Can a Construction Contractor Write Off Tax on the Resale of Purchased Material in California?

With the housing crunch occurring throughout California, many contractors are busier than ever trying to construct new homes and apartment buildings to keep up with the sprawling demand. Construction contractors need to be sure to keep up with tax reporting to the IRS as well as to state agencies like California Franchise Tax Board (FTB) and the California Department of Tax and Fee Administration (CDTFA). Because they often pay workers as independent contractors and buy large amounts of materials from different sources, there can be some especially tricky tax issues for those in this profession. In one recent case that caught the attention of our skilled Dual Licensed Tax Attorneys and CPAs at the Tax Law Offices of David W. Klasing, the California Office of Tax Appeals ruled on whether or not contractors are permitted to write off sales taxes if they intend to use some of the materials they use for construction activities and to resell the rest.

Background of The Case

The case involved the actions of a California construction contractor called the Martinez Steel Corporation (Martinez). The company purchased steel materials in the amount of $18,374,604 under resale certificates with no tax or tax reimbursement paid or reported at the time of purchase. Martinez did, however, report and pay tax on $15,534,190 of steel materials that were withdrawn from inventory, of which the company used $15,516,870 for installation purposes in its construction projects, and resold $17,320. After an audit, Martinez received a tax bill from the CDTFA for $400,402 in back sales tax and interest that the CDTFA said was owed on the remaining $2,840,414 of steel material in inventory.

Martinez appealed this bill on the grounds that they should be taxed based on the fact that they were engaged in the business of selling these materials rather than furnishing and installing them in the performance of their construction contracts. This would permit them to write off the purchase of these materials and not have to pay the sales tax. In support of this argument, Martinez claimed that their original intent when purchasing the materials was to resell them, and pointed to the fact that they resold $17,320 of this batch of materials as well as $1,392,413 worth of the same materials during the eight preceding quarters and $98,780 worth of the materials in the two quarters following the liability period.

The appeal of the $400,402 tax bill was handled through the California Office of Tax Appeal and heard by an Administrative Law Judge (ALJ). ALJs are somewhat different than a regular judge as they go through a separate process of licensing and qualification. These trials and pre-trial procedures are also much different than a typical trial in a criminal or civil court. As such, it is vital to make sure when you are dealing with the CDTFA or another state agency that you hire an attorney with experience specific to these types of cases, like those on the team at the Tax Law Offices of David W. Klasing.

The Administrative Law Judge’s Ruling

In the Martinez matter, the ALJ ruled in favor of the CDTFA, confirming that the company was, in fact, subject to tax at the time of purchase. In the words of the court, “During the audit period, appellant consumed $15,516,870 of steel materials and resold $17,320 of steel materials at retail, which is 0.1 percent of total materials pulled from inventory during the liability period. The fact that appellant consumed 99.9 percent of the materials it purchased and resold only 0.1 percent of the materials establishes that it was not engaged in the business of reselling the materials. Therefore, CDTFA's determination is reasonable and rational, and the burden of proof shifts to the taxpayer to establish that a result differing from CDTFA's determination is warranted.” In this case, the ALJ ruled that the burden of the taxpayer to prove the result was not warranted and was not met in this instance. The ruling stated that Martinez’s argument that the company had intended to sell the materials was not borne out by the evidence, including their numbers for the prior and subsequent quarters, which the court felt gave “no evidence of the total amount of materials it purchased [those quarters], nor the amount of those it consumed, so there is no way to determine whether the gross sales were comparatively significant to those [during the time frame in question].”

If You Have Questions Related to Your CDTFA Tax Bill, Call our Experienced Sales Tax Attorneys and CPAs Today

In this case, the Office of Tax Appeals did not believe that the Martinez Steel Corporation could make a compelling argument that they were engaged primarily in the resale of the steel products they purchased based on the simple fact that 99.9 percent of the materials purchased were not resold. As such, they could not write off the resale of any of the material purchased. However, this does not mean that others in similar situations where they devote a larger percentage of their business to resale are necessarily ineligible for a write-off. The facts of each case are different, and you should consult with a skilled tax attorney and CPA like those at the Tax Law Offices of David W. Klasing before making any decisions about whether to pay or challenge a bill from the CDTFA.