Texas Court Addresses Flow-Through of Sales Tax Exemptions for Government Contractors
March 1, 2023
By: Michael Colavito, SALT Director
At a glance
- The main takeaway: A Texas court decision is an important reminder that being a government contractor does not necessarily exempt your business from sales tax on purchases made in connection with that contract.
- Assess the impact: Since the exemption from sales tax on purchases does not typically flow-through to businesses performing services for the government, it’s critical for government contractors to be proactive in understanding the sales tax rules in states where they make purchases.
- Take the next step: Aprio’s State and Local Tax (SALT) team regularly helps government contractors with sales tax issues. Our team can ensure your business is aware of the applicable rules upfront, so that you can accurately price your contracts and avoid unexpected tax liabilities and penalties.
The full story:
A recent decision issued by the Texas Court of Appeals provides an important reminder to government contractors that they are generally subject to sales tax on their purchases of equipment and supplies that they use when performing a service for the government.  There are some states that have specific exemptions for certain types of purchases made by government contractors. However, most states adhere to the general rule that a business performing a service for the government is not able to utilize the government’s exemption from sales tax when the business makes purchases of items that will be used in the performance of those services.
A closer look at the case
The taxpayer was a government contractor that operated correctional and detention facilities located in Texas for both the United States and the State of Texas. The Texas Court of Appeals ruled that the contractor was required to pay Texas sales tax on it purchases of items such as computers, furniture, food and electricity required to operate the facilities. In general, businesses are subject to state sales tax on items that they use and consume in conducting their activities, unless a specific exemption applies. However, state sales tax laws generally provide a specific exemption for similar purchases made by states and the federal government. Texas’ sales tax regulations include additional guidance on the exemption for purchases made by the government by providing the entities and organizations exempt from the payment of sales tax, including “[t]he United States, its unincorporated agencies and instrumentalities” and “the State of Texas, its unincorporated agencies and instrumentalities.” 
The taxpayer argued that its purchases of items used or consumed in operating the detention and rehabilitation facilities were exempt from Texas sales tax because the services provided by the taxpayer were a quintessential governmental function. Further, due to its services needing to be conducted pursuant to certain published government standards, the taxpayer claimed that it was acting as an “instrumentality” of the government and that its purchases were therefore exempt from sales tax.
The Texas Court of Appeals, in disagreeing with this argument, pointed to the longstanding rule established by the US Supreme Court’s 1982 decision in United States v. New Mexico.  The US Supreme Court, in examining a similar exemption, concluded that tax-exempt status applies when the tax is levied directly on the government itself, or on an agency, or instrumentality that is connected to the government in such a way that the two cannot be viewed separately. As explained in New Mexico, to have tax-exempt status as an agency or instrumentality of the government, a contractor must “stand in the government’s shoes.”
The ruling explained
Relying heavily on the decision in New Mexico, the Texas Court of Appeals looked to factors considered in determining whether an agency relationship was created by virtue of the taxpayer’s contract with the government. Although the court conceded that the taxpayer performed a function (i.e., housing detainees) closely identified with the government, it was nonetheless not a government instrumentality. In reaching that conclusion, the court reasoned that the taxpayer:
- Maintained a substantial role in procuring and managing its facilities,
- Exercised discretion in managing its daily operations,
- Controlled the means, methods and details of its work, and
- Purchased materials in its own name and did not bind the government in making such purchases.
These facts led the court to conclude that the taxpayer was not a government instrumentality and was subject to Texas sales tax on it purchases.
The bottom line
Most state tax practitioners have heard at least one client ask, “Isn’t our business exempt from sales tax because we perform services for the government?” Unfortunately, as illustrated in the case above, the government’s exemption from sales tax on purchases does not typically flow-through to a business performing services for the government. Government contractors are typically permitted to account for the cost of paying sales tax in bidding on government contracts. Thus, it’s critical for government contractors to be proactive in understanding the sales tax rules in states where they will make purchases related to performing services for the government.
Aprio’s SALT team works with government contactors regularly to provide guidance on these types of sales tax issues. Our assistance ensures that your business is aware of the applicable rules upfront so that you are able to accurately price your contracts, avoid unexpected tax liabilities and penalties as well as take advantage of any tax exemptions that may exist. We constantly monitor these and other important state tax topics, and we will include any significant developments in future issues of the Aprio SALT Newsletter.
 The GEO Group, Inc. v. Comptroller, No. 07-22-0000-CV, Tex. Ct. App., 7th Dist., January 23, 2023.
 Tex. Admin. Code Rule §3.322(c)(1), (4).
 455 U.S. 720 (1982).
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About the Author
Michael assists clients with a broad range of state and local tax issues. His expertise extends to many areas of multistate taxation, including income, franchise, sales and use, and property taxes. Michael’s experience also includes representing clients at all stages of tax controversy—from audit through appellate litigation as well as advising clients on restructurings and state tax refund and planning opportunities.