Can a general contractor allocate a lump-sum contract between new construction and nonresidential remodeling based on square footage, and what records are needed to back that up?

Plain-English summary

A general contractor asked the Comptroller how to split a lump-sum contract between the new construction portion of a project (adding about 16,000 square feet to an existing building) and the nonresidential remodeling portion (about 84,000 square feet of existing space). The Comptroller confirmed that square footage is a permissible method to allocate the labor portion of the contract between the two categories, but the allocation only applies to labor — materials used in both new construction and remodeling remain taxable regardless of how the contract is split. The contract must state the new-construction and remodeling labor charges as separate dollar amounts, not as percentages of the total contract price.

On documentation, the ruling points to Rule 3.357(b)(7) as governing what records are needed, and notes that in past administrative hearings contractors have been expected to produce blueprints or similar evidence showing the nature of the work, and that new-construction labor must be separately stated as the rule requires. The remodeling charge should approximate what the fair-market value of that work would be if the new construction were not being done at the same time.

Importantly, a square-footage allocation is not automatically presumed reasonable — not even between unrelated (arm's-length) parties. The Comptroller can review and recalculate any allocation, including one based on square footage, if it doesn't accurately reflect the actual cost of remodeling labor compared to new-construction labor on a per-square-foot basis.

What this means for you

General contractors on mixed construction/remodel jobs

You can use square footage as a shorthand to divide labor charges between new construction and nonresidential remodeling in your contract, but you must state those labor amounts as separate dollar figures in the contract — not as percentages — and keep documentation (such as blueprints or similar evidence) showing the actual scope of each type of work. Materials are taxed the same way no matter how the contract is split.

Owners entering construction/remodel contracts

Because the Comptroller can recalculate an allocation that doesn't reflect actual costs, even a contract you and your contractor negotiated at arm's length isn't automatically safe from adjustment. Make sure the stated remodeling charge realistically reflects what that work would cost on its own.

Accountants and tax professionals

The key compliance point is documentation under Rule 3.357(b)(7): a percentage-based allocation of the total price is not sufficient, and if the square-footage split doesn't line up with the relative cost of remodeling versus new-construction labor, expect it to be adjusted on review.

Common questions

Q: Can we just state the split as a percentage of the total contract price?
A: No. The ruling says the contract must separately state the new-construction and remodeling labor charges as dollar amounts, not merely as a percentage of the total contract price.

Q: Does the square-footage allocation apply to materials too?
A: No. The ruling states the provision for separately identifying new construction and remodeling charges applies only to the labor portion of the contract — materials for both new construction and remodeling are taxable.

Q: If the owner and contractor are unrelated (arm's length), is the allocation automatically accepted?
A: No. The ruling says any allocation may be subject to review by the Comptroller to determine its accuracy, and that review isn't barred just because the allocation was agreed to by an arm's-length owner and contractor.

Q: What records should we keep to support the allocation?
A: The ruling points to Rule 3.357(b)(7) for documentation requirements, and references past administrative hearing outcomes requiring blueprints or other evidence detailing the nature of the work, plus a separately stated new-construction labor charge.

Citations and references

Rules cited:

• Rule 3.357(b)(7) — governs documentation for allocating contract charges between new construction and nonresidential real property repair/remodeling, and allows the Comptroller to recalculate an allocation that appears unreasonable.

Source

• STAR search: https://star.comptroller.texas.gov/search?doc_type_code=L&tax_type_code=SST
• Opinion: https://star.comptroller.texas.gov/view/9301906L

Original ruling text

January 25, 1993

Dear **:

I am responding to your inquiry for your client, a general contractor, who
desires to separate the new construction portion of its contract with the
project owner from the nonresidential remodeling portion of the contract. You
and your client submitted the following questions for response.

1. May General Contractor allocate the price of the new construction and
   remodeling based on square footage? i.e., the remodeling area consists of
   approximately 84,000 square feet, and the additional square footage to be added
   to the existing structure is approximately 16,000 square feet. May General
   Contractor separate the cost of new construction and remodeling for the
   contract as follows:

16 000 (new construction sq. ft.)
New Construction: Total Contract $ X 100,000(total sq. ft.)

84 000 (remodeling sq. ft.)
Remodeling: Total Contract $ X 100,000(total sq. ft.)

Or must General Contractor determine exactly how many linear or square feet of
concrete, steel, duct work, plumbing, electrical, tile, etc., are contained in
the new construction and remodeling areas and determine a precise allocation of
costs between new construction and remodeling?

Response: It is permissible to use the allocation of square footage to
determine the portion of labor attributable to new construction and the portion
of labor attributable to nonresidential realty repair or remodeling; however,
the provision for separately identifying charges for new construction and
nonresidential repair or remodeling in the same contract applies only to the
labor portion of the contract. The materials for both new construction and
remodeling are taxable. Also, the contract must separately state these charges
not merely state them as a percentage of the total contract price.

2. Exactly what documentation should the general contractor and owner retain to
   establish that the allocation of costs between new construction and remodeling
   is reasonable?

Response: Documentation required is discussed in Rule 3.357(b)(7). The only
other formal response that has been made concerning documentation is quoted
below from an administrative hearing, " . . . . . blueprints or any other form
of evidence to show in detail the nature of its work." and " . . . . . the
charge for new construction labor was not separately stated as required by the
rule."

The reasonable charge for remodeling must be approximately what the fair-market
value of these services would be without the new construction being performed.

3. Is there a rebuttable presumption that an allocation agreed upon based on
   actual square footage is reasonable?

Response: I am not sure I understand this question. However, Rule 3.357(b)(7)
allows the Comptroller to recalculate the charges if the allocation appears
unreasonable. If the allocation of charges based solely, upon square footage
does not correctly reflect the costs of new construction labor versus
remodeling labor, then the allocation can be adjusted. For example, if the
allocation discussed in Question 1 is based upon the total contract price and
the costs of labor for remodeling exceeds the cost for new construction labor
on a per square foot basis, then the allocation based upon square footage alone
does not correctly identify new construction from remodeling labor; such an
allocation could be recalculated.

4. Is there a rebuttable presumption that an allocation between an "arm's
   length" owner and a general contractor is reasonable?

Response: Any contract containing a percentage allocation or other such
allocation between new construction and nonresidential real property repair or
remodeling service may be subject to review by the Comptroller or his
representative in order to determine the accuracy of the allocation. This
review and recalculation, if necessary, is not prohibited by any agreement
between the owner and general contractor.

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

Sincerely,

Tax Administration Division