Modular Construction Industry Sales and Use Tax
Modular Sales and Use Tax Audits
Prepare Now, Before a State Tax Auditor Calls to Make an Appointment
When was the last time your company underwent a state sales tax audit? For most modular companies that have gone through a state sale and use tax audit, they will tell you that they would rather have had a root canal performed. There are a number of reasons why, companies in the modular industry dread sales and use tax audits so much.
Whether your company is involved in the modular industry as a residential or commercial modular manufacturer, a residential modular builder, or a commercial modular wholesale or retail dealer, there are things you need to know about a state sales and use tax audit before you go through one and there are things your company can do to insure that the outcome is not a disaster. But you have to take steps now, before you get audited.
When a state’s tax department auditors come to audit your preceding years tax records for sales in that auditor’s state, they will want to review the contracts and related documents for each sale made in their state. As a result, the way you structure your sales transactions, and the associated documents used to memorialize each sale, will be the information the auditors use to base their decision on your tax liability. And make no mistake; they will do everything they can to find liability, whether you actually do or do not have any.
Ideally, the best time to structure your business transactions, and prepare the contracts and related documents used between manufacturers, contractors and subcontractors and retail buyers, to memorialize the sales transaction, is when you are a start-up, on day one. But for companies that have been doing business for many years, it is not too late to review the contracts you are using and restructure your sales and use tax methodology if needed to ensure your company does not receive a big bill the next time you are audited. If your company decides to begin doing business in a state or states where you have not previously done business, that is the time to review that state’s sale and use tax law. In any event, all states have statutes of limitation limiting how far back your company can be held liable for unpaid taxes.
Problem 1: Most state sale and use tax laws were written before there was a modular industry or with little or no understanding of how the modular industry does business. With a peripheral understanding of how the conventional construction industry did business, and knowing next to nothing about the modular industry, state legislatures passed sale and use tax laws without regard to how the modular construction industry would be affected. Fast forward to today, and you have tax auditors and their respective tax policy officials trying to compare the existing tax law with the modular construction industry, and it’s like trying to fit a square peg into a round hole, determining how existing state tax law relates to the modular industry.
Problem 2: Even if the current state tax law on the books is applicable to the modular industry, most state sales and use tax auditors…and the heads of their respective tax departments for that matter…do not know their own tax law and how it pertains to the modular industry.
As a result, when you do undergo an audit, the initial determination you receive from the tax department is almost always incorrect, or at least arguable, and it often involves sizable, sometimes six figure, assessments.
In most cases, the auditor’s approach is to review the company’s sales records and simply throw as big an assessment (referred to as the “determination”) as possible at the company and leave it to the company as to whether they can make a case for an appeal. If you do decide to appeal, many states require the company to pay the tax in dispute or post a bond in order to appeal a tax dispute. If you are successful on appeal, you will get the money back; but it could take several years. Auditors know this, and they also know that often, the approach many companies (and unfortunately their attorney’s) take, in order to lessen the financial exposure, is to attempt to negotiate as low a figure as possible, and pay it, rather than to litigate, even though the entire assessment is wrong. It’s a lot like pleading to a lesser crime, even when you didn’t do it, because of the risk of being found guilty of the big crime, and because it costs a lot of money to fight it. (Yes that happens too!)
Here’s the issue: When a conventional building contractor or developer builds a commercial building or residence, they go to the lumber yard or purchase building supplies from a building supply retailer and the state sales tax is paid at the time of the purchase. The structure is then built on site, and other than the sales tax paid on the materials at the time of purchase, there is no more sales tax liability. Moreover, the building materials are purchased in the same state where the construction project takes place, so the sales tax went to the state where both the sale and the use occurred. What could be more simple and straight forward?
Not so for the modular industry. Modular manufacturers purchase building materials from wholesalers or building supply manufacturers in large quantities, tax exempt under a manufacturer’s exemption. When a modular manufacturer purchases material, the manufacturer does not know, what state those materials will end up in, as part of the modular building components shipped from the factory.
When the modular building is shipped to the job site and placed on a permanent foundation, the building is viewed by tax officials as a “capital improvement to real property.” If the building is not permanently installed, the building is considered “tangible personal property.” This distinction will have a big impact on the amount of sales or use tax due in most states.
In the late 1990’s as the modular industry grew, and as state tax officials began to focus on the modular industry as a potential source of increased tax revenue, initially, state tax officials took the position that all modular buildings were tangible personal property and as such, the manufacturer should remit sales tax on 100% of the selling price of the modular building to the state where the home was shipped. As a result conventional building contractors, were paying tax on only the materials used in the construction of the building, while a modular manufacturer was required to pay tax on the entire selling price of the building, which included not just building material, but labor, overhead, shipping costs, and profit. Modular manufacturers were being forced to pay, in excess of, twice the amount of tax on a modular building as the same building would generate if built on site. This determination substantially affects the profitability of modular construction and the modular industries ability to compete for conventional building projects.
