How the money runs can alter whether a payment that is ordinarily not subject to retail sales tax becomes subject to the tax. Architecture and design fees, for example, are normally classified for B & O purposes under the service classification and service providers do not have to collect retail. But where, for example, a custom boat builder who must charge sales tax on its contract pays the bill of third party service parties in the course of the builder’s work for the customer, the service fees may be deemed non-deductible expenses of the boat builder and become subject to sales tax. In other words, the design fees can become wrapped in the building contract and be subject to retail sales tax.
This happened in Det. No. 14-0098, released by Department of Revenue appeals division on June 24, 2016. The case concerned a custom yacht builder who often engaged the services of a third-party naval architect and a third-party marine designer to design and engineer the yacht to the customer’s specifications. The problem arose because in some cases the customer would pay the design fees itself directly to the provider of the services, while in other cases the taxpayer/builder paid the service providers and billed the customer. As explained by appeals:
When Taxpayer pays for these services, it is generally for goodwill or the convenience of the customer. On these occasions, Taxpayer bills its customer for the design, drafting, and engineering costs separately from construction costs. Taxpayer does not add mark-up to the design and engineering costs.
The audit division did not assert sales tax where customer itself paid the design fees directly to the designer, but it did assert sales tax on the amounts which the taxpayer received from its customers to reimburse it for what the taxpayer itself had paid the design service providers. As the taxpayer would likely not seek to recover the sales tax from the customer it was out of pocket for amount of the sales tax.
The reason is this: A boat builder is for B & O purposes taxable as a manufacturer and also also as a retailer when it sells directly to an end user and must collect sales tax. (The multiple activities credit protects the boat builder from a double B & O tax). The base on which the sales tax is imposed for the retail sale is “gross proceeds of sales.” Gross proceeds of sales “includes the amount of profit or fee above cost received, plus the reimbursements or prepayments received on account of materials and supplies, labor costs, taxes paid, payments made to subcontractors, and all other costs and expenses incurred by the manufacturer or processor for hire.” Therefore, concluded appeals, the boat builder’s gross receipts included the reimbursements it received for payments to the designers which were not deductible from its tax base.
Note that appeals assumed that the payments to the designers were “reimbursements” for “labor or expenses” incurred by the builder. But were the expenses really “incurred” by the boat builder? The facts in the determination state only that the boat builder “engages” the services of these providers, although the determination acknowledges that there were no written contracts, just “handshakes.” In other words there is no specific finding that the service providers were in fact subcontractors of the boat builder/taxpayer. What appeals appears to have done is “follow the money trail”: In the present case, Taxpayer’s customer was not billed directly by the naval architect and marine designer for the engineering and design services. Taxpayer paid the costs directly to the subcontractors and billed its client for these services in addition to billing and receiving payment for the yacht construction itself.
It is common for DOR to say that if the seller side of a transaction, such as a boat builder, receives money (or accrues it in the case of an accrual basis taxpayer), it is included in proceeds of sales without deduction in any way. Appeals in this case did not do a close examination of whether it was the boat builder or its customer who had a contract with the boat builder, and whether the money that the boat builder received from its customer was reimbursement for an “expense” of the boat builder. It satisfied itself with the general statement that in some general way the boat builder “engaged” the designers. It is likely, I think, that if the boat builder had asked the customer to pay the designers directly, the audit division could not have attributed the payment to the builder and subjected it to sales tax. Reason: the customer would have paid an architect fees, taxable as a service and not subject to retail sales tax.
It can be difficult to counter this line of reasons, which is why we say that the first line of defense is for the taxpayer not to receive or accrue money proceeds to begin with. We have often had discussions with clients who sometimes feel it is bad for business to show the customer the money trail, or bad because the business wants to mark up the service provider’s fee, or bad to put a burden on the customer to deal with several service providers rather than one centralized provider. That may be, but businesses that have to collect sales tax on their activities should at least be aware of the pitfall and should consider the possibility of letting the customer receive and pay the bill.
Learn more about tax lawyer Martin Silver.