Unlike the Federal income tax Washington’s tax system is not based on a uniform tax on net income derived from all sources: it is a gross receipts tax with rates dependent on what classification an activity fits into. Moreover, a business may perform several different activities which fall into different classifications, taxable at different rates, with some requiring the collection of sales tax and some not. For example, a business such as ours, the law business, provides a service, which is taxable at 1.5% of gross receipts, while a seller of footballs is classified as a retailer which bears a B & O rate of .00471% on gross receipts. If I practiced law and also sold footballs I would have income which falls into two different classifications, service and retail. If I mistakenly reported my football sales as service income an audit would reclassify my football income for the whole audit period from service (.015 of gross) to retail (.00471 of gross) and I would be entitled to a refund for overpaid B & O taxes. Sounds great. But because retail transactions require that I collect sales tax, I will owe sales tax for the audit period on all of the income reclassified from service to sales. Not so great.
While no part of my business is likely to be reclassified as retail because I don’t sell footballs, a recent DOR appeals decision (Det. No. 15-0135, 35 WTD 135, 2016) upheld an audit finding that reclassified a business’ income earned on an architectural/design contract from the service classification – the way such income is normally reported – to retail construction. And audit imposed retail sales tax – anywhere from 9-10% depending on the rate in effect at the time in the audit period and what locale the business worked in. This doubtlessly came as a shock to the business owner who likely will not, or cannot, seek reimbursement from his customers. Here’s what happened:
A business provided architectural design services for both commercial and residential projects, and also provided construction services from remodels to commercial construction. The majority of the taxpayer’s work related to residential and the taxpayer estimated to the Department that approximately half of its work is design work and half construction work. The auditor assessed retailing B&O and retail sales tax on income from design work on projects where the Taxpayer subsequently also provided construction services, relying on language in the design contracts that stated “It is anticipated that [Taxpayer] will also handle the construction phase of the project if the client so wishes and agreements and documents shall be provided to address that phase in due course.” In addition, the appeal noted that there were circumstances which arguably supported an intention that the taxpayer would do both the design and construction work notwithstanding that the customer was under no obligation to hire taxpayer to do the construction work, and that a separate contract would be required to do the construction work. Among other facts in its defense, the taxpayer provided a list of 25 projects, including work done after the audit period and including 13 projects where it performed only design work. For the remaining 12 projects, construction work started between 4 and 24 months after the design work.
The appeals decision cited a statute which provided that where the same person performs both contracts, a service contract (design) and a retail sale contract (construction) “shall not be combined and taxed as a single activity if at the time of the first contract or agreement it was not contemplated by the parties, as evidenced by the facts, that the same person would be awarded both contracts”. The appeal first noted that “The statute does not require a fixed agreement that both contracts are to be awarded to the same person, and specifically applies even when there are two separate contracts. Thus, the fact that the Taxpayer subsequently negotiated a separate contract for the construction work is not sufficient to segregate the two activities.” The issue is whether it was “contemplated” that the same person would do both the design and construction. The Department found sufficient evidence of “contemplation” stating as follows:
In this case, the facts available establish the requisite contemplation. The language in the design contracts provides evidence that the Taxpayer, doing both construction and design work, was contemplated by both parties, [particularly] the selection of the term “anticipated” . . . . Additionally, the manner in which the Taxpayer markets its services and emphasizes the benefits of consolidating architectural design work with the construction services, also indicates that both components of the work being performed by the Taxpayer is contemplated by the parties, because this capacity is used to promote the Taxpayer’s services and set them apart from other vendors…
We do not find that the varying length of time between when design and construction contracts are negotiated indicates that there was no contemplation the Taxpayer would provide both services. Neither does the fact that the Taxpayer does provide design only services negate the fact that the parties contemplate that the Taxpayer may provide construction services.
Accordingly, we sustain the Audit’s reclassification of the income at issue because there is evidence that the parties contemplated that the construction and design work would be performed by the same person, and this is sufficient to classify the design work as a retail service.
This was an almost impossible case for the taxpayer to win. First, the business was required to prove a negative – that it was not contemplated that taxpayer would do both legs of a project. It is famously difficult, if not almost impossible, to prove a negative, nor does the law set any particular level of proof which is required to negative “contemplated.” One would think that the absence of a binding agreement which provides for both architectural and construction services would suffice, but the term “‘contemplated” fairly suggests something between a mere possibility that the same person will perform both services and a binding contract for both services. In this case it is pretty clear to us that the business severely damaged its case by having a contract that said “it is anticipated that [Taxpayer] will also handle the construction phase.”
Second, appeals also emphasized that the business was marketing to clients that there were savings to be gained from its ability to do both a project’s design and build work. Unfortunately the exact marketing language was redacted in the Department’s written opinion, but we suggest that it will not take much evidence for the Department to rely on this point in the future.
Are there steps that a design/build firm can take to avoid having its design services collapsed into a subsequent building contract, all of which will be subject to retail sales tax? Open and competitive bidding for the constructive phase is advisable and possibly the best remedy and every effort has to be made to negate a present intention that a design contract is looking to a construction contract by the same person or entity. If advertising offers the option of combining the two services it must be clear that the customer is free to make its own determination as to choice of contractor and there should be no discounts involved if the customer chooses the designer as the builder. Businesses should consider, however, that the burden is on them to show that it was not “contemplated” that both jobs would be awarded to the firm.
Learn more about tax lawyer Martin Silver.