. Admin. Code §§ 3.356(i)(2); 3.357(b)(9). While this presumption is rebuttable, it creates an additional potential stumbling block for many taxpayers. There are many instances where a taxpayer may legitimately question whether the Comptroller can apply or has properly applied the 5% rule.

Some key issues that arise in determining whether the contractor rules apply to a taxpayer for Texas sales and use tax purposes include:

Given the complexity of and often very factual nature as to how these rules may apply, taxpayers and tax practitioners should keep in mind that there are often one or more ways to challenge a position an auditor has taken either in audit, investigation or refund claim denial. If you find yourself confronted by an actual or potential assessment or refund denial by the Texas Comptroller involving these or any other issues, give us a call, shoot us an email, or even go full 1980s by sending a fax—we are always here to help. You can reach David Colmenero by email at dcolmenero@meadowscollier.com and Alex Pilawski by email at apilawski@meadowscollier.com. The firm’s main phone number is 214.744.3700 and the firm’s fax number is 214.747.3732.