Can a Texas construction contract be changed from lump-sum to separated (or vice versa) by an addendum or change order, and how are cost-plus contracts and profit percentages treated for sales tax?
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This page answers the general question as of 1992. Ezel answers yours, under current Texas tax law, with citations.
Subject
Cost Plus — Contract — With/Without Guaranteed Maximum Price — Profit And Overhead Treatment
Plain-English summary
This 1992 Texas Comptroller letter answers five follow-up questions from a taxpayer about converting a lump-sum construction contract into a separated contract (and vice versa) by addendum or change order, and about how cost-plus contracts and profit percentages are treated for sales tax purposes.
The Comptroller explained that a change order, addendum, or contract amendment can change a contract's form from lump-sum to separated (or the reverse), but only if three conditions are met: (1) the change is made before the work is completed, (2) it applies retroactively to the origination of the original contract, and (3) the document expressly states that one of its purposes is to change the entire contract from one form to the other and specifies the separated charges for materials and labor. Simply adding a section that breaks out materials and labor amounts — without stating that purpose — is not enough, as illustrated by Hearing 9987, where a change order that only added a "Project Recap" section with separate material/labor figures did not convert a lump-sum contract into a separated one. By contrast, Hearing 25,636 supports allowing a properly drafted amendment to make that conversion.
The letter also addresses:
- Cost-plus contracts: these are generally treated as separated contracts because they typically separate incorporated materials from skill and labor and add a percentage markup to each category separately. Because contractors cannot sell incorporated materials for less than cost, a "non-binding estimate" of materials cost in a cost-plus contract must be fairly accurate, or the contractor may face an additional tax liability.
- Monthly invoices: separating materials from other costs on monthly invoices does not, by itself, change a lump-sum contract into a separated contract, and separated billings on a separated contract do not turn it into a lump-sum contract. However, if the contract itself requires separated invoices and incorporates those invoices as controlling contract documents, the contract is treated as separated even though the contract states a lump-sum dollar figure.
- Profit as a percentage: profit calculated as a percentage of the total contract is not treated as part of the taxable materials price. But a charge (including profit) calculated as a percentage of the cost of materials is included in the taxable sales price of the incorporated materials, per the rule on new construction contracts (Rule 3.291), which defines the "agreed contract price of materials."
What this means for you
Contractors and construction businesses
If you want to convert an existing lump-sum contract to a separated contract (or the reverse) through a change order or amendment, make sure the document is executed before the work is finished, is drafted to apply retroactively to the whole contract, and explicitly states that its purpose is to change the contract's form while specifying the separated charges for materials and labor. Just adding a recap or breakdown section that shows materials and labor separately, without that stated purpose, will not accomplish the conversion — as the Comptroller found in Hearing 9987.
Contractors using cost-plus or guaranteed-maximum-price contracts
Cost-plus contracts are generally treated as separated contracts. If your cost-plus contract uses a non-binding estimate for materials cost, be careful that the estimate is reasonably accurate, since you cannot sell incorporated materials for less than their actual cost — doing so can create an additional tax liability.
Accountants and tax professionals advising on invoicing practices
Separated line items on monthly invoices, by themselves, do not change a contract's classification as lump-sum or separated — the classification follows the contract's own terms. However, if the contract requires separated invoicing and treats those invoices as part of the controlling contract documents, that structure is enough to make the contract a separated contract even if the face amount is stated as a lump sum. Also note the distinction in how profit percentages are taxed: profit as a percentage of the total contract is not taxable as part of materials, but profit as a percentage of materials cost only is included in the taxable price of incorporated materials under Rule 3.291.
Common questions
Q: Can we change our lump-sum contract into a separated contract after signing it?
A: Yes, through a change order, addendum, or amendment — but it must be made before the work is completed, apply retroactively to the entire original contract, and expressly state that one of its purposes is to change the contract's form, specifying the separated charges for materials and labor.
Q: Is it enough to just add a section to a change order that lists materials and labor amounts separately?
A: No. In Hearing 9987, a change order added a "Project Recap" section showing separate materials and labor amounts, but because the change order did not state that its purpose was to convert the contract's form, the Comptroller held the contract remained lump-sum.
Q: Are cost-plus contracts treated as lump-sum or separated contracts?
A: Generally, cost-plus contracts are treated as separated contracts, because they typically separate incorporated materials from labor/skill and apply a percentage markup to each category.
Q: If our cost-plus contract only gives a non-binding estimate for materials, is that a problem?
A: It can be. Contractors cannot sell incorporated materials for less than their cost, so the estimate needs to be fairly accurate, or the contractor may incur additional tax liability.
Q: Does billing materials and labor separately on monthly invoices convert a lump-sum contract into a separated contract?
A: No, not by itself. Separated invoices or billings do not change a lump-sum contract into a separated contract, and vice versa. But if the contract requires separated invoices and incorporates them as part of the controlling contract documents, the contract is treated as separated even if it states a lump-sum price.
