General Sales Tax Principles in Arizona
Sales taxes in Arizona are imposed on the retail sales of tangible personal property, the sale of specified services and admissions, and the leasing of tangible personal property. The State imposes a transaction privilege tax upon those engaged in business in Arizona, which is essentially a sales tax on the seller rather than the consumer. However, municipalities (cities and towns) also levy transaction privilege taxes on the gross receipts from the sale of tangible personal property and certain services. The transaction privilege tax rate varies by city and business activity. As of May 2016, the highest total state and local combined city transaction privilege tax rate, which includes the state transaction privilege tax, was 11.2 percent for businesses engaging in retail sales in Phoenix. However, for construction contractors , the city transaction privilege tax rate recently reached 6.3 percent in both Tucson and Mesa, bringing the total transaction privilege tax rate for those areas to 11.6 percent.
Although sales taxes are not actually sales taxes levied on the purchaser, businesses are required to charge, collect and remit transaction privilege taxes to the Department of Revenue on a monthly, quarterly or annual basis. Business activities that are taxed in Arizona include: retail sales, rental or leasing of tangible personal property, restaurants or bars, amusement and restaurant operations, prime contracting, mining or quarrying, manufacturing, publishing, and telecommunications. Taxable services taxed at the State level depend on the industry, but generally include: data processing, Internet access, job printing, storage and warehousing, utilities, landscaping, janitorial, pest control, repossession, and utility line clearance.
Labor vs. Materials: Which Part Gets Taxed?
Evaluating what services you are actually selling to your customer is essential. Is the sale of your service primarily labor with minimal materials needed or is there a substantial amount of material required to perform the service? For example, when a salesperson sells the service of a painting house, the costs of the paint needed to perform the job, while perhaps substantial, is still incidental to the labor in a home painting job. The same is true with a plumbers bill to fix sink or a locksmith bill. The materials and parts needed to make the repair and provide the service perhaps represents a fraction of the total bill. In such instances sales tax need not be charged on the labor for the service. In contrast, if a contractor specializes in kitchen cabinets and sells cabinets to a client, a fair amount of sales tax will need to be charged on the sale and delivery of the cabinets. Construction components such as windows (when sold separately) and including other doors, shingles, flooring — anything which can be considered separate infrastructure or a fixture may be subject to sales tax. The measurement of the labor component of the sale of the service and the measurement of the incidental materials needed to perform the taxable service are important to determine if a material sales tax is applicable. For example, if a client orders a door and installation services — the sales tax is calculated on the value or fair market value of the door and on the labor of the installation. Conversely, if a door is ordered from a cabinetry manufacturer and later installed by the contractor — the sales tax on the sale would be calculated on the door as well as on the delivery. If the doors are being manufactured by the contractor and he has provided the hardware and handles — they are not taxable, as the labor was in manufacturing the item. But, if the hardware and handles were not manufactured by the contractor, the doors being manufactured by the client would be subject to sales tax on the labor and sales tax on the value of the doors manufactured for the client.
Do Contractors Need to Collect Sales Tax on Labor?
Contractors are not required to charge sales tax upon labor for real property contracts or maintenance contracts. Sales tax laws in Arizona regarding construction are governed by A.R.S. § 42-5075(B) and (C), which explain how the contractor’s burden of tax is to be born.
"A. A tax is imposed on the business privilege of conducting the business of contracting at the rate prescribed by section 42-5351, computed on the gross receipts from contracting activities. Business and occupation classifications include each of the following:
- General contractor.
- Residential prime contractor.
- Retailing contractor.
- Prime contracting.
- Specialty contractor.
- Use tax contractor.
- Retail seller.
- Job printer.
- Fabricator.
- Seller of manufactured goods.
B. A contractor who performs work with respect to real property is not required to collect and remit tax on the amount charged for services to the real property if:
1. The sale to the contractor on materials, tools and equipment are taxable; and
2. The contractor does not mark up the cost of the material supplied.
C. The contractor is a consumer of – and owes tax on the purchase of – all building materials, tools, and equipment that become an integral and inseparable part of the construction project for the duration of the contract. Materials that become part of the real property include concrete, wood, paint, nails, piping, wiring, roofing and insulation. Tools and equipment which are consumed in the course of a contract that become an inseparable part of the real property include saw blades, drills and master levels."
Some Exceptions and Special Scenarios
There are certain exceptions and special circumstances in which contractors will not charge sales tax on labor. For example, when materials are sold as tangible personal property to a consumer who does not use the property in the construction of the improvement to real property, the sales tax would be applicable on the property itself and not the labor upon installation. If the labor is separated and separately itemized on the contract, then the sales tax would be applicable on the property. The most common example of this is furniture, which can often be purchased as tangible personal property (furniture) or installed into a home for use with real property (built-in furniture).
Further, certain types of contracts are not taxed according to the underlying property. For example, contracts for landscape maintenance or repair of an emergency nature are not taxable. In addition, if the contractor is contracted to install a structure on real property but after the structure is built and constructed the real property is split into different parcels, and the contractor sells one or more of those parcels to a buyer who uses the structure as an apartment, hotel, resort, etc., that contractor does not owe tax on the structure.
For example, if a contractor constructs a convention center, hotels, and restaurants at a job site but after the site is completed the property is split into separate parcels and the convention center and associated commercial properties are sold to a buyer who intends to use it as a resort, the contractor does not owe tax on their labor to build the buildings. This is true even if the contractor sells the buildings and improvements to the buyer.
How Do Contractors Bill Out Sales Tax
If sales tax is applicable to your services and/or materials, it is best practice to clearly itemize the sales tax on invoices provided to the customer. This makes it much easier to collect the dependent tax from the customer, if necessary. It also saves you the aggravation of having to go back later on and adjust your records and receivables (which is difficult enough to manage, even under the best circumstance, let alone when you have to reach out to past customers).
