When a contractor's work will be occupied by the tax-exempt US Postal Service, does the contractor's sales tax obligation depend on whether the contract is with the landlord or directly with the Postal Service, and on whether the work is remodeling or new construction?

Plain-English summary

A general contractor asked the Comptroller how sales tax would apply to a project where a new tenant -- the US Postal Service -- would occupy previously-used warehouse space. Only about 10% of the space had been finished out by the prior tenant; the rest was still bare warehouse with exposed concrete and roof structure. The project also included new work outside the existing building, such as parking and site work. The contractor's own contract would be with the landlord, though part of the work might also be contracted directly with the Postal Service.

The Comptroller explained that finishing out the previously-occupied space counts as remodeling under Rule 3.357, even though most of that space had never been finished out for any use other than warehousing -- because it had been occupied and used, it counts as previously "finished out," so further finish-out work is remodeling rather than new construction. By contrast, the new square footage being added (the parking and site work) is new construction under Rule 3.291, where the tax result depends on whether the contract is lump-sum (one combined price for labor and materials, contractor pays tax as consumer of materials) or separated (materials and labor separately stated, contractor collects tax from the customer on the materials).

The central holding is about who the contractor is dealing with, not just what kind of work is performed: leasing the building to the Postal Service, a tax-exempt entity, does not exempt the contractor's charges to a nonexempt landlord. The exemption only follows a contract made directly with the Postal Service itself -- if the contractor (or a subcontractor) signs a contract directly with USPS for either remodeling or new construction, that portion of the work is exempt from sales tax, and the USPS contract itself is sufficient documentation to support the exemption.

Finally, the letter addresses mixed contracts: when a single contract covers both remodeling and new construction, the parties must separately state the charges for each, or the whole contract will be presumed taxable remodeling. The total charge for remodeling nonresidential real property performed for a nonexempt customer (like the landlord here) is subject to tax.

What this means for you

General contractors and subcontractors on tenant build-outs

Your tax treatment depends on who you contract with, not who ultimately occupies the space. If your contract is with a nonexempt landlord, your charges for improving the property are taxable even if the future tenant is a government entity or other exempt organization. To get the exemption, you (or the relevant subcontractor) need a contract directly with the exempt entity -- here, a direct USPS contract was described as sufficient on its own to establish the exemption, without needing a separate exemption certificate.

Contractors mixing remodeling and new construction in one project

If your project includes both remodeling of existing space and new construction (like this project's warehouse finish-out plus new parking/site work), separately state the labor and material charges for each type of work in the contract. Otherwise, the whole contract is presumed taxable remodeling, even the new-construction portion.

Accountants and tax professionals structuring construction contracts

Watch the lump-sum vs. separated distinction under Rule 3.291 and Tax Code § 151.056 for new-construction charges: in a lump-sum contract the contractor is the consumer of materials and pays tax to suppliers; in a separated contract the contractor is the seller of the materials and must collect tax from the customer on the contract (or cost) price of materials, whichever is greater. This choice has real cash-flow and compliance consequences for clients bidding government-occupied projects.

Common questions

Q: The building will be leased to the tax-exempt US Postal Service. Does that make my construction contract with the landlord exempt?
A: No. The letter is explicit that leasing to an exempt entity "will not serve to exempt your charges for taxable services performed under a contract with a nonexempt building owner." The landlord's arrangement with USPS doesn't pass through to you.

Q: What if I contract directly with the Postal Service instead of the landlord?
A: Then you are not required to charge sales tax on that transaction, whether it's a remodeling contract or a new-construction contract -- the contract with the Postal Service is itself sufficient to establish the exemption.

Q: Is finishing out warehouse space that a prior tenant used, but never fully built out, considered "new construction"?
A: No. Because the space was previously occupied and used, it is treated as already "finished out" once, so any further finish-out work is remodeling under Rule 3.357 -- even if 90% of the space still looks like raw warehouse.

Q: My contract covers both remodeling the existing building and building new parking/site improvements. How is that taxed?
A: Separately identify the charges for the taxable remodeling labor and the (potentially different) new-construction charges. If you don't separate them, the entire contract is presumed to be taxable repair, restoration, and remodeling.

