When a customer breaches a taxable data-processing services contract and settles a lawsuit for damages plus past-due charges, is the entire settlement amount subject to Texas sales tax?

Plain-English summary

A company that provided taxable data processing services had a client who breached its services contract while owing $14,000 for services already performed. The company sued to collect the past-due amount, all future amounts owed under the contract, attorney's fees, interest, and court costs. Before trial, the parties settled for $43,000, covering the $14,000 owed for prior services plus attorney's fees and an amount for the breach of contract.

The company understood that at least the $14,000 portion was taxable and asked whether any other part of the $43,000 settlement was also subject to tax. The Comptroller's office responded that the portion covering attorney's fees is not taxable, and the portion covering the breach of contract is also not taxable because it represents damages (lost income) rather than a sale of a taxable service.

The letter also flagged a related but distinct point: early termination fees written into a contract for the sale of a taxable item are treated as part of the taxable sales price of that item. This is common in contracts for renting tangible personal property, but the same principle can apply to other contracts for taxable items that include an early termination clause.

What this means for you

Businesses settling disputes over taxable service contracts

If a customer breaches a contract for taxable services and you settle a resulting lawsuit, only the portion of the settlement that represents payment for taxable services actually performed is subject to sales tax. Amounts allocated to attorney's fees or to damages for breach of contract (i.e., compensation for lost income rather than for services rendered) are not part of the taxable sales price.

Businesses drafting or relying on contracts with cancellation/termination fees

Distinguish this fact pattern from a true early termination fee. Where a contract for the sale of a taxable item (commonly a rental of tangible personal property) includes an early termination fee as a contractual term, that fee is included in the taxable sales price of the item — it is taxed differently than a lawsuit settlement for breach of an already-terminated contract.

Accountants and tax professionals allocating settlement proceeds

When a settlement lumps together multiple types of recovery (past-due service charges, attorney's fees, and breach-of-contract damages), only the amount attributable to the taxable service itself is subject to sales tax. Documentation that clearly allocates settlement proceeds among these categories will support correct tax treatment.

Common questions

Q: Is an entire lawsuit settlement over a breached services contract subject to Texas sales tax?
A: No. Only the portion covering the price of taxable services already rendered is taxable; the ruling addressed a $43,000 settlement where only the $14,000 for prior services was subject to tax.

Q: Are attorney's fees included in a settlement subject to sales tax?
A: No. The portion of a settlement covering attorney's fees is not taxable.

Q: Are breach-of-contract damages included in a settlement subject to sales tax?
A: No. Amounts settled upon to cover damages (loss of income) from a breach of contract are not taxable.

Q: Are early termination fees on contracts for the sale of taxable items subject to sales tax?
A: Yes. Early termination fees on contracts for the sale of taxable items are included in the sales price of the taxable item — this is commonly seen in contracts for renting tangible personal property, but can apply to other taxable items with early termination clauses.

Citations and references

No specific statutes or administrative rules are cited in the text of this letter.

Source

• STAR search: https://star.comptroller.texas.gov/search?doc_type_code=L&tax_type_code=SST
• Opinion: https://star.comptroller.texas.gov/view/9501L1336E13

Original ruling text

January 18, 1995

Dear *****:

I am responding to your letter dated December 21, 1994, mailed on January
9, 1995. You explained that a client provides taxable data processing services.
Your client entered into a contract to sell taxable data processing services to
a customer. The customer breached the contract at a point when the sum of
$14,000.00 was owed for taxable data processing services already rendered.

Your client filed a lawsuit to collect the past due amounts plus all amounts
owed in the future under the contract and attorney's fees, interests and court
costs. Before trial, the parties agreed to a settlement of $43,000.00 that
covered the $ 14,000.00 for prior services and the remainder covers attorney's
fees and the breach of the contract. You understand that at least the
$14.000.00 is subject to tax and asked whether any other portion of the
$43,000.00 is taxable.

The portion of the difference that covers the amount due for attorney's fees is
not taxable. The amount due for breach of contract is not taxable because it is
an amount settled upon to cover damages (loss of income) incurred.

I feel I should point out that early termination fees on contracts for the sale
of taxable items are included in the sales price of the taxable item. This is
commonly found in contracts for renting tangible personal property, but may be
applicable to contracts containing early termination clauses for the sale of
other taxable items.

This opinion is based upon the facts presented. If there are additional facts,
this opinion may change.

You may also write to Tax Administration Division, Comptroller of Public Accounts.

Sincerely,

Tax Administration Division

NOTE: Previous Accession Number 9501901L