Rulings of the Tax Commissioner

May 16, 2016

Re:     § 58.1-1821 Application: Retail Sales and Use Tax & Employer Withholding Tax

Dear *****:

This is in response to your letter, submitted on behalf of ***** (the "Taxpayer"), appealing the retail sales and use tax assessments issued to the Taxpayer as a result of an audit for the periods July 2010 through April 2015.  The Taxpayer also appeals the employer withholding tax assessments issued to the Taxpayer for the periods May 2009 through April 2015.  I apologize for the delay in responding to your letter.

FACTS

The Taxpayer is an out-of-state business engaged in the sale and installation of stone countertops to customers in Virginia and elsewhere.  An audit resulted in the assessment of sales tax on untaxed sales of tangible personal property, as well as the assessment of withholding tax on employee wages paid for services performed in Virginia.

The Taxpayer takes exception to the inclusion of installation labor in the audit. The Taxpayer maintains that it separately stated such labor on its invoices and therefore should be exempt from the retail sales and use tax.  The Taxpayer also contends that it has not understated the cost of materials, which are in the range of $13 to $23 per square foot.  The Taxpayer indicates that the countertops are always fabricated at its shop located in another state.  Fabrication consists of cutting the stone slab to size, edging, and cutting holes for sinks and other appliances.  The Taxpayer contends that its fabrication costs are of a de minimis amount when compared to the total labor charges.  The Taxpayer has furnished a spreadsheet itemizing the amount of sales tax claimed to be owed on materials and fabrication labor.

In regard to the withholding audit, the Taxpayer contends that not all invoiced labor represents wages subject to Virginia withholding.  Rather, the Taxpayer maintains that the invoiced labor includes a significant markup for profit and payments to independent contractors.  The Taxpayer contends that such profit and contractor payments do not represent wages subject to Virginia withholding. 

DETERMINATION

Retail Sales and Use Tax

Subsection A of Virginia Code § 58.1-633 sets out statutory recordkeeping requirements of dealers:

Every dealer required to make a return and pay or collect any tax under this chapter shall keep and preserve suitable records of the sales, leases, or purchases, as the case may be, taxable under this chapter, and such other books of account as may be necessary to determine the amount of tax due hereunder, and such other pertinent information as may be required by the Tax Commissioner.

Title 23 of the Virginia Administrative Code (VAC) 10-210-470 is the Department's regulation on recordkeeping requirements of dealers.  Such regulation requires a dealer to maintain complete records necessary to determine the amount of tax liability, as well as, to substantiate any deductions and exemptions claimed.

Virginia Code § 58.1-609.5(2) provides an exemption from the retail sales and use tax for “[a]n amount separately charged for labor or services rendered in installing, applying, remodeling, or repairing property sold or rented.”  [Emphasis added.]  This statute allows an exemption if the charge for labor or services rendered in installing property sold is separately stated on the customer's invoice.  If such charges are not separately stated, the charges become a part of the sales price subject to the tax. When a seller does not segregate a nontaxable installation charge from a taxable charge, but instead combines the two into a single charge, the combined charge is taxable.

I would further point out that the term "sales price" is defined in Code of Virginia § 58.1-­602 as “the total amount for which tangible personal property or services are sold, including any services that are part of the sale, valued in money, whether paid in money or otherwise, and includes any amount for which credit is given to the purchaser, consumer, or lessee by the dealer, without any deduction therefrom on account of the cost of the property sold, the cost of materials used, labor or service costs, losses or any other expenses whatsoever.”  (Emphasis added.)  Based on this sale price concept, sales taxation is the rule and not the exception.

In this case, the Taxpayer contends that the labor charges noted in its spreadsheets minus the fabrication labor calculated represent the amount of installation labor charges that should be removed from the audit.  Despite this contention, I cannot ignore the fact that the labor charges billed on the invoices include “a significant markup for profit.”  Profit does not in any way constitute installation labor, which is “labor rendered after the product is complete in order to install it for the customer.”  See Public Documents (P.D.) 94-351 (11/22/94) and 86-­186 (9/18/86).  Rather, profit is an expense payable to the Taxpayer and is a part of the sale of tangible personal property.  Under the Virginia Retail Sales and Use Tax Act, there is no statutory exemption or exclusion for profit, whether separately stated or not.

