What’s in a name? For real estate developers operating in Washington State as a “speculative builder” rather than a “prime contractor,” naming matters. Speculative builders are not required to pay retailing business and occupation (B&O) tax or collect and remit sales tax on construction services. On the other hand, prime contractors are required to pay retailing B&O and collect and remit sales taxes on construction services. The distinction creates material incentive to operate as a speculative builder rather than a prime contractor.
The relevant rules define a “prime contractor” as a person who performs construction services on real property for a consumer. A “speculative builder” constructs buildings for sale or rental upon real estate they own.
A recent case from the Washington Court of Appeals impacts a common real estate development structure and highlights a trap for the unwary. Developers should determine whether they are at risk for underpayments of retailing B&O and uncollected sales taxes.
The Douglass Case
In Lanzce G. Douglass, Inc. v. Dep’t of Revenue (__ P.3d __, 2023 WL 2579065), the taxpayer purchased property for development purposes and subsequently contributed it to a single member LLC. The taxpayer’s purpose in contributing the property to the LLC was to isolate liabilities. The taxpayer entered into a purchase agreement with the LLC that permitted the taxpayer to possess the land and repurchase it at a fixed price, but the agreement did not transfer the property back to the taxpayer. The taxpayer constructed houses on the property while the LLC held title. Following construction, the LLC transferred the property to the taxpayer before selling finished lots to third parties. The taxpayer took the position it was a speculative builder and the Washington Department of Revenue (the “Department”) disagreed. The Court of Appeals agreed with the Department and the Superior Court in holding the taxpayer was a prime contractor rather than a speculative builder.
The Appeals Court honed in on what it means to “own” real property and makes two important distinctions. First, a taxpayer must generally hold title to property being developed in order to be a speculative builder. In cases where a taxpayer does not hold title, the court distinguishes “real estate contracts” from “purchase and sale agreements.” It notes that in a real estate contract the seller retains title but transfers substantial rights to the purchaser. The seller in a real estate contract transfers title when the purchaser pays the contract price in full. In contrast, a purchase and sale agreement does not transfer title or substantial rights and is an agreement to transfer title in the future.
Second, the rules create an anti-avoidance rule that may apply when a taxpayer holds title. The relevant rule states:
“The attributes of ownership of real estate for purposes of this rule include but are not limited to the following: (i) The intentions of the parties in the transaction under which the land was acquired; (ii) the person who paid for the land; (iii) the person who paid for improvements to the land; (iv) the manner in which all parties, including financiers, dealt with the land. The terms ‘sells’ or ‘contracts to sell’ include any agreement whereby an immediate right to possession or title to the property vests in the purchaser.” Id. at p. 4.
The court noted the intent of the rule is “to keep taxpayers from using property transfers and corporate structures to avoid tax liability.” Id. Contractors should not only retain title to property they are developing, but also navigate the anti-avoidance rule where they may not retain the attributes of ownership.
Attribution of Activities
The Douglass case does a good job of walking through the relevant case law covering attribution of activities. For instance, it is common for real estate developers to partner with outside investors to develop real property. The real estate developer contributes the subject property to a newly formed LLC or limited partnership. Outside investors contribute cash to fund development for their interests. If the developer provides construction services to the LLC or limited partnership, should the activities of the contractor member (or general partner) be attributed to the LLC (or limited partnership)? Conversely, when a member owns real property and the LLC performs construction services, should the LLC’s activities be attributed to the member-owner?
The relevant case law examined in Douglass noted the activities of a member are not attributed to an LLC because they are separate entities. Id. at p. 3, quoting Bravern Residential, II, LLC v. Dep’t of Revenue, 334 P.3d 1182 (2014). Similarly, the activities of an LLC are not attributed to a member because they are separate entities. Id. at p. 2 quoting Dep’t of Revenue v. Nord Nw Corp., 264 P.3d 259 at 263 (2011).
The Department recognizes joint ventures in the form of LLCs and limited partnerships are a common way to develop real estate. In published guidance, the Department notes, “[t]o be treated as a speculative builder, a joint venture entity must actually exist and the joint venture entity must own the land and perform the construction itself.” Emphasis original. The construction cannot be performed by a member on behalf of the joint venture entity, nor can it be performed by the joint venture entity on behalf of a member owning the property.
This does not mean that a contractor member cannot perform contracting services and obtain speculative builder status for the joint venture. Joint ventures must be carefully structured and operated to achieve speculative builder status. Rather than performing construction services as a separate entity distinct from the joint venture, the Department suggests the “contractor performs construction services as a member of the joint venture (versus a separate entity).”
Tax Avoidance Structures
Taxpayers must also navigate potential tax avoidance traps. Washington state law requires disregarding transactions and the tax benefits attributed to tax avoidance transactions. The relevant rules for speculative builders and construction joint ventures require a contractor to assume risk with respect to the project. The underlying economics of the joint venture arrangement should not guarantee payment to the contractor essentially equivalent to a construction contract. The contractor should be at risk of the project failing and there should be an economic upside greater than what would be expected in a construction contract.
There remains tension between minimizing Washington B&O and sales and use taxes and isolating developer liability within joint venture entities. As described above, there are several ways a development project may fail to achieve desired tax outcomes. Joint ventures must be carefully structured and managed to achieve speculative builder classification.
This article is provided for informational purposes only—it does not constitute legal advice and does not create an attorney-client relationship between the firm and the reader. Readers should consult legal counsel before taking action relating to the subject matter of this article.