When an engineering and design firm creates original plans for a client and also produces a prototype, is the prototype production taxable, and does it matter whether the client later requests identical or altered copies?

Plain-English summary

This letter is a follow-up to two earlier rulings (July 15, 1999 and September 16, 1999, both included in the original text below) addressing an engineering and design firm that creates original plans for clients and also builds demonstration prototypes from those plans. The earlier rulings established the baseline: professional engineering/design services are excluded from Texas sales tax under Tex. Tax Code § 151.0101(a), and when a prototype is produced as part of developing the client's original design, the prototype charge — even if separately invoiced — is part of that nontaxable service. The Comptroller applied the "essence of the transaction" test (citing Sharp v. Direct Resources for Printing, 910 S.W.2d 535): since prototypes have very short useful lives and exist to let the client refine the design, the client's real purchase is engineering services, not a prototype as an end product.

This 2000 letter addresses the next question: what happens when the client later asks for additional prototypes beyond the original? The Comptroller split the answer in two:

• Identical copies of the original prototype are taxable — once the design is finalized, extra copies are just fabricated tangible personal property, no longer part of an ongoing design service.
• Altered copies reflecting new design changes the client requested are different: the charge for the engineering work plus the first revised prototype remains nontaxable (it's still part of the design process), but any further copies of that revised prototype are taxable.

What this means for you

Engineering and design firms

Your original design work, and the first prototype that embodies it (even if invoiced separately), stays nontaxable as part of your professional service — provided you're genuinely producing original plans under an agreement for design services. But once a client wants a second (or third) identical copy of a finished prototype, start charging tax on those — they're no longer part of the design process. If the client requests design changes, the resulting first revised prototype stays nontaxable, but additional copies of that one are taxable again.

Manufacturers and product developers who commission engineering/prototype work

Ask your vendor how they're billing: a first-of-its-kind design prototype should come tax-free as part of engineering services, but ordering multiples of an already-finished prototype should show up as taxable fabrication.

Accountants and tax professionals

The key test is Tex. Tax Code § 151.0101(a)'s professional services exclusion combined with the "essence of the transaction" doctrine (per Sharp v. Direct Resources for Printing): ask whether the item being billed is genuinely part of an evolving design process (nontaxable) or a finished-design reproduction (taxable fabrication of TPP). The line redraws itself each time the client requests a design change — a fresh iteration resets to nontaxable, but repeat copies of a settled design do not.

Common questions

Q: Is a prototype produced along with engineering/design services taxable in Texas?
A: Not the original one — if it's produced as part of developing the client's original design under an agreement for engineering services, it's nontaxable even when separately invoiced, under Tex. Tax Code § 151.0101(a)'s professional services exclusion.

Q: What if the client wants a second, identical copy of the same prototype?
A: That copy is taxable. Sales tax is due on additional prototypes that are identical copies of the original.

Q: What if the client requests design changes and a new prototype reflecting those changes?
A: The engineering work plus the first prototype reflecting the alteration is not taxable — it's still part of the design process. But additional copies of that revised prototype are taxable.

Q: Does it matter whether the prototype and design charges are on the same invoice or itemized separately?
A: Based on the underlying analysis in the earlier rulings referenced here, no — separately stated charges for prototype production are nontaxable as long as the prototype is genuinely part of the nontaxable engineering/design service; what matters is whether the item is an original design iteration or a repeat/finished-design copy, not the invoice format.

Q: Can I rely on this letter for my own engineering firm?
A: No. Each ruling in this chain is based on the specific facts presented by that taxpayer; other facts, though similar, may yield a different result.

