If a company assembles a septic tank system and sets it into a pre-dug hole on a vacant lot, but someone else later connects it to the home's sewer and electrical lines, is that a tax-exempt real-property-improvement contract or a taxable sale and installation of tangible personal property?

Plain-English summary

A developer subdivided acreage into roughly 200 lots and planned to sell each lot with a septic system already in the ground (instead of connecting to a central sewage plant). The developer hired a company (the letter's requester) as a subcontractor to: order and take delivery of septic tanks, aerobic-system components, and sprinkler heads (all bought with sales tax already paid to the manufacturer); assemble the components into the tank at its own shop; prepare an engineer-sealed plot drawing for county permitting; deliver the fully assembled tank to each lot and set it into a hole the developer had already dug; and perform two years of required maintenance on the system afterward -- all for one lump-sum price. Critically, the developer's own crew would lay and backfill the sprinkler lines, and the future homebuyer would be responsible for running and connecting the electrical and sewer lines from the home to the aerobic system once a house was actually built on the lot.

The whole answer turns on a single legal distinction: is this a tax-exempt lump-sum contract to improve real property, or a taxable sale and installation of tangible personal property? Under § 151.056, a true real-property-improvement contractor is the "consumer" of the materials it incorporates and pays tax only on ITS OWN costs -- the customer isn't taxed on the lump-sum price. But under Rule 3.347(b)(2), furnishing property without being responsible for the final affixation/installation does NOT count as a realty-improvement contract at all.

Texas courts and Comptroller hearings use a three-factor test for whether installing an item makes it become part of the real property: (1) real or constructive annexation, (2) fitness/adaptation to the realty's purpose, and (3) intent of the parties. Here, the company setting the tank in the hole never performed the step that actually annexes the tank to the property -- connecting it to the home's plumbing and electrical system. The letter is explicit: "If you were to connect the tank to the home's plumbing and wiring system, you would be providing the necessary annexation... Simply setting the tank in the hole does not qualify [the] job as making a permanent improvement to realty." Because the annexation step is left entirely to whoever later buys the lot and builds a house, the subcontractor's job stays a sale and installation of tangible personal property -- the entire lump-sum charge is taxable, and the company is treated as a "material man" supplying goods, not a contractor improving real property.

Two practical notes: the company can buy its own tank/cone/pump/piping components tax-free from its supplier using a resale certificate (or get a refund/credit if it already paid tax on them), since it's reselling them to the developer as part of a taxable sale. And the two-year maintenance obligation can escape tax entirely if billed as a separately stated charge, since repair/remodeling/restoration of residential real property is nontaxable on its own -- but folding maintenance into the same lump-sum sale-and-installation price makes the whole thing taxable.

What this means for you

Developers and subcontractors installing septic systems, utility equipment, or similar items on vacant lots before construction

The single most important fact in this analysis is who performs the final hookup/annexation. If your installer's work stops short of connecting the item to the structure's actual plumbing/electrical/utility systems -- leaving that step to a future homeowner or a separate contractor -- your installer's charge is a taxable TPP sale in full, not an exempt realty-improvement contract, even though the item is physically sitting in the ground.

Contractors weighing lump-sum vs. separately stated pricing

If you want a genuinely nontaxable realty-improvement contract, make sure your own scope of work includes the actual annexation step. If it doesn't, structure pricing carefully: a separately stated maintenance/repair charge can stay nontaxable even when the underlying sale-and-installation charge is fully taxable.

Accountants reviewing installation contracts near the realty-improvement line

The three-factor annexation/fitness/intent test from this letter is a reusable framework for any borderline "is this now realty" question -- septic systems, HVAC units, prefab structures, or other equipment set in place but not yet fully connected.

Common questions

Q: Does physically placing an item in the ground make it part of the real property?
A: Not by itself, per this letter -- simply setting a tank in a hole doesn't complete the annexation. What matters is whether the installer actually connects the item to the structure's systems (here, plumbing and electrical).

Q: Who owes tax if the final hookup is left to a future homeowner?
A: The company that assembled and set the tank owes tax on its entire lump-sum charge, since its own work doesn't complete the annexation that would make the job a realty improvement.

