On February 4, 2022, the Texas Comptroller recently provided guidance clarifying several Texas franchise tax Cost of Goods Sold (“COGS”) issues for Texas taxpayers. The Comptroller issued the guidance as responses to Frequently Asked Questions (“FAQs”). The FAQs touch on several important topics, including the proper calculation of COGS and whether labor and other expenses across certain industries qualify for subtraction, which components of mixed transactions qualify for a COGS subtraction, how to determine Internal Revenue Code (“IRC”) Section 179 expense limitations and federal bonus depreciation for Texas COGS purposes, and information on capitalizing versus expensing costs.
Texas COGS is calculated separately from federal reporting and industry calculations.
Subtractable costs must be expressly listed in Texas Tax Code § 171.1012. Several industry-specific COGS subtractions covered by the FAQS include:
Is the Expense Included in COGS Calculation?
Contractor’s payments to subcontractors
Yes, if the expenses relate to real property construction, improvement, remodeling, repair or industrial maintenance.
Costs to drill for oil and gas
Yes, because oil and gas extraction falls under the definition of production in Tex. Tax Code 171.1012(a).
Flow-through funds excluded from total revenue
Cost of labor for retailer store stocker
Yes, until the point that goods are displayed for sale; No after that point, unless they qualify as “additional” costs under Tex. Tax Code 171.1012(d).
Cost of labor for restaurant cooks
Cost of labor for restaurant waitstaff
Cost of labor for fulfillment center stocker
Yes, until the point that goods are available to fulfill specific orders; No, after that point, unless they qualify as “additional” costs under Tex. Tax Code 171.1012(d).
Cost of labor to install tangible personal property
No, unless they are part of construction, improvement, remodeling, repair, or industrial maintenance of real property.
Compensation and benefits of salespersons
Motor vehicle sales finance company interest expenses
Yes, in an amount equal to interest expense, so long as it qualifies as a lending institution.
Partnership or S corporation depletion
Yes, to the extent oil and gas depletion is related to production and reported to its owners for federal tax purposes, but the owners may not also include the depletion in their COGS.
IRC Section 179 expense limitations and federal bonus depreciation amounts are based on the IRC in effect for the federal tax year beginning on January 1, 2007.
As a result, the Section 179 expense is limited to $25,000 and the property acquisition threshold is $200,000 in effect for the 2007 tax year under federal law. Federal bonus depreciation may not be included in COGS because it was added to the federal tax laws after the franchise tax’s fixed conformity date of January 1, 2007.
Entities generally must capitalize all allowable costs and may change from capitalizing costs to expensing—and vice versa—on an annual basis.
An entity that elects to capitalize must capitalize all allowable subtractable costs that it capitalized for federal tax purposes, except the entity must exclude from COGS those costs not allowed pursuant to Texas Tax Code 171.1012. Moreover, the decision to capitalize or expense costs is made on an annual basis. An entity that switches from capitalizing costs to expensing them may not subtract any costs incurred before the first day of the report period, including ending inventory from a previous report. An entity that switches from expensing costs to capitalizing them may not capitalize costs incurred before the first day of the report period.
A limited partnership may not elect to amortize intangible drilling costs (“IDCs”) over 60 months instead of expensing the IDCs
The election to amortize IDCs is not available to the partnership and must be made at the partner level. A taxable entity that elects to capitalize its allowable COGS under Texas Tax Code 171.1012(g) must capitalize those costs in the same manner and to the same extent they are capitalized on the taxable entity’s (i.e., the partnership’s) federal income tax return. Since the IDC amortization election is made at the partner level, the partnership must deduct its IDCs in the year incurred for the COGS subtraction.
A “mixed transaction” involves the sale of tangible personal property and the provision of a service. Only the allowable costs related to the sale of tangible personal property may be subtracted.
Conversely, labor and other costs related to the services performed may not be included in the COGS subtraction.
Readers interested in viewing the full text of the Comptroller FAQs may find them available at https://star.comptroller.texas.gov/view/202202001L .
About Martens, Todd & Leonard
Martens, Todd & Leonard is a trial and appellate law firm headquartered in Austin, Texas. It handles only Texas tax cases, specifically those involving the Texas sales tax and Texas franchise tax. The firm’s attorneys have handled cases all the way through the Texas Supreme Court and U.S. Supreme Court. They speak and write frequently on a variety of Texas sales tax and franchise tax topics and have published articles in publications such as the Journal of State Taxation, the Texas Bar Journal, the Texas Lawyer, and the Texas Tech Administrative Law Journal. For more information, please visit texastaxlaw.com.