Sales Tax Exemptions for Construction Projects

Category | Briefing Papers

If it is true that the two certainties in life are death and taxes, ^[1] human endeavors to avoid the inevitable are as hopeless as they are limitless. And yet, while evading death remains the subject of fairy tales, fables and science fiction, there really are ways to avoid taxes without selling one’s soul. The devil, however, is in the details. This Briefing Paper discusses what to look out for when considering the Minnesota sales tax exemptions applicable to construction projects.

I. Who Is Tax-Exempt?

Several types of project owners are generally exempt from Minnesota sales taxes. These include (1) the United States and its agencies, (2) certain states (other than Minnesota) and their political subdivisions, (3) various educational organizations in Minnesota (including school districts, the University of Minnesota, state universities, community colleges and technical colleges), (4) hospitals and nursing homes owned and operated by political subdivisions of Minnesota, (5) public libraries, (6) nonprofit organizations, and (7) hospitals and outpatient surgical centers. ^[2]

II. Qualifying for the Exemption

Unless a project owner intends to purchase the building materials itself, the owner must appoint a purchasing agent and comply with a phalanx of related statutory and regulatory requirements. This complex web of laws, which some Minnesota government officials privately acknowledge presents a “trap for the unwary,” permeates all facets of the construction project from inception to completion.

A. Preconstruction Phase

The most troublesome requirements come into play before the owner has even selected a contractor. The Department of Revenue advises that a tax-exempt owner who wishes to appoint a purchasing agent must (1) initially advertise for separate bids for materials and labor; (2) be able to accept one bid without accepting both bids; and (3) issue separate contracts for the accepted bids for materials and labor. ^[3] In other words, to qualify for the sales tax exemption, the bidding, awarding and execution of the contract for materials must be handled separately from the bidding, awarding and execution of the contract for labor. As discussed below, Minnesota law also requires that the materials contract contain several specific statements concerning the owner’s purchase of materials through the purchasing agent.

Owners frequently rely upon design professionals to prepare bidding documents and attorneys to prepare contracts. It is incumbent upon whomever is preparing the bidding documents and contracts to ensure that these requirements are met. Otherwise, the sales tax exemption will be lost.

1. Bidding Documents

The advertisement for bids must request separate bids for materials and labor. Because drawings and specifications are typically prepared to include all of the labor and materials required for the entire project, special care must be taken when preparing the bidding documents to identify which materials the owner intends to purchase tax-exempt. The owner need not purchase all materials tax-exempt. For example, it may not be worthwhile for the owner to purchase minor, incidental materials which are of such little cost that the sales tax implications are negligible. The critical point is that any and all materials which the owner does intend to purchase tax-exempt be identified so that a separate bid can be provided.

Under the Department of Revenue’s guidelines, the owner must be free to decide to whom it will award the materials contract independent of its decision concerning to whom it will award the labor contract. This does not mean that the owner must select two different contractors, one to furnish materials and one to furnish labor. In fact, in many cases, owners will wisely choose not to hire separate contractors for materials and labor. However, the owner needs to have the freedom to select two different contractors if it so chooses. Therefore, the instructions to bidders must make clear that the award of the materials contract is not contingent upon the award of the labor contract, nor vice-versa. To drive home this point, it is advisable to provide separate bid forms for the materials and labor portions of the work.

2. Contract Forms

If the owner ultimately decides to award the materials contract and the labor contract to the same contractor (as will frequently be the case), the owner and the contractor must still execute a separate materials contract, rather than having a single contract covering both material and labor. Moreover, the applicable laws require that the materials contract clearly state that: (1) the contractor has been appointed as the owner’s purchasing agent; (2) the owner takes title to all materials at the point of delivery; (3) the owner has the risk of loss for the materials; and (4) the owner, and not the purchasing agent, has responsibility for all defective materials, including those incorporated into the project.

B. Construction Phase

As construction of the project proceeds, a contractor acting as a purchasing agent must comply with two additional requirements. First, the contractor must include a notice in all purchase orders and other documents furnished to material vendors clearly stating that the contractor is the owner’s purchasing agent and that the owner, not the contractor, is obligated to pay for the materials.