Citations and references

Statutes:

• Tex. Tax Code § 151.0101(a) (professional services excluded from taxable services)

Case law:

• Sharp v. Direct Resources for Printing, 910 S.W.2d 535 (essence-of-the-transaction test: whether the ultimate object of a transaction is tangible personal property or a nontaxable service)

Source

• STAR search: https://star.comptroller.texas.gov/search?doc_type_code=L&tax_type_code=SST
• Opinion: https://star.comptroller.texas.gov/view/200005304L

Original ruling text

May 15, 2000

Dear **:

Your letter to Ms. Adina Christian requesting an administrative ruling with
regard to the proper Texas sales and use tax treatment of your client's
engineering and design services, has been assigned to me for response. Your
fact situation, discussion and request for a ruling regarding this transaction
are outlined below.

FACTS

I originally requested an administrative ruling on July 15 1999 regarding the
taxability of prototype production that Company A provides with its engineering
and design services.

Your response indicated that as long as Company A is using its engineering
design services to produce original plans for its customers, then the
production of prototypes would be considered part of the nontaxable engineering
design services. Additionally, your September 16, 1999 response indicated that
even separately stated charges for prototype production would be nontaxable. I
have enclosed a copy of the original July 15, 1999 administrative ruling
request and your September 16, 1999 response.

DISCUSSION

Company A's clients occasionally request production of additional prototypes
associated with the original nontaxable engineering/design service. These
additional prototypes could be identical copies produced from the original
plans or altered copies due to engineering/design changes.

REQUEST FOR ADMINISTRATIVE RULING

With regard to the foregoing discussion, we respectfully request the following
administrative rulings:

1. Is Company A excluded from collecting tax on prototype production under
   Texas Tax Code 151.0101(a) when Company A's clients request additional
   prototypes that are identical copies?

Response: Sales tax is due on the additional prototypes that are identical
copies of the original.

2. Is Company A excluded from collecting tax on prototype production under
   Texas Tax Code 151.0101(a) when Company A's clients request additional
   prototypes due to altered original plans?

Response: If Company A's client requests alterations to the original plans
resulting in the production of a new prototype, the charge for the engineering
involved and the production of the initial revised prototype is not taxable.
Charges for additional copies of the revised prototype will be taxable.

This opinion is based on the facts presented. Other facts though similar may
provide a different result.

I hope this information answers your questions. If you need additional
information, please call me toll-free at 1-800-531-5441, extension 3-4502. The
direct line is 512/463-4502. You may also write to Tax Policy Division,
Comptroller of Public Accounts. You may also e-mail our tax help section at:

Sincerely,

Gilbert Zamora
Tax Policy Division

cc: Adina Christian

September 16, 1999

Dear **:

Thank you for your recent letter concerning the taxability of a prototype
produced by your client, en engineering and design firm.

You have provided the following information. Company A is an engineering and
design firm providing professional services to a variety of businesses in the
State of Texas. A large portion of Company A's business involves obtaining
ideas from its clients and applying its employees' specialized knowledge to
create original designs which may or may not be used by its clients to
manufacture a product for sale. In addition to drawings, Company A produces
models or prototypes used for demonstration purposes when presenting its
designs to clients.

Prototypes are essential to the service Company A is providing to its clients.
Prototypes allow the company's client to see a three-dimensional representation
of the product it has designed. Therefore, Company A's clients can study the
prototypes and request additional changes to the drawings before the final
design is accepted. In most instances, prototypes have very short useful lives
and are transferred to the clients. Company A separately states the charges for
the engineering design services from the production of the prototype and or
issues separate invoices to its client for the engineering/design services and
for the production of the prototype.

Response: If your client fabricates tangible personal property under an
agreement using specifications provided by its customer, your client is
fabricating tangible personal property. The total charge made for fabricating
the prototype is taxable even if your client provides some engineering or
design services. Your client is providing nontaxable engineering/design
services when It produces original plans for its customers under an agreement
for such services even if a separately stated charge is made for production
of a prototype.

This opinion is based on the facts presented. If there are additional or
different facts, the opinion may change.

If you have any questions or need more information, you may call me toll free
at 1-800-531-5441, extension 3-4004.

