Home improvement retail chains are receiving heightened scrutiny from state revenue agencies for unpaid taxes in transactions where the big box stores act more like construction contractors than traditional retailers.
Best Buy, Home Depot, and Lowe’s could be on the hook for millions in unpaid sales tax liabilities and penalties under two lawsuits advancing in Illinois. And South Carolina’s Department of Revenue is pursuing $2.8 million in back taxes, penalties and interest against Lowe’s after winning a $2 million judgment against Home Depot.
The tax question involves whether home improvement stores should be viewed as retailers or contractors when appliances, cabinets, furnaces and other products are installed. The tax duties for the two groups are different. Asserting the contractor designation, the chains often remit use tax based on their cost for materials used during installations rather than the higher sales tax based on the retail sales price of the materials.
While South Carolina and Illinois lead the states with aggressive audit tactics, tax practitioners say other states that haven’t updated their tax codes may follow suit as consumer demand for store-sponsored installation services surges.
“Construction is one of the most complicated areas of the sales and use tax,” said Scott Peterson, vice president of U.S. tax policy at the tax software company Avalara and a former state sales tax director. “Across the country there are multiple definitions of a contractor, multiple definitions of what it means to incorporate material into a construction project, and multiple definitions of construction.”
The lack of clarity and consistency across state tax codes for retailers and contractors “is nothing new,” said Steven Wlodychak, national state and local tax leader for Ernst & Young LLP. But the issue is coming up in audits because installations have become a prominent feature of the home improvement business model.
“The difference is that from a business perspective more retailers are also engaging in contracting activities and the state laws weren’t originally designed to conceive that the two could be the same,” he said.
Contractor or Retailer?
Home Depot declined to comment on the tax controversies in South Carolina and Illinois. The Atlanta-based company, however, predicted significant revenue growth from installations going forward in its most recent annual report.
“We believe that changing demographics are increasing the demand for our installation services, particularly for our ‘baby boomer’ customers who may have historically been DIY customers but who are now looking for someone to complete a project for them,” the company stated.
Illinois has already successfully targeted Best Buy in a similar action. In a unanimous decision, an appeals court affirmed an Illinois Department of Revenue argument that found Best Buy wasn’t a contractor and wasn’t exempt from tax duties on the sale of certain home appliances it delivers and installs. Best Buy had relied on a provision of the code that carves out an exemption for construction contracts that incorporate tangible personal property into real estate.
In so ruling, the court upheld the department’s basis for an assessment against Best Buy of $192,147 for the period July 2012 through December 2013.
Best Buy didn’t respond to Bloomberg Tax’s request for comment on the ruling.
The Best Buy decision provided fresh ammunition in a separate tax fraud lawsuit, brought by a whistleblower, who alleges Best Buy, Lowe’s, and Home Depot have cheated Illinois out of millions in tax revenue for more than a decade. The whistleblower, a small regional appliance retailer, filed an action under the Illinois False Claims Act alleging the national chains deliberately misclassified their installations of dishwashers, dryers and microwave ovens as construction contracts.
Attorneys representing the whistleblower folded the Best Buy ruling into a motion relating to claims against Lowe’s.
“The fundamental legal claim we’ve been making is right based on the appellate court’s decision,” said relator’s counsel Paul Berks, a partner with Massey & Gail LLP in Chicago. “Now all that’s left for us to prove is the knowing part—whether they knew, or were reckless, or disregarded evidence that they had this obligation.”
Berks has been pursuing claims against the retailers in Cook County Circuit Court since 2015. In April 2019 Berks won an appeals court ruling, rejecting Home Depot’s campaign to dismiss the case.
Revenue spokesman Sam Salustro said the department has issued various letter rulings and compliance statements regarding the construction contractor classification.
The revenue department tried to put the issue to rest with a June 2015 compliance alert, addressing tax collection problems spotted during an agency investigation. The department also recommended the retailers perform self-audits going back to July 2012. Businesses could then enter into voluntary compliance agreements with the state and avoid late payment penalties.
Paul Bogdanski, a tax partner in the Chicago office of Reed Smith LLP, said the appeals court made a shallow analysis of the contractor exemption and noted the department’s own compliance alert acknowledges a seller can act as either a retailer or a contractor, depending on the transaction.
“I don’t think the appellate court considered the potential for a taxpayer to do multiple things,” said Bogdanski, a former revenue department deputy general counsel. “They never gave consideration to the history the department has on this issue.”
South Carolina Litigation
Home Depot’s problems in South Carolina arose after the state revenue department audited the company and asserted it had failed to properly remit sales tax on its cost for materials utilized across all installation contracts. The state’s administrative law court sided with the department in March 2018, finding “Home Depot was acting in its capacity as a retailer” and ordered an assessment of $1.5 million in back taxes and $487,514 in interest. A spokesperson for the agency said Home Depot withdrew its appeal and the matter is now resolved.
The department made similar allegations against Lowe’s and seeks to collect $2.2 million in taxes, $360,000 in interest and $290,000 in penalties. The case was tried in 2016, but the department said the court still hasn’t issued a decision. Lowe’s declined comment on the pending litigation.
The department has taken a very narrow view on a tax question that should be clarified by the state legislature, said Rick Reames, a tax partner with Nexsen Pruet LLC in Columbia. S.C.. Reames, who has represented businesses in sales tax disputes, predicted audits in any state with an aggressive revenue agency and vague rules delineating tax duties for retailers and home remodelers.
“Since the Home Depot decision, the South Carolina Department Revenue has continued to take an incredibly broad view of what should be included in the sales tax base,” said Reames, a former state revenue director. “Like many states, it has staked out positions that are better taken by state legislatures.”