Although the Taxpayer's spreadsheets exclude fabrication labor from the labor charges noted on the invoices, none of the profit has been excluded from the labor charges.  As such, the revised labor charges consist of a combination of exempt installation labor and taxable profit.  This combined charge is taxable and cannot be removed from the audit.

Because this audit was the first sales and use tax audit conducted by the Department of the Taxpayer, I will allow a final opportunity for the Taxpayer to correct this situation.  The Taxpayer may submit separate calculations of the profit[1] and installation labor[2] for each sale included in the audit to the Department's auditor.  In addition, the Taxpayer must furnish internal records that substantiate the calculation of the profit, installation labor and fabrication labor.  Such submissions and records must be presented or made available to the Department's auditor within 60 days of the date of this letter.

Of final importance, I am concerned that the invoices presented to the Department and the labor amounts claimed as representing installation labor are not accurate.  For these reasons, I am expecting the Taxpayer to cooperate fully with the Department's audit staff in its requests for records to substantiate the re-calculation of the installation charges.

Employer Withholding Tax

The Taxpayer claims that there was no verification of any wages paid from any source.  It is my understanding from the Department's audit staff that the Taxpayer did not provide records for the withholding audit.  As such, there was no way to confirm any of the Taxpayer's contentions.  Absent such records, the Department assessed the omitted withholding tax as allowed by Va. Code § 58.1-1812.  The withholding tax assessments will not be adjusted unless the Taxpayer provides the records needed to substantiate the Taxpayer's Virginia withholding tax liabilities.  The Taxpayer presents several contentions that are addressed below.

1.     The Taxpayer contends that the labor billed includes a significant markup for profit. However, the Taxpayer has not furnished any evidence in support of its contention.  As such, it has not met its burden of proof as required by Va. Code § 58.1-205(1).[3]

2.     The Taxpayer claims that the auditor was told that there were no Virginia sales in 2009. Based on this claim, the Taxpayer maintains that no withholding tax should have been assessed for such period.  Because no records have been furnished to establish the Taxpayer's contention, the Taxpayer has not met its burden of proof.

3.     The Taxpayer claims that it utilized the services of valid independent contractors for installation services for the period 2010 through part of 2014.  While there is no requirement to withhold Virginia tax from the amounts paid to independent contractors, no records have been furnished to establish the Taxpayer's contention.  As such, the Taxpayer has not met its burden of proof. 

4.     The Taxpayer claims a safe harbor on the classification of independent contractors based on an income tax discrepancy adjustment document (Form 4549-A) used by the Internal Revenue Service (IRS) to inform the Taxpayer of a mathematical error made on its 2012 income tax return.  According to the IRS, the purpose of the discrepancy adjustment program is “to reduce the number of referrals for income tax examinations for what may require essentially a minor recalculation of tax.”  See the IRS’ EP Examination Process Guide — Discrepancy Adjustments, last updated 11/23/15.  This program allows an IRS agent to make certain line adjustments to income tax returns.  I understand that discrepancy adjustments do not constitute an inspection of a taxpayer's books and records. I also understand that the Office of Chief Counsel for the IRS has opined that correction of mathematical errors does not constitute an examination.

Based on these facts, I must conclude that the Form 4549-A presented indicates only one minor adjustment was made because of a mathematical error, i.e., the Taxpayer's taxable income per the return incorrectly reported a zero amount rather than a negative amount.  I can find no other reason as to why an adjustment was made or why the Taxpayer's return was examined.  While the Taxpayer's return was reviewed to some degree, there are no details that the discrepancy adjustment went beyond a cursory review or in any way involved a detailed examination of the cost of labor reported on the Taxpayer's Schedule C.  There is no evidence presented to suggest that the IRS requested a more detailed examination of the Taxpayer's return, i.e., no letters from the IRS have been furnished showing that the IRS requested detailed records to support the labor costs reported.  Moreover, the Taxpayer has not furnished any evidence (such as IRS Form 1099s filed for each contractor) for the 2012 year or for any other assessed year that establishes the Taxpayer's contention that independent contractors were used. If independent contractors were used to install countertops in Virginia, the Taxpayer should have provided each contractor with a Form 1099 to report the amount paid to each contractor.  However, the Department has received no information as to what the Taxpayer reported to the IRS.  It may or may not have reported forms 1099 or may have used W-2s or a combination of both.  The Form 4549-A presented does not establish how the contractor income was reported.  Thus, lacking sufficient evidence, the Department cannot presume that the Taxpayer used any forms 1099 to report payments to contractors.