Sincerely,

Karey W. Barton
Director, Tax Policy

C: Bryant Lomax, Manager, Tax Policy

July 15, 1999

Mr. Karey W. Barton
Manager, Tax Policy Division
Comptroller of Public Accounts
State of Texas
Post Office Box 13528
Austin. Texas 78711

Re: Request for Administrative Ruling

Dear Karey:

On behalf of our client, Company A, we hereby request an administrative
ruling with regard to the proper Texas sales and use tax treatment of its
engineering and design services. The important facts regarding this
transaction are outlined below.

FACTS

Company A is an engineering and design firm providing professional services
to a variety of businesses in the State of Texas. A large portion of Company
A's business involves obtaining ideas from its clients and applying its
employees' specialized knowledge to create original designs which may or
may not be used by its clients to manufacture a product for sale. In addition
to drawings, Company A produces models or prototypes used for demonstration
purposes when presenting its designs to clients.

Prototypes are essential to the service Company A is providing to its clients.
Prototypes allow its clients to see a three-dimensional representation of the
product it has designed. Therefore, Company A's clients can study the prototypes
and request additional changes to the drawings before the final design is
accepted. In most instances, prototypes have very short useful lives and are
transferred to the clients.

DISCUSSION

1. Excluded Service

Under the provisions of Texas Tax Code 151.0101 (a), professional services
are excluded from sales and use tax. Additionally, Administrative Ruling
9711949L clarifies the taxability of engineering services with the following
statement:

If the Company works with its clients to develop (or if the Company
independently develops) the original specifications, schematics, etc., as well
as to produce the actual design, the services would be considered professional
engineering services and would not be subject to tax even if a finished design
is delivered.

As stated above, businesses engage Company A to develop original designs.
Businesses approach Company A with concepts and ideas of products, and
Company A's skilled personal take those concepts and produce completed designs.

2. Essence of the Transaction

In addition to providing professional engineering and design services, Company
A produces prototypes for demonstration purposes. Sharp v. Direct Resources/or
Printing, 910 SW2d 535 discusses the issue of the true essence of a transaction
in the following statement:

The established test for determining whether a transaction is subject to sales
tax involves the determination of the ultimate object or the essence of the
transaction. The inquiry concerns what is being sold. In other words, the essence
of the transactions is the customer's basic purpose in entering into the
transaction. In determining the object of the transaction, many factors are
relevant, and the issue must be determined on a case-by-case basis. If the
essence of the sale is not tangible personal property but instead concerns
intangible property such as a service, the transaction is not taxable under
any definition of sale. Any ambiguities in the application of the essence of
the transaction test must be resolved in the taxpayer's favor; taxing statutes
must be construed strictly against the taxing authority and liberally in favor
of the entity sought to be taxed.

As the facts above stated, Prototypes produced by Company A are only a part of
the overall service clients are buying. Prototypes are essential in completing
the final design of a product. Since the useful life of a prototype is very
short, the client's goal was not a purchase of a prototype but instead a
purchase of engineering/design services.

REQUEST FOR ADMINISTRATIVE RULING

With regard to the foregoing discussion, we respectfully request the following
administrative rulings:

1. Is Company A excluded from collecting tax on engineering/design services
   under Texas Tax Code 151.0101(a) when charges for engineering/design services
   and prototype production are billed on separate invoices?

2. Is Company A excluded from collecting tax on prototype production under
   Texas Tax Code 151.0101(a) when charges for engineering/design services and
   prototype production are billed on separate invoices?

3. Is Company A excluded from collecting tax on engineering/design services
   and prototype production under Texas Tax Code 151.0101(a) when charges for
   engineering/design services and prototype production are billed on the same
   invoice but separately itemized?

4. Is Company A excluded from collecting tax on engineering/design services
   and prototype production under Texas Tax Code 151 .0101 (a) when charges for
   engineering/design services and prototype production are billed as a lump-sum
   charge on an invoice?

5. In cases where engineering/design services and prototype production-have
   been billed as a lump-sum charge, is Company A allowed to break out the charges
   of the two components after-the-fact?

Thank you very much for your assistance with this matter. Please contact me at
** if you have any questions.

Very truly yours,