A review of the tax laws in states where this issue first came to light, provided an argument for the modular industry that, if the modular building was permanently installed on a foundation, it should be taxed at the same rate as conventional construction, i.e. as a capital improvement to real property, and the tax should be paid on only the materials used in the manufacture and installation of the building. In some states the modular industry has been successful in getting the tax department to agree that, provided the manufacturer installed the modular building and not the building contractor or dealer, the construction will be considered a capital improvement to real property and use tax can be remitted on materials only, or on some agreed to percentage of the total invoice price (usually 60%), representing an estimate of the actual cost of materials.
Recognizing that most manufacturers do not install the modular building, turning that responsibility over to the building contractor, who usually subcontracted the installation to a set crew, the industry was successful in many states in reaching agreements that if the set crew was paid by the manufacturer, the state would consider the modular building an improvement to real property, and the tax could be paid on materials only.
Essentially what happens in those states is that the manufacturer enters into a contract with the building contractor for the sale of the modular building, and a separate contract with the set crew, usually identified by the contractor or dealer for the installation. A copy of both contracts must be kept on file to provide evidence to the tax auditor that the manufacturer has contracted with the installer for the installation. Usually the manufacturer negotiates a “set allowance” when the building is sold to the builder or dealer. The result – if the manufacturer structures the transaction properly, and has the proper documents on file, the manufacturer can cut in half, the amount of sales and use tax they are paying. However, if the manufacturer does not have the correct documentation on file come audit time, the manufacturer will be looking at substantial tax liability.
It is important to note that not all states tax the modular industry exactly the same, and in fact, nearly every state has its own nuances, (or “land mines”) which every modular manufacturer and building contractor must be aware of. For a detailed review of your sale and use tax procedures and contracts for each state you do business in, call Steve Snyder, at (717) 975-7799 to arrange a meeting to discuss your operation in each state you do business in.
The majority of the residential modular transactions throughout the industry are structured in essentially the same manner, as outline above. As a result of many years battling state tax auditors and state tax departments, most residential modular manufacturers have become quite adept at correctly documenting residential sales for each state, and having the necessary contracts on file for each state. Given the narrow margin in the residential modular industry and the state of the housing market over the last ten or so years, the ability to minimize sales and use taxes has been imperative in order to survive.
This issue has not been as well managed in the commercial modular industry, due in part to a much different type of contractual relationship between the commercial modular manufacturers, and the building contractors and dealer. In addition, since a large percentage of the commercial industry is made up of commercial relocatable modular buildings, many states will not recognize that type of construction as a capital improvement to real property. However, there are states that do not require that the modular building be permanently affixed in order to remit tax on materials only, and for the sector of the commercial industry that does permanently install the modular building, there are great savings available to the prudent manufacturer who is willing to understand the tax law in each state and structure their sales transactions accordingly.
It has been my experience, in talking to many companies involved in the commercial modular industry that, almost across the board, commercial modular manufacturers and builders and dealers involved in the commercial modular business could reduce the amount of sales and use tax they are paying today by close to 50% by revising the contracts used in the sales transaction of the commercial modular building.
Builders and Dealers of Residential and Commercial Modular Structures have an additional problem – who is responsible to remit the tax, the manufacturer, the builder or dealer, the retail buyer? The answer is, “it depends.” Not what you wanted to hear, I know. However, depending of what state you are in, what agreement you have with the manufacturer, how the transaction is structured, where the builder or dealer takes actual possession of the modular components…these factors will all have an effect on who has the liability to pay sales and/or use tax, the manufacturer or the builder or dealer.
If you ask a state tax official who is responsible to remit the tax, the manufacturer or the builder or dealer, (and I have) they will tell you, “both.” It is generally the view of most state tax regulators that the manufacturer and the builder or dealer are both jointly and severally liable for the tax until it is paid. I would disagree and depending on the particular state, either one or the other entity will have the initial liability. However, most states will still try to collect any unpaid tax from both parties involved. In fact, most states, at one time or another have audited both the manufacturers and the builders and dealers, and the state will hold liable, whomever they are auditing at the time. I have represented both manufacturers and builders in tax disputes and tax litigation in multiple states.
