Is a not-for-profit organization exempt from sales tax on Michigan real estate construction? The answer can be confusing. A tax-exempt organization is typically exempt from purchases used to further its exempt purpose. This exemption can extend to the construction of real property in limited circumstances.
When an exempt organization decides to construct or improve real property, it will typically issue a request for proposal and may indicate the project is tax exempt. While the organization itself may be exempt from sales tax, the contractor engaged to construct the property typically is not. This disparity can cause issues for both parties in the event those involved aren’t familiar with this aspect of the law.
A real property contractor is considered the consumer of the materials and supplies used in constructing, altering, repairing, or improving real estate for others. However, a contractor is exempt from tax on materials used in projects for nonprofit hospitals, qualified nonprofit housing, church sanctuaries, qualified water pollution control facilities, and qualified air pollution control facilities. In order to claim an exemption from sales tax as a result of one of the exceptions, the contractor must obtain documentation from the exempt organization specifying the legal and factual basis for the claimed exemption.
When a project doesn’t meet one of the exemptions, a contractor pays sales or use tax on the purchase of equipment, supplies, and materials and cannot charge sales or use tax directly to the customer. However, the contractor can include the amount of the tax in the total contract price as an overhead cost. It’s also important to note that a contractor is required to pay use tax on construction materials supplied to it by the exempt organization, unless the exempt organization previously paid sales tax on the materials supplied.
For example, let’s say a nonprofit school purchases building materials in a tax-exempt transaction and provides the materials to the contractor for use or consumption in performing the contract upon the school's real property. The contractor must pay use tax on the property, absent any other applicable exemption.
All parties involved need to understand how these rules work in connection with the terms of the contract. The rules are complex and often a contractor will include an indemnification clause for sales, use, or other transaction taxes. If an indemnification clause is present and the contractor doesn’t include tax in determining the bid price but it’s later determined that tax is due, the exempt organization issuing the request for proposal could contractually be liable to the contractor as a future price adjustment. The future price adjustment would not per se be the payment of tax by the exempt organization but rather an adjustment to the contract price to cover the contractor’s tax cost. Thus, it’s in the exempt organization’s best interest to thoroughly review all proposals and contracts to ensure the terms and conditions are comparable in regards to tax matters and to fully understand any indemnification clauses.
Stay tuned…Each month we’ll focus on a different state within our geographic footprint. Next month we’ll focus our discussion on Ohio sales and use tax.