Citations and references

Statutes and rules:

• Tex. Tax Code § 151.056 (taxability of property consumed in contracts to improve real property; lump-sum vs. separated contracts)
• 34 Tex. Admin. Code § 3.357 (repair, remodeling, and restoration of real property)
• 34 Tex. Admin. Code § 3.291 (contractors; new construction)

Source

• STAR search: https://star.comptroller.texas.gov/search?doc_type_code=L&tax_type_code=SST
• Opinion: https://star.comptroller.texas.gov/view/9206L1179A09

Original ruling text

June 5, 1992

Dear **:

Thank you for your recent letter which is restated in part with response below.

Please provide a ruling on the following scenario regarding the applicable
sales taxes:

1. A construction project located in **.
2. A proposed new tenant is the US Postal Service.
3. My contract will be with the landlord.
4. Part of my contract might be directly with the US Postal Service.
5. It occurs in an existing structure, a small portion of the space has been
   finished out, (10%), but the majority of the space is still in warehouse
   condition with exposed concrete flooring and roof structure, warehouse area has
   been previously used by former tenant. Part of the work will be outside the
   existing building for new parking and site work.

Please clarify my tax obligations as the General Contractor, my subcontractors
and suppliers, and the landlord's obligation, and the US Postal Service (are
they exempt?) with any specific instructions regarding contract particulars
between the parties (i.e. contract breakout of labor and material, USPS
contract may consider the landlord as 'contractor', and etc.) so I may complete
my proposal.

Response: To the extent you are modifying a building that has been previously
occupied, you will be treated as a remodeler under Rule 3.357 (enclosed). This
is true even though most of the space was never "finished out" for use as
anything other than a warehouse. The fact that it was occupied and used means
it was previously "finished out". Subsequent finish out is remodeling. The fact
that the building may be leased to the US Postal Service (an exempt entity)
will not serve to exempt your charges for taxable services performed under a
contract with a nonexempt building owner. If you contract directly with the US
Postal Service and perform the remodeling service for them, you will not be
required to charge sales tax on the transaction. Your contract with the Postal
Service will be sufficient to establish the exemption.

The construction of additional square footage will be treated as new
construction under Rule 3.291 (enclosed). You should be careful to determine if
the contract you enter into is lump-sum or separated since the tax consequences
differ.

Rule 3.291 - Contractors, subsections (a), (4) &(5) defines lump sum and
separated contracts.

(a) Definitions:

(4) Lump-sum contract - A contract in which the agreed contract price is one
lump-sum amount and in which the charges for materials are not separate from
the charges for skill and labor. Separated invoices issued to the customer will
not change a lump-sum contract into a separated contract unless the terms of
the contract require separated invoices.

(5) Separated contract - A contract in which the agreed contract price is
divided into a separately stated agreed contract price for materials and a
separately stated agreed contract price for skill and labor. If prices of
materials and labor are separately stated, the fact that the charges are added
together and a sum total given is irrelevant. Cost-plus contracts are generally
regarded as separated contracts.

Tax Code Section 151.056 explains the taxability of property consumed in
contracts to improve real property.

(a) A contractor is the consumer of tangible personal property furnished by him
and incorporated into the property of his customer if the contract between the
contractor and his customer contains a lump-sum price covering both the
performance of the service and the furnishing of the necessary incidental
material.

(b) A contractor is the seller of tangible personal property furnished by him
and incorporated into the property of his customer, from whom he shall collect
the tax, if the contract between the contractor and his customer contains
separate amounts for the performance of the service and for the furnishing of
the necessary incidental material. The tax rate is applied to the price of the
materials as agreed in the contract or the price of the materials to the
contractor, whichever is the greater.

If you enter into a separated contract directly with the Postal Service to
perform new construction for them, you will not be required to charge sales tax
on the transaction. Your contract with the Postal Service will be sufficient to
establish the exemption. If the contract were lump-sum, you would be considered
to be the consumer of the incorporated materials and would pay tax to your
supplier at the time of purchase.

When both remodeling and new construction are being performed under the same
contract, the parties to the contract should separately identify the charges
for taxable and nontaxable labor in the contract; otherwise, the entire
contract will be presumed to be for repair, restoration, and remodeling. The
total charge for remodeling nonresidential real property for a nonexempt
customer is subject to tax.

This opinion is based on the facts you presented. Other facts, though similar,
may yield different results. If you have questions or need more information,
please call or write. You may reach me by calling toll free, (800) 531-5441. My
direct line number is (512) 463-4680. The number for FAX transmissions is (512)
475-0900. You may write to me in care of Tax Administration Division.

Sincerely,

Al Van Allen Tax
Administration Division