In addition, no information has been presented that the independent contractors qualified as such under the twenty-factor test addressed in P.D. 99-143 (6/11/99).  Such test is used to distinguish between an employee and an independent contractor.

Virginia's income taxing system is based largely on the theory of self assessment, which is also how the federal system operates.  When only a line examination is performed, the IRS and Virginia rely on a taxpayer's reported information to make minor corrections.  It is only when an examination goes beyond a cursory review that the IRS will perform a more extensive investigation generally by requesting supporting records from the taxpayer.  In this case, a detailed examination, particularly of the cost of labor reported, has not been established based on the income tax discrepancy document presented.  Accordingly, I cannot agree to a safe harbor protection under these circumstances.

In this case, the Taxpayer has not furnished any essential records or information (e.g., Form 1099s, list of names and addresses of all contractors used in Virginia for each year in question, contracts with contractors providing rights, instructions and work expectations including tooling required or furnished and the time when payments were to be made, licensing required, whether or not the contractors offer services to the public in general, the type and nature of training provided to contractors, etc.) to establish its treatment of certain persons as independent contractors for the years in question.

While Virginia generally conforms to rules and regulations of the IRS for income tax purposes, the Department has a right to independently review a taxpayer's records when a failure to withhold is suspected.  Accordingly, to establish the Taxpayer's contention that it used independent contractors, the Taxpayer must provide the Department's auditor with the following: (a) copies of all Form 1099s furnished to independent contractors that performed services in Virginia for all of the taxable periods in question; (b) a project log or similar documentation that identifies the locations of all jobs performed in 2009; (c) supporting documentation or information setting out a breakdown of the "cost of labor" reported to the IRS on the Taxpayer's Schedule C for each year under contention; (d) a breakdown of the amount of labor services performed in Virginia by employees and independent contractors for each year in question, along with the supporting documentation upon which such breakdown is based; (e) copies of audit letters from the IRS requesting information and/or providing closing information related to any labor cost issue examined in detail by the IRS for the taxable periods in question; and (f) the information to complete the twenty factor test discussed above.

5.   The Taxpayer contends that even if contractor labor was considered wages, it would be incorrect to state that all contractor labor was subject to Virginia withholding since less than 19% of gross sales came from Virginia.  It is my understanding that the auditor did not assess all labor invoiced as labor.  Rather, I understand that the auditor assessed 80% of such labor charges.

6.        The Taxpayer concurs that some liability for the payment of Virginia withholding tax exists for 2014.  The Taxpayer identifies three individuals having Virginia wages in 2014.  The Taxpayer also uses a formula to calculate its 2013 Virginia withholding liability based on a percentage of Virginia sales to gross sales.  Since no supporting documentation was furnished, the Department will need to review the Taxpayer's internal records to confirm the 2014 amounts and to determine whether the 2013 estimate is reasonable or not.

Because records have not been furnished to support the Taxpayer's contentions, I find no basis for revising the withholding tax assessments at present.  Despite this, I will allow the Taxpayer a final opportunity to provide the information and records needed to revise the withholding tax assessments.  An auditor will contact you to arrange for the review of the Taxpayer's records needed in this matter within fifteen (15) business days of the date of this letter.  The Taxpayer must furnish such records, or make them available, within 60 days of the date of this letter.

CONCLUSION

Based on this determination, the assessments are correct.  Once the audits are re­examined or in the event that the requested documentation is not submitted to the Department within the time allotted, revised or updated bills, with interest accrued to date, will be sent to the Taxpayer.  The outstanding balance should be paid within 30 days of the bill date to avoid additional interest charges.  The Taxpayer should remit its payment to: Virginia Department of Taxation, 600 East Main Street, 15^th Floor, Richmond, Virginia 23219, Attn: *****.  If you have any questions concerning payment of the assessments, you may contact ***** at *****.

The Code of Virginia sections, regulation and public documents cited are available on­line at www.tax.virginia.gov in the Laws, Rules and Decisions section of the Department's web site.  If you have any questions about this matter, please contact ***** in the Department's Office of Tax Policy, Appeals and Rulings, at *****.

Sincerely,

Craig M. Burns
Tax Commissioner

AR/1-6143033791.R