When sales tax exemption is the exception — Wacky Tax Wednesday

This post has been updated; it was originally published on August 26, 2020. 

Construction management is one of the most stressful jobs around. So why would a retailer opt to be treated as a construction contractor rather than a retailer?

Because of sales tax, of course. 

A few years back, a large retailer decided not to collect sales tax on the appliances it delivered and installed in customers’ homes. The retailer did collect sales tax on appliances when customers handled delivery and installation themselves, or if the retailer delivered the appliance but didn’t install it. It just didn’t charge tax on the appliances it sold, delivered, and installed.

But taxation is the rule in Illinois; exemption is the exception. Thus, anyone seeking an Illinois sales tax exemption — like the retailer in this wacky tax tale — has the “very heavy burden” of proving it’s entitled to the sales tax exemption. 

In this case, the retailer seemed to think calling itself a contractor would enable it to sell, deliver, and install appliances tax free. It claimed it met the definition of a construction contractor, that the sale of the built-in appliances were incidental to a construction contract, and that the built-in appliances were permanently affixed to and an integral part of the real estate.

 Keep that in mind as we explore the following:

• Are appliances subject to Illinois sales tax?
• Do installed appliances necessarily become part of real property?
• Can an appliance retailer be a construction contractor?
• Are the installed appliances incidental to the installation contract?
• Does taxing appliances violate the Illinois state constitution?

Appliances sold at retail are generally subject to Illinois sales tax.

So, what prompted the retailer to tax some appliance sales but not others? The answer can be found in the court case that arose after the Illinois Department of Revenue audited the retailer and found it liable for the uncollected sales tax. Because of course the tax authorities noticed what the retailer did (or didn’t). And of course the retailer challenged the assessment, and the case went to court.

According to the court documents, whether the retailer collected sales tax depended on whether the installed appliance became part of the real property or retained its character as personal property. If the retailer determined the appliances were “incorporated into, and permanently affixed to, real estate,” it didn’t collect sales tax on the sale of the appliance.

The retailer considered built-in dishwashers, over-the-range microwaves, wall ovens, and similar appliances to be “built-in” and “permanently affixed to real estate” after installation. And you can see their point. An over-the-range microwave is certainly more affixed to real estate than an on-the-counter microwave.

However, the court found the built-in appliances in question to be neither permanently affixed nor an integral part of the real estate. It didn’t have to go far for evidence, because the retailer’s installation contract specified that the customer must be replacing an existing appliance. 

“The fact that the to-be-installed appliance is replacing a similar one would fatally undermine any characterization of either permanency or integrality,” observed the court.

The retailer explained that, “when it installs certain appliances, it is a construction contractor and not a retailer.” It argued that as a construction contractor, “it was not obligated to collect and remit sales taxes on the appliances it sells and installs.”

The court agreed that “a construction contract involves the incorporation of tangible personal property into real estate,” and that “those contracts are not subject to sales tax on the labor furnished and tangible personal property (e.g., materials and fixtures) incorporated into a structure.” 

Yet the court noted that for a business to enter into a construction contract with a client, its “primary” or “real” occupation must be that of a contractor: i.e., engaged in “the occupation of entering into and performing construction contracts for owners.” Becoming a construction contractor isn’t as easy as calling yourself one.

When a business’s real occupation is in doubt, the primary occupation of a taxpayer is based on the “substance of the transaction” test. Here it comes down to whether the article sold has any value to the purchaser without the services rendered by the vendor. 

For a sales tax exemption to apply to the retailer’s sales of appliances in this situation, the retailer would have to prove the appliances have “no value to the customers except as a result of the services” rendered by the taxpayer. 

And it couldn’t: The retailer conceded that it sells appliances to purchasers who don’t hire the retailer to perform the installation services. “Clearly, the product (i.e., the built-in appliance) has value even in the absence of the service (the installation),” noted the case text. The substance of the transaction test established the retailer to be a retailer and not a construction contractor, “even when it contracts with a purchaser to install the appliances [it] sells.”

Furthermore, the court found there to be “a real and substantial difference between a retailer … [that] primarily sells appliances to the end user and whose installation services are merely incidental to the sale of the appliance, and a construction contractor … [that] provides a service for which the appliance is merely incidental.”

For the record, construction contractors aren’t necessarily exempt from Illinois sales tax. 

True, “a construction contractor does not need to collect sales tax when incorporating taxable items of tangible personal property into real estate under a construction contract.”

However, the Illinois Department of Revenue reminds that “in this scenario, Illinois law considers the construction contractor the end user of the items permanently incorporated into real estate. The construction contractor must either pay tax on the cost price of these items directly to its supplier or remit the tax directly to the Illinois Department of Revenue.”

So, there’s that.

Perhaps built-in appliances could be incidental to a construction contractor’s installation contract under some circumstances. But that’s not the case here. Although the retailer insisted the built-in appliances it sold were “incidental to a construction contract,” the court disagreed. 

And as noted above, the court rejected the claim that the installed appliances were incorporated into the real property or an integral part of real property.

The retailer’s final argument in its defense was that assessing sales tax on installed appliances violates the uniformity clause of the Illinois state constitution. This provides, in part, that similar types of businesses be taxed uniformly, and that exemptions should be reasonable.

The retailer argued that “there is no real and substantial distinction between 1) a business acting exclusively as a construction contractor and 2) one acting as both a retailer and a construction contractor.” I know a construction contractor or two who might disagree with that, and the claim was soundly rejected by the court.

There is “a real and substantial difference,” observed the court, between a business like the retailer and a construction contractor. The retailer provides installation services that are incidental to the sale of the appliance. A construction contractor provides a service for which the appliance is merely incidental.

On September 30, 2024, an Illinois appeals court affirmed that the retailer violated the Illinois False Claims Act for periods after June 2015, when the Illinois Department of Revenue published a compliance alert clarifying tax obligations for retailers that both sell and install appliances. However, the appeals court determined the retailer was not liable for the tax for periods prior to publication of the alert.   

The appeals court held the retailer is liable for sales tax for the audit period, minus a credit for any use tax already paid — and then added that the trial court must triple the difference as allowed under the False Claims Act. The exact amount of the damages, along with attorneys fees to be awarded, will be determined by a new trial. The retailer will also be assessed a penalty for each false tax return made from June 2015 to March 2021.

Like construction projects themselves, sales tax law can be messy. Sometimes honest mistakes happen; sometimes corners are cut to save money. Either way, someone usually finds out eventually.

When it comes to determining taxability in Illinois, it’s often best to err in favor of taxation. Remember, as the Illinois Appellate Court noted in its analysis of the case, “In Illinois, taxation is the rule; tax exemption is the exception.” Unless there’s a clearly stated exception to that rule in a specific case, “the party seeking the exemption must prove that it is entitled to it. This is a ‘very heavy’ burden.” 

One way to alleviate that burden, and to ensure what should be taxed gets taxed, is to automate sales tax calculation and remittance. Cloud-based tax calculation software like Avalara AvaTax determines what rate should be applied to each transaction using item taxability rules and regulations, geolocation, tax laws, and more.