Q: Can the installer buy its components tax-free?
A: Yes -- since the transaction is a sale of tangible personal property, the installer can issue a resale certificate to its own supplier (or seek a refund/credit for tax already paid).

Q: Is the ongoing maintenance charge taxable too?
A: Only if it's bundled into the same lump-sum sale-and-installation price. If separately stated, maintenance/repair of residential real property is nontaxable on its own.

Q: Does this letter bind the Comptroller for other septic installers?
A: No -- this is an informal 2001 letter addressing one taxpayer's specific contract and scope of work, not a modern Private Letter Ruling or General Information Letter, and it cannot be relied on by anyone else.

Citations and references

Statutes:

• Tex. Tax Code § 151.056(a), (d) (contractor as consumer under lump-sum new-construction contracts)
• Tex. Tax Code § 151.007 (sales price includes total amount charged, no deductions)

Rules:

• 34 Tex. Admin. Code Rule 3.357(a)(5) (definition of real property)
• 34 Tex. Admin. Code Rule 3.347(b)(2) (furnishing TPP without responsibility for final affixation is not a realty-improvement contract)

Legal test applied:

• Three-factor annexation test from Texas case law and Comptroller hearings: (1) real or constructive annexation, (2) fitness/adaptation to the realty's purpose, (3) intent of the parties

Source

• STAR search: https://star.comptroller.texas.gov/search?doc_type_code=L&tax_type_code=SST
• Opinion: https://star.comptroller.texas.gov/view/200108418L

Original ruling text

August 22, 2001

Diane Miller

Dear ** and Ms. Miller:

I have attached all of the information I have received from each of you
regarding the transaction in question. I have summarized the facts and provided
a taxability response below.

Facts:

A developer has subdivided acreage into approximately 200 lots. The developer
is going to sell the lots with a septic system in the ground complete with
sprinkler lines and heads. He plans to sell these lots with the septic systems
already installed rather than have a sewage treatment plant. The developer
wants to purchase the following package from your company for a lump sum price:

-- Septic Tanks - delivered to lot (sales tax paid to manufacturer)

-- Aerobic system components - assembled and delivered to lot (sales tax paid
to manufacturer)

-- Sprinkler heads (sales tax paid to manufacturer)

-- Plot plan drawing of the lot showing layout of septic system and sprinkler
spray area locations complete with engineering seal as required for permitting
(the drawing of the lot to be taken from the survey plat filed with the county)

Your company will purchase the septic tank and install the cone, electrical
wiring, piping and pump in the tank at your place of business. The developer
will have his equipment at the lots to construct the driveway, dig the hole for
the tank, and the trenches for the sprinkler lines. You will then deliver the
completely assembled tank to the lot and set the tank in the hole. At the time
you put the system into the ground, there will be no home constructed on the
lot. The developer will lay and connect the sprinkler lines and backfill the
lines and holes. It will be the responsibility of the purchaser of the lot to
have the electrical line and sewer line run to the aerobic system and hooked up
to the home after the home is in place on the lot. Your company will prepare a
drawing of each lot. The drawing will be rendered from the subdivision plat
that was prepared by a surveyor and filed with the county. The drawing will
show the location of the septic system, lines and sprinkler heads as required
by the county for obtaining a permit for the system. In addition to delivery
and installation, your company will be responsible for performing all the
maintenance on the septic system under an initial two-year maintenance contract
required by the State of Texas for the installation of new septic systems. Your
companies' contractual obligations will be performed for a lump-sum amount.

The developer is a licensed septic installer who can purchase tanks and
components at the same price as your company. The developer is using your
company as a subcontractor to provide:

(1) the labor to order and take delivery of materials;

(2) the labor to install the components into the tanks;

(3) the labor to prepare the required drawings;

(4) the labor to deliver the assembled components and set them into the holes
that the developer has prepared;

(5) the labor to perform the required maintenance on the system for the first
two years after installation.

Response: The taxability of this transaction turns on whether you are
improving real property under a lump-sum contract for new construction or
selling and installing tangible personal property.