Pennsylvania is an example of a state where the law is different than most. In most states, the manufacturer is liable to collect and remit the tax to the state where the building is sited, regardless of where the building was manufactured. An amendment in the Pennsylvania tax law passed in July 2000 provides that, with regard to “prebuilt housing” the builder has the responsibility to collect the tax, unless, by agreement, the manufacturer elects to collect and remit the tax. And many manufacturers in Pennsylvania do. However, if there is no agreement, the builder will be held liable. The 2000 change in the law does not include commercial modular construction; however, the existing law still provides that if the manufacturer (or a subcontractor under contract with the manufacturer) installs the commercial modular building, the manufacturer can remit tax on the manufacturers actual cost of materials, or 60% of the invoice price to the builder. The law in Pennsylvania does not address commercial relocatable and as such, it would be my belief that the tax on those buildings would still be on 100% of the invoice price, although I do not believe the issue as ever been contested with the Department of Revenue or in the courts. If the builder in Pennsylvania elects to remit the tax to the state, the builder remits tax on 6% of 60% of the invoice price from the manufacturer, since the builder will have no way of knowing the manufacturer’s actual cost of materials…and it goes on from there, state by state.
Issues that every modular manufacturer, builder and dealer needs to address are:
Does the state have a sales or use tax (See for example Delaware which has no state sales tax)?
What is the tax rate in each state where you do business?
Are there any local sales taxes in any municipalities within the state?
Is the manufacturer or the builder/dealer responsible to remit the tax to the state?
Is the manufacturer required to install the modular building in order to pay tax on materials only?
Can the manufacturer subcontract the installation to an installer?
Is the tax computed on the actual cost of materials or on some pre-agreed-to percentage of the manufacturer’s invoice price such as 60%?
Does your company have a separate contract with the installers you are using for each installation, or a negotiated blanket contract covering every installation?
Is the installation contract separate from the sales agreement or part of a combined agreement?
Does the manufacturer pay the installer, or provide a set allowance to the builder/dealer and the builder/dealer pay the set crew?
Do you separately state the tax on the invoice for every state?
Does the state you are shipping into require that tax be paid on shipping cost?
Situations where Attorney Snyder can assist your firm now or in the future:
Steve can arrange to meet with you at your location to review your company’s current sales transactions in the states were you currently do business to make sure you have properly structured the sales transaction and the contracts you are using for each state to minimize your exposure.
Steve can provide information on what is required under the current state law, regulations, and any tax bulletins or negotiated agreements for each state you do business in and outline the differences for each state and what is required in order to minimize your tax liability and legal exposure.
Steve can meet with owners, controllers and other management staff, as well as your sales people to review the tax law and outline the importance of keeping to the set requirements for each state so as not to open your company to tax liability in the future.
Steve can be present and represent your company when a state’s tax auditors arrive to begin their audit and at the end of the audit in the event that any questions or disputes arise during the initial meeting or at the end of the audit.
Steve can represent your company in disputes before the state’s tax department in the event that a dispute arises or where the department has issued an unfavorable determination, that your company owes unpaid taxes.
Steve is available to represent your company in any tax litigation resulting from an unfavorable audit in that state.
Steve is available to represent your company in any other legal issues your company may be facing and brings a wealth of technical and legal experience in complex business issues and litigation as it related directly to the residential and commercial modular industry
Attorney Steve Snyder has spent over 20 years representing the modular construction industry both in a legislative and regulatory affairs capacity as a lobbyist for the industry, as well as in legal representation of modular manufacturers, modular building contractors, and commercial modular dealers. Steve has represented companies in the modular industry during sales and use tax audits, in appeals before state tax departments, and in litigation of sales and use tax disputes as well as legal representation and litigation on a myriad of general and specific legal issues affecting your company.
While the Executive Director and Legal Counsel of the Modular Building Systems Association, (MBSA), Steve drafted the language which has been passed in numerous states, amending the modular tax laws in those states were negotiations with tax regulators were unsuccessful. In other states, Steve was successful in negotiating agreements on how modular construction would be treated under the states existing tax law. While Steve headed the MBSA, the association published an exhaustive sales and use tax manual outlining the sales and use tax law and policies for nearly every state in the United States east of the Mississippi. “We are still working on the states West of the Mississippi but we can handle individual questions if they arise.” It is also important to monitor the tax laws in states that may be considering changes in the law or in the way they administer the law.
Steve is available to consult with modular manufacturers, building contractor, subcontractor and dealers, including reviewing current business and tax practices, as well as representation through tax audits, tax regulatory appeals, and tax litigation in any state where your company is involved in a dispute. Steve is also available to provide legal representation involving any other business issue in which your company may be involved.
Call Steve Snyder at (717) 975-7799 or email him at stevenrsnyderesq@gmail.com.