Second, to the extent that the contractor intends to purchase any of the materials from someone other than a vendor (e.g., a subcontractor), the contractor must appoint such person as a sub-purchasing agent. All of the above requirements applicable to the owner’s appointment of the contractor as purchasing agent also apply to the contractor’s appointment of a subcontractor as a sub-purchasing agent, including separate bids for materials and labor which can be separately accepted or rejected, as well as separate contracts for materials and labor. The subcontractor must also include a notice in all purchase orders and other documents furnished to material vendors which clearly states that the subcontractor is the owner’s purchasing agent and that the owner, not the subcontractor, is obligated to pay for the materials.

III. Additional Considerations

When considering whether to take advantage of the sales tax exemption applicable to any of the above types of projects, several factors should be considered. First, an owner ought to consider whether it wants to accept some of the risks that are associated with purchasing materials tax-exempt. For example, in appointing the contractor as purchasing agent, the owner relieves the contractor of responsibility for any defects in the materials. If any material or piece of equipment proves to be defective, the owner cannot turn to the contractor and will have to pursue the vendor itself. If the vendor responds by claiming that the material was not defective but, rather, was improperly installed, the owner will get caught between the vendor and the contractor. This predicament is avoided under the traditional approach in which the contractor is hired to both supply and install the materials.

Second, all parties (the owner, the contractor, the architect and the lawyer) should consider what might happen if one or more of the requirements applicable to the sales tax exemption are not met. If the Department of Revenue audits the project, finds a shortcoming, and assesses sales taxes, all of the parties may be sorry. The loss of the anticipated sales tax savings may spawn one or more disputes among the parties. The contractor, who will initially be tagged with the sales tax, along with interest and penalties, may turn to the owner if there is an indemnity clause in the materials contract. The owner, in turn, may look to the architect or lawyer for indemnification if the bidding documents or contract forms were not drafted to comply with the tax exemption requirements.

Third, public owners who are required to award contracts to the lowest responsible bidder should give additional consideration to the ramifications of using the purchasing agent approach to qualify for the sales tax exemption. Such owners may be compelled by competitive bidding laws to award the materials contract to Contractor A and the labor contract to Contractor B, based upon the lowest bids received for each contract. It is easy to imagine how such an arrangement can cause coordination headaches for the project and lead to disputes. Knowing this, many prospective bidders may be disinterested in bidding, and those who decide to submit bids in spite of this unattractive possibility may increase their bids accordingly. This bidding climate would likely produce higher bids which would offset (and could potentially exceed) any anticipated sales tax savings.

Conclusion

The sales tax exemption offers a potential for significant savings. However, owners should carefully weigh the benefits and risks before deciding to structure a given project as a tax-exempt project. An owner who opts to go tax-exempt on a project should seek the assistance of an architect and lawyer who are knowledgeable about the requirements applicable to the sales tax exemption very early in the planning process to make sure that the bidding documents and contract forms are properly drafted to comply with those requirements.

[1] Daniel Defoe, The History of the Devil, 1726; Benjamin Franklin, Letter to Jean Baptiste Le Roy, 13 Nov. 1789.

[2] Construction projects for Indian tribal governments on reservations are also tax-exempt. Moreover, in response to special interest groups, the Minnesota legislature has established dozens of “project-specific” sales tax exemptions. Such exemptions have been created for certain types of projects, including correctional facilities, low-income housing, and facilities for particular kinds of commercial endeavors (e.g., agricultural or mineral processing, aircraft maintenance, direct satellite broadcasting, and biomass electrical generation). Exemptions have also been created for numerous specific projects, including the Lake Superior Center, the Earle Brown Heritage Center, the Long Lake Conservation Center, the RiverCentre Arena, the Minneapolis Convention Center, the Science Museum of Minnesota, and a new ballpark for the Minnesota Twins. The Indian-owned project exemption and the project-specific exemptions have their own rules and are not the subject of this Briefing Paper.

[3] For purposes of this discussion, “materials” means the materials the owner intends to purchase tax-exempt, and “labor” means all of the labor as well as any materials that the owner does not intend to purchase tax-exempt.

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