Arizona Court of Appeals Division One Holds That “Construction Manager” Is A Taxable “Prime Contractor” For Purposes of Transaction Privilege Tax, But Cannot Be Taxed For Amounts It Received To Pay Other Contractors On Behalf of Project Owners.

Ormond Builders Inc. entered into “construction management” agreements with the Show Low and Payson Unified School Districts under which it supervised and coordinated school construction projects. These duties included developing time schedules, inspecting the performance of trade contractors, maintaining full-time employees at the sites, processing change orders, and assisting the schools in determining substantial completion of the work. Trade contractors also assisted in the projects, who entered into agreements directly with the schools. The trade contractors submitted their payment requests, however, to Ormond, which processed them The schools then paid Ormond amounts due to trade contractors, and Ormond deposited the funds in its own accounts before disbursing the funds to the trade contractors.

The schools’ payments to Ormond fell into three categories: (1) a construction manager fee, (2) payment of certain costs associated with the projects, including wages and salaries of Ormond’s personnel stationed at the sites, costs of permits, etc., and (3) amounts due to trade contractors for work performed pursuant to the trade contracts. The second two categories were in issue.

Arizona imposes a transaction privilege tax on a “prime contractor’s” gross income derived from the business of prime contracting. A.R.S. §§ 42-5008, –5010, –5075 (Supp. 2006). Subcontractors who work for a taxable prime contractor are not taxed. A.R.S. § 42-5075(D).
After conducting an audit, the ADOR issued an assessment against Ormond as prime contractor for unpaid taxes based on all payments received by Ormond from the schools, including amounts paid to Ormond by the schools in order for Ormond to process payments to the trade contractors. After a trial, the tax court upheld ADOR’s assessment.

On de novo review, the Arizona Appeals Court partially reversed, holding that Ormond constituted a prime contractor subject to transaction privilege taxes, but that it could not be taxed for amounts it received from the schools and paid to the trade contractors merely as “a conduit” between the schools and the trade contractors. The Court “easily conclude[d]” that Ormond was a “contractor” because it “entered into contracts with the Schools to personally or through its supervision of others build or alter structures.” A.R.S. § 42-5075(M)(2). Ormond was also a “prime contractor” because it “agreed to do certain tasks and was compensated for doing so, both in the construction management fee and payments to reimburse it for costs it incurred.” A.R.S. § 42-5075(M)(6). The Court noted that Ormond need not be a “general contractor” to constitute a “prime contractor” under the statute.

As to the categories of payments on which it could be taxed, the Court noted that “gross income” does not necessarily include “all monies paid to [the prime contractor] relating to a construction project.” The Court quickly found that Ormond’s gross income included the items paid to it by the schools for various costs (as noted above), and spent the bulk of its analysis on the payments by the schools to Ormond for purposes of paying the trade contractors. The agreements entered into by the parties established that (1) Ormond was not liable to the trade contractors for payment under the trade contractors’ contracts with the schools, (2) Ormond was not a party or signatory to any of Payson trade contracts, but rather each trade contractor contracted directly with Payson, and (3) Ormond did not sign any of the change orders. Ormond thus processed the payments from the schools to the trade contractors but did so “only as agent of the schools.” As such, the amounts simply “flowed through” Ormond’s accounts before being paid to the trade contractors and should not have been included (and taxed) as Ormond’s taxable gross income.

The Arizona Appeals Court also briefly addressed a privilege license tax assessed by the City of Show Low on “construction contracting.” Finding the definition of “construction contracting” at least as broad as the state law definition of “prime contracting,” Division One held that Ormond’s activities constituted construction contracting under Show Low’s municipal code.

Judge Irvine authored the opinion, with Judge Portley, Presiding Judge, and Judge Johnsen concurring.