I have not seen DOR do a worse job of explaining any sales tax law than how the sales tax applies to federal construction contracts, especially contracts for military construction. And that can create traps for developers and contractors, especially sub contractors.
This situation is particularly surprising because the most important part of the law was enacted in 1975, so there has been plenty of time to make things understandable. But, while the basic law is easy to state, piecing together how the law has complicated ordinary business situations is unusually confusing. The confusion has only been heightened by the poor job that DOR has done. In fact, from what I have read and experienced on behalf of my clients, the DOR appears to do little more than parrot the 1975 changes in a simplistic manner with little or no attention to the internal contradictions the 50-year old law creates.
I hope that the basic way in which the law works has now been understood by builders and contractors. But to the extent that is not yet understood I hope this article will be helpful.
A brief look back at how we got here.
Before 1941, building contractors were treated as consumers for sales tax purposes: all sales of tangible personal property to them, most important, sales of construction materials, were subject to sales tax and the tax was collected by their suppliers. In 1941, Washington changed how the sales tax worked, and the landowner who purchases the construction work was defined as the consumer who paid the full tax on the project. The net result was that a contractor’s labor costs and markups were added to the tax base, which had previously included the cost of tangible personal property sold to contractors.
But the post-1941 system could not be applied to construction for the Federal government because a state cannot constitutionally tax the United States Government. So, when the U.S. was the landowner Washington did not collect any tax on sales either of tangible personal property to the contractor or on the finished building to the U.S.
The legislature tried to avoid a loss of revenue in 1975 with a new law that basically re-imposed the pre-1941 tax on contractors that work for the U.S. After this chang the State taxed nonfederal projects to the landowner, and taxed the sale of materials to federal contractors. The sale of materials to contractors was made taxable by a new law “deeming” a sale of materials to a federal contractor to be a sale to a consumer, so that the contractor owed “use tax” that was due at the time of the purchase by the contractor. RCW 82.04.190(6).
The net result was that, for federal projects the legal incidence of the tax falls on the contractor, rather than the landowner, and the tax is measured by a lesser amount than the tax on nonfederal projects, because the contractor’s labor costs are not included in the tax base. (This explanation was given by the U.S. Supreme Court when it affirmed the constitutionality of this system in Washington v. United States, 460 U.S. 536 (1983)).
Let’s look at what this means in practice:
(1) Resale certificates/reseller permits cannot be used.
Normally, goods purchased for installation in a construction project are either resold to the owner, or to an upper tier contractor who passes the tax on the entire project to the owner. Therefore, the purchasing contractor can normally use a “reseller document” and not pay sales tax at the time it purchases materials. The sales tax will be passed up the line of contractors and ultimately be collected from the owner.
I used the general term “reseller document” because before 2010 a document called a “resale certificate” was used, while commencing 2010 a new “reseller permit” was instituted. But commencing with the new law in 1975, “resale certificates” could no longer be used to purchase materials for installation in a construction performed on real property “of or for” the United States. Recall that this happened because the purchasing contractor had been deemed the “consumer” of the materials, so logically it could no longer be a “reseller,” because a “consumer” by definition buys stuff to use, not for the purpose of reselling it.
This started the problem because the resale certificate in use up until 2010, that is for thirty-five years after the enactment of the 1975 law, did not state on its face that it could not be used to purchase materials for installation in a federal contract. As bad, if not worse, none of the DOR regulations, publications or notices stated that resale documentation could no longer be used to purchase materials for use in installation on a federal project. Somehow, for 35 years, builders and contractors were supposed to be able to figure this out. Experience says, however, that many did not, and faced assessments for use tax on audit
It is true that the 2010 reseller permit finally inserted language stating it could not be used to buy materials for use in a federal contract. But that change was evidently too late for many contractors and their vendors who automatically continued not to charge sales tax on what they believed to be normal wholesale situations. To repeat, none of the DOR pronouncements offered any guidance as to how reseller permits fit with federal military contracts. For example, resale documentation was never stated to be unusable in either the general contractor rule (WAC 458-20-170) or the government contractor rule itself (WAC 458-20-17001), nor did any of the blurbs published on the DOR’s constantly updated website state how reseller permits fit with federal contracts. As for the 2010 language added to reseller permits, that is simply easy to overlook.
As far as I can tell, the first time that DOR actually examined the role of resale documents in the context of purchases for use in a federal construction contract is 2015, which is some 40 years after the passage of the 1975 law. A DOR appeals determination, 13-0306, only then examined whether a subcontractor that obtained resale certificates/reseller permits from the prime contractors could properly report its income under the wholesaling classification where the construction of military housing was on real property owned by the United States.
In Det. 13-0306 the question of the use of a reseller permit was examined briefly, but it was buried in a footnote. That footnote gave a lengthy and rambling analysis proving that logically the subcontractor could not use its reseller permit in purchasing materials to install in the project because it had not purchased the materials for resale purposes to begin with, inasmuch as it was deemed a consumer by the 1975 change in the law. Therefore, there was no purchase for resale, and therefore there was an improper use of the resale permit to begin with, and therefore the taxpayer could not have reported as a wholesaler. And, therefore….? Therefore, as a consumer the contractor that bought the materials owed use tax.
While this was logical, the explanation was so contorted that reading it is like navigating a rapid but shallow and winding river. It is amazing that the DOR had not earlier clearly and simply stated the impossibility of using a reseller permit before this single reference. The explanation is correct enough, but it should have been publicly stated 40 years earlier and not buried in an obscure footnote in a little read determination letter.
Another problem is that federal subcontractors may have signed contracts with big national military contractors that contains a clause that says the general, contractor will pay all sales/use taxes. The general contractor may do this to ensure that it delivers a lien free job. This language of course is inconsistent with the statute that imposes use tax on the contractor that buys materials. The general can pay the sales tax on material, but will that get the contractor purchasing the materials off the hook for the use tax?
(2) A sub contractor likely cannot rely on contract language that says the general contractor will pay all sales taxes.
National military construction contractors, who build in many states besides Washington, may insert clauses into their contracts that state that they will pay all sales and use taxes. I have seen this several times. This of course leads a sub to believe the sales tax will be paid by the general, so it goes ahead and uses its reseller permit (despite general cautionary language in the reseller permit), because it is expected that this would be an exception to the sub’s “deemed” use tax situation. If the general contractor states in writing it will pay all sales and use taxes, why would the sub contractor pay it twice?
Unfortunately, there is no exception that I know of that says relying on the language in a contract that shifts the burden of paying sales tax onto the higher level contractor will be honored by DOR. I think there should be, but there is no published statement from DOR that there is such an exception, and certainly nothing that describes what kind of proof it would take to avoid a second assessment of sales tax against the sub. In fact, in my experience the department is likely to say that the sub should have followed the law and simply paid the tax. Double payment of the same use tax or not.
I think that is a runaround, because I think the DOR owes federal contractors a good and comprehensive explanation in a well written rule that explains exactly why there is such an unusual and unexpected result as negating a written contract. And, I think DOR owes it to the federal contracting community to lay out some procedure for allowing a contractor to rely on language that shifts the obligation for all sales and use taxes to upper tier contractors.
Learn more about Martin Silver, PS. If you need assistance with a similar tax matter, contact us at 206-244-3461 today. Our offices are conveniently located on 5th Avenue just off Union Street in Seattle.