The “services addendum model” of contracting seemed to be all the rage for a while. In a talk I gave a while back entitled “21st Century Subcontracting,” it warranted—wait for it–two very informative PowerPoint slides. But after Division II of the Washington Court of Appeals issued its published decision in Bravern Residential II, LLC v. Dep’t of Revenue on September 23, it looks like it might be the end for that contracting model.
Some really smart lawyer or accountant must have come up with the model. It was a device used by developers to lessen the tax burden associated with hiring a general contractor to build a speculative building. Generally, a general contractor’s services (including particularly, the labor it provides to a project) are subject to both retail sales (WSST) and Washington Business and Occupation (B&O) taxes. In today’s world with municipalities’ WSST rates up to nearly ten percent (both Seattle and Bellevue are at 9.5%), taxes on a general contractor’s work adds up quickly on a large project.
As with most big projects today, developers create a single-purpose entity (generally, a limited liability company) that is the “developer” and “owner” of the project. The members of that LLC are generally the project’s investors, including often a traditional real estate development firm. The extra entity layer further insulates project investors from potential liability. In the service addendum model, the developing LLC makes the erstwhile general contractor a one-percent member, with the investor-members contributing land and capital, and the general contractor contributing “services” to the LLC. By asserting that the LLC is actually the “speculative builder” of the project (by virtue of the “services” being provided to it by the contractor-member), the LLC could take advantage of two provisions in the Washington Administrative Code, one which exempts “speculative builders” from both WSST and B&O on the builder’s direct labor, and one which provides tax exemptions for the transfer of “capital assets,” i.e., that there was no “sale” of the services. No sale = no sales tax.
In Bravern, the Court of Appeals upheld the 2008 decision of the Department of Revenue, which said neither exemption applied. The Bravern LLC, having lost its appeal at the agency level, paid more than $107,000 in disputed taxes, and then sued the Department to get those taxes back. In dueling motions for summary judgment, the trial court sided with the Department, and Bravern appealed. The Court of Appeals agreed that because PCL—not Bravern—was required to perform the construction work, it was not a “speculative builder” under the WAC definition.
Further, the court ruled that the transfer of credits to PCL’s “capital account” was the kind of transfer of “capital asset” that allows tax to be avoided. Rather, the Court, citing a 42 year-old case, said that “capital assets” are “a device or article kept, maintained, employed and utilized in the conduct and operation of the business,” in other words, something tangible. “Services,” the court said, do not fall under that definition, and therefore tax on such services cannot be avoided by transferring their value between the members of an entity.
The “services addendum” model was always a conundrum to construction lawyers. And, many of us thought that a decision like this was just a matter of time, if for no other reason than the state would want developers to start paying these taxes. In one instance, I represented a subcontractor trying to negotiate a contract with the contractor-one percent-member of a developing LLC. Though the subcontract purported to incorporate the “Main Contract” by reference, I was repeatedly denied access to that contract. When finally granted a chance to review it, I was told I could see it only at the contractor’s office, and was initially denied a copy of it. It turned out to be a heavily marked-up AIA A 111/A201 Guaranteed Maximum Contract, retitled “Services Addendum” in which the duties of the contractor to the Owner had been altered to be its “contributions” to the developing LLC.
There were a number of things about that agreement that made subcontracting a little tricky. The standard form subcontract that the general was proposing didn’t really fit too well given that the general was, in essence, the project’s owner. First, all the pass-through provisions that purported to make the sub’s duties to the general mirror those of the general to the owner were hard to understand. “But, aren’t you the owner?,” I would ask, a bewildered look on my face.
And, curiously, the general insisted that my client, whose subcontract amount was to be substantial, agree to a “pay if paid” provision. This really stumped me. If the general contractor was the project owner, what possible meaning or effect could the risk shifting provisions of a “pay if paid” clause even have? As I understood it, the reason for “pay if paid” was to put a subcontractor in the same position as a general in regard to the risk of the owner’s non-payment. But, if the general was the owner, did that risk even exist? As you might guess, it was all a little confusing.
But at least for now (I guess a petition for review by the Washington State Supreme Court is still possible), it seems that the Court of Appeals has closed the “services addendum” loophole (if it ever existed). And so, perhaps we’re back to the straight-over-tackle owner-general-sub flow down contracting that old guys like me grew up with and are so used to. At least until some really smart person comes along with another bright idea.