taxes

Franchise Tax Frequently Asked Questions

Cost of Goods Sold (COGS)

Is the calculation for COGS similar to the federal reporting and industry calculations?

No, allowable costs to be included in COGS are specifically defined for franchise tax reporting purposes in Texas Tax Code (TTC) 171.1012.

Can flow-through funds excluded from total revenue be included when calculating COGS?

No, any amounts excluded from total revenue cannot be included in COGS. See TTC 171.1011(j).

Are a contractor's payments to subcontractors included in the computation of COGS?

A contractor's payments to subcontractors for the construction, improvement, remodeling, repair or industrial maintenance of real property may be included in the computation of COGS (TTC Section 171.1012(i)). However, if the payment has already been excluded from total revenue as a flow-through fund mandated by contract in connection with the actual or proposed design, construction, remodeling or repair of improvements on real property (per TTC Section 171.1011(g)(3)), it may not be included. In other words, the same subcontractor payment may only be subtracted once, either as a flow-through fund or as COGS, when calculating margin

Is a store stocker providing labor included in COGS?

Yes, a store stocker's labor is considered a handling cost and included in COGS.

Is the labor a cooking or wait staff provides in a restaurant included in COGS?

The labor of the cooking staff can be included in COGS, but the labor of the wait staff cannot be included.

If an entity elects to capitalize allowable costs for COGS, is it required to capitalize all allowable costs?

A taxable entity that elects to capitalize allowable costs for COGS must capitalize all allowable costs for franchise tax reporting that it capitalized for federal tax purposes. Any allowable costs for franchise tax reporting that were not capitalized for federal tax purposes must be expensed in computing COGS. Any costs not allowed under TTC 171.1012 may not be included in COGS even if the entity capitalized the cost for federal tax purposes.

Can an entity switch from capitalizing to expensing allowable costs for COGS – or from expensing to capitalizing allowable costs for COGS?

Capitalizing or expensing allowable costs for COGS is an annual election.

If a taxable entity capitalizes allowable costs for COGS and later elects to begin expensing those allowable costs, the entity may not deduct any costs incurred before the first day of the report period upon which the tax is based, including any ending inventory from a previous report.

If a taxable entity expenses COGS and later elects to begin capitalizing those allowable costs, costs incurred before the first day of the report period upon which the tax is based may not be capitalized.

Are entities that drill for oil and gas allowed a COGS deduction?

Yes, they are allowed a COGS deduction for the Texas franchise tax. Oil and gas extraction falls under the definition of production in TTC 171.1012(a)(2).

How are Internal Revenue Code (IRC) Section 179 expense limitations and federal bonus depreciation amounts determined for Texas COGS?

For Texas franchise tax purposes, both are based on the IRC of 1986 in effect for the federal tax year beginning on January 1, 2007, and do not include any changes made by federal law after that date.

After 2009, IRC Section 179, effective Jan. 1, 2007, sets the Section 179 expense to $25,000 and the property acquisition threshold to $200,000.

Federal bonus depreciation is not allowed for Texas COGS, because the Economic Stimulus Act of 2008, which introduced the current bonus depreciation rules, became part of the IRC after Jan. 1, 2007.

What is a "mixed transaction," and does it qualify for a COGS deduction?

TTC 171.1012 provides that the only taxable entities eligible to use COGS in computing margin are those entities that sell real or tangible personal property in the ordinary course of business and a service is not considered the sale of tangible personal property. However, the Comptroller's office included the following provision in Rule 3.588(c)(7):

"Mixed transactions. If a transaction contains elements of both a sale of tangible personal property and a service, a taxable entity may only subtract as cost of goods sold the costs otherwise allowed by this section in relation to the tangible personal property sold."

The taxable entity may not subtract as COGS the labor and other costs related to the services performed.

Examples:

  • Oil Change Services: A taxable entity providing an oil change may include in its COGS computation only the cost of the oil filter and oil that is that is included in the performance of the service. No labor costs would be included as part of COGS.
  • Crop Duster: A taxable entity that provides crop dusting services may include