The taxability of a contract to improve real property is handled differently
than the sale and installation of tangible personal property. New construction
contracts performed for a lump sum (i.e., the costs for materials, labor,
overhead and profit, etc. are included in a single amount in the contract) are
not taxed. Instead, the contractor pays tax on his costs of the materials,
consumables and other taxable items used to perform the job. Contracts for the
sale and installation of tangible personal property are taxed in whole. The
seller may purchase items transferred in the sale tax free as a sale for
resale.

The relevant sections of the tax code and sales tax rules are:

Texas Tax Code Section 151.056:

(a) A contractor is the consumer of tangible personal property furnished by
him and incorporated into the property of his customer if the contract between
the contractor and his customer contains a lump-sum price covering both the
performance of the service and the furnishing of the necessary incidental
material.

(d) In this section, "contractor" means a person who makes an improvement on
real estate and who, as a necessary or incidental part of the service,
incorporates tangible personal property into the property improved.

151.007. "Sales Price" or "Receipts"

(a) Except as provided by Subsections (c) and (d) of this section, "sales
price" or "receipts" means the total amount for which a taxable item is sold,
leased, or rented, valued in money, without a deduction for the cost of:

(1) the taxable item sold, leased, or rented;

(2) the materials used, labor or service employed, interest, losses, or other
expenses;

(3) the transportation of tangible personal property; or

(4) transportation incident to the performance of a taxable service.

(b) The total amount for which a taxable item is sold, leased, or rented
includes a service that is a part of the sale and the amount of credit given to
the purchaser by the seller.

"Real property" is defined in Rule 3.357(a)(5) for the as "land including
structures and other improvements embedded in or permanently affixed to the
land.

Rule 3.347 states:

(b) "Contract for the improvement to realty" does not include:

(2) the furnishing of tangible personal property if the person furnishing the
property is not responsible for the final affixation or installation of any of
the property furnished.

Texas courts and several of the Comptroller's administrative hearings on
similar issues determined that there are three factors to consider when
determining whether installation of tangible personal property causes the item
to become realty. The factors to consider are:

(1) real or constructive annexation,

(2) fitness or adaptation to the purposes of the realty; and,

(3) intention of the parties.

Your company does not provide the real or constructive annexation of the tank
to cause it to become realty. You stated: "It will be the responsibility of the
purchaser of the lot to have the electrical line and sewer line run to the
aerobic system and hooked up to the home after the home is placed on the lot."
This is the step that annexes the tank to the realty such that the tank becomes
realty. If you were to connect the tank to the home's plumbing and wiring
system, you would be providing the necessary annexation of the property to
qualify the job as an improvement to realty. Simply setting the tank in the
hole does not qualify job as making a permanent improvement to realty.

Therefore, the job is the sale and installation of tangible personal property.
You are in the position of a material man supplying the materials to be
incorporated into realty rather than a contractor or subcontractor.
Installation that equals incorporating tangible personal property into realty
means there has been some action taken by the installer to affix/annex the
tangible personal property to realty. Your total charge for the sale and
installation of the tank is taxable because the tank retains its identity as
tangible personal property after it is installed in the hole.

You may issue a resale certificate to your supplier of the tanks, cones, pumps,
and piping that are resold to the developer. If you have already paid the tax
to your supplier, you may issue the resale certificate and ask for a refund or
you may lower your taxable sales on your next sales tax return by the cost of
the tanks, not including the tax, to take a credit for the tax paid. Be sure to
keep invoices showing tax to document the credit.

If you can separate a charge for the two-year maintenance part of the contract
from the sale and installation, you would not be required to collect tax on the
maintenance of the tank. Repair, remodeling, or restoration of residential real
property is not taxable. However, if the maintenance is included in the
lump-sum price of the sale and installation, the total charge is taxable.

This opinion is based on the facts presented. Other facts, though similar, may
result in different answers.

I hope this information is helpful. I'll be glad to help you if you have
additional questions. You may e-mail your questions to
[email protected]. My direct telephone line is (512) 475-0037. The
toll-free number is 1-800-531-5441, ext. 5-0037.

Sincerely,

Lindey Osborne
Tax Policy Division