Q: Is profit taxable as part of the materials price?
A: It depends on how the profit is calculated. Profit calculated as a percentage of the total contract is not considered part of the materials' taxable sales price. Profit calculated as a percentage of the cost of materials only is included in the taxable sales price of incorporated materials under the new-construction-contracts rule (Rule 3.291).
Citations and references
Statutes and rules:
- 34 Tex. Admin. Code § 3.291 (rule relating to new construction contracts; defines "agreed contract price of materials" under section (a)(1))
Comptroller hearings referenced (not independently verified beyond what is stated in this letter):
- Hearing 9987 — change order adding a "Project Recap" section separating materials from labor/profit did not convert a lump-sum contract into a separated contract.
- Hearing 25,636 — supports allowing a change order, addendum, or amendment to convert a contract's form from lump-sum to separated (or vice versa) when properly drafted.
Source
- STAR search: https://star.comptroller.texas.gov/search?doc_type_code=L&tax_type_code=SST
- Opinion: https://star.comptroller.texas.gov/view/9209L1196A13
Original ruling text
September 24, 1992
Dear *****:
I am responding to your letter requesting confirmation of your recent telephone
conversation with Mr. Roger Rives of this office. Your conversation and
written questions concern the changing of a lump-sum contract to a separated
contract by amendment or change order.
Although I cannot confirm your conversation, I can provide a written response
to the questions you asked.
- Is an addendum separating materials from labor and profit sufficient to make
the contract a separated contract? What must be done to insure that such an
addendum does in fact act to form a separate contract?
As you pointed out, Hearing 9987 did not allow a particular change
order/addendum to change a lump-sum contract into a separated contract by
simply separating materials from labor and profit. In this hearing, the
original contract is lump-sum; change order 8 reduced the price of the original
contract and gave a revised lump-sum amount for the contract. This change
order also included a section entitled "Project Recap." Only in this section
were separate amounts for materials and labor reflected. Based upon the facts
of this case, it was decided that the change order did not change the contract
from lump sum to separated.
However, the Comptroller has allowed a change order, addendum, or contract
amendment to change the original contract from a lump-sum contract to a
separated contract and vice versa. This action must be taken before the work
is completed and is retroactive to the origination of the original contract.
The addendum, change order, or amendment must provide that the contract is to
be considered a separated contract and must specify the separated charges for
materials and labor. Hearing 25,636 supports this opinion.
Therefore, in order to change the contract from one form to another, the
addendum must mspecify that one of its purposes is to change the entire
contract from one form to the other form.
- Can an addendum to an existing contract operate to create a separated
contract, even if the original document created a lump-sum contract?
Yes, an addendum to an existing contract can operate to create a separated
contract even when the original contract was created as a lump-sum contract.
Again, the addendum is retroactively changing the entire contract from lump sum
to separated. Perhaps, for such changes, it is more correct to call the
document that alters the original contract an amendment rather than addendum or
change order. Regardless of the title given the document, the context and
purpose of said document will determine its ability to alter the form of the
contract. Please refer to the response to question 1.
- Can the contract be structured so as to leave the dollar amount of
materials separate, but open, such as for a cost-plus contract? Does the price
of the materials need to be firmly set in the initial contract, or can a non
binding estimate be provided instead?
Generally speaking, cost-plus contracts are considered separated contracts
because most cost-plus contracts also separate incorporated materials from
skill and labor and add the percentage to the separate categories. Please note
that contractors cannot sell the incorporated materials for less than their
cost; so, the "non binding estimate" must be fairly accurate or the contractor
may incur an additional tax liability.
- Must materials and other costs be separated on monthly invoices, assuming
the initial contract is a separated contract, and a final recap will provide
total costs of materials separated from labor and profits?
No; separated invoices or billings will not change a lump-sum contract into a
separated contract. Lump-sum invoices or billings will not change a separated
contract into a lump-sum contract. However, a contract requiring separated
invoices thereby incorporating said invoices as part of the controlling
contract documents is considered a separated contract even though the dollar
amount in the contract is a lump-sum figure.
- Is it a correct statement that "profits calculated as a percentage of the
total contract are not considered as materials for purposes of the sales and
use tax," versus profits and other charges calculated as a percentage of the
cost of materials only?
The rule relating to new construction contracts (3.291, copy enclosed)
stipulates what isincluded in the taxable sales price of incorporated
materials. This stipulation in found in the definition of agreed contract
price of materials, section (a) (1) of the rule. Any charge directly
attributable to the incorporated materials is included in their taxable sales
price. A charge calculated as a percentage of the total contract is not
considered a part of the materials' taxable selling price.
This opinion is based on the facts presented. If there are additional or
different facts, the opinion may change.
Sincerely,
Tax Administration
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