With respect to providing appropriate information to your customers, you would be well served by indicating on your invoices (in 1- to 6-point font at the bottom of the invoice—on either the front or back of the form) that sales tax may be applicable to the charges; that sales tax is imposed (and must be collected/paid) unless the customer provides a valid Arizona Transaction Privilege Tax (Arizona TPT) Exemption Certificate; and that unless a valid exemption certificate is provided by the customer, the contractor must collect the applicable sales tax and submit them to the Arizona Department of Revenue.
While this information is communicated to your customers , it is also a good business practice to limit your exposure for transactions where the correct tax rate has not been applied such that you end up incurring a liability for the difference in the rates. As a component hereof, you may also want to consider including language on your invoices (again in 1-6 point font at the bottom of the invoice – back or front) that your company reserves the right to pass through any retroactively imposed taxes to current customers. This is something that should be part of your standard invoice language to limit the risk that your customers will be surprised with retroactive tax increases.
As mentioned above, it is important to keep good records of the exemption certificates that you receive from your customers. In fact, if a contractor has failed to receive the appropriate exemption certificates from the purchaser, the contractor could find itself liable for any additional tax deficiency that the State of Arizona imposes as a result. This is particularly true under the "passing through" provisions, whereby contractors who fail to pass through the full amount of the applicable tax to its customers can be liable for the difference.
Legal Consequences of Misapplying Sales Tax
There can be significant legal and financial implications for a contractor that misapplies sales tax on a contract with a private purchaser of construction services. In fact, it is relatively common for contractors to come under audit for incorrectly charged or uncharged tax on labor. Most commonly, a contractor will fail to charge sales tax on labor included into the contract price, treating the transaction as a "resale" when the contractor does not intend to resell the labor, but rather perform it. This error results in the contractor being liable for the seller’s use tax; however, this may not be the only exposure. While Arizona does not have a reseller exemption like the Internal Revenue Code, it does have a "vendor nexus" provision in the transaction privilege tax (TPT) laws that may create nexus where none existed before.
If a contractor does erroneously charge tax on labor included into the contract price, the exposure may be rather large. A taxpayer that has misapplied tax on labor has three potential options. First, the contractor may apply for an adjustment by the Department of Revenue for the tax on labor misapplied if it determines the contractor overpaid tax on its contract price. Second, the contractor may refund the tax to the private purchaser, who, in turn, must return the excess amount to the contractor. This payment will be reported when the contractor files its next TPT return to the Arizona Department of Revenue. Finally, the contractor may pay the excess tax to the private purchaser as an adjustment to the contract price. Third, and arguably a very bad option, is that the contractor may try to pass through the legally owing tax to the purchaser by charging the excess amount pursuant to the contract terms; this would be an attempt to pass through what is owed by law to the contractor itself. This third option is a horrible idea unless the Director of the Department of Revenue approves the arrangement in writing. In either event, the contractor should make sure to request that the private purchaser submit a certified statement to the contractor that the overpayment was returned. If the contractor obtains this written demarcation from the private purchaser, this would act as some evidence that the contractor did not "pass through" the tax to the private purchaser. Therefore, doing the right thing could reduce exposure for the contractor.
With regard to relief from tax overpayment, there are some limitations that taxpayers should be aware of. First, as referenced above, the contractor must be an Arizona resident. Next, a contractor may only apply for refund relief to the Department of Revenue for tax on labor for the last 48 months. Lastly, the Department of Revenue may provide refund relief to corporations for taxes on labor; however, limited liability companies organized as corporations do not receive a refund. In other words, the claim by the limited liability company is treated as a "pass-through" entity. These limitations create a substantially smaller amount of tax that a contractor can recover if it chooses to pursue relief.
The contractor also must be wary of the fact that if a private purchaser is charged sales tax on labor without the Director’s prior approval, it is possible that the Director may require the contractor to eat that tax. This could result in considerable exposure to the contractor as it may end up having to pay tax on taxes – a nuisance indeed!
Overall, a contractor should know it’s customer to see if the private purchaser is exempt from tax. Next, the contractor should inquire whether the director of the Department of Revenue has approved the charges by the contractor of tax on labor. Finally, if the contractor’s failure results in tax that is not defended by a resale exemption, the contractor should notify the private purchaser of its incorrect application of tax and either refund the excess or request an adjustment and collect the amount from the purchaser.
Helpful Resources for Arizona Contractors
Resources for contractors in Arizona include the Arizona Department of Revenue and the now defunct Construction Law Section of the State Bar of Arizona (which has now become the Construction and Public Contracting Division of the State Bar’s Real Property Section).
The Arizona Department of Revenue publishes a wide variety of guidance to taxpayers in the form of factual examples, frequently asked questions, and policy papers answering specific questions.
You can find these publications on the Department of Revenue’s website, including: TR-3, TR-5, TR-6, TR-9, TR-110, TR-113, TR-151, TR-152, TR-155, TR-165, TR-159, TR-157, and TR-26. Although they are no longer regularly updated and should be used with caution, the Construction Law Committee of the former State Bar of Arizona issued a series of guidelines for complying with Arizona’s tax laws for contractors . Please note that these guidelines do not supersede the advice of a qualified tax advisor and are made to apply only to situations common in the industry. The links for these prior guidelines can be found here: TR 145, TR 146, TR 147, TR 148 and TR 149. Many local taxing jurisdictions also publish guidelines to aid contractors and keep contractors abreast of any changes in local tax law. The City of Phoenix, for example, has a number of tax publications available at its website: Tax Guide For Contractors. As a general rule, if you are one of the thousands of contractors doing business in Arizona, it is always best to consult with your tax advisor before buying materials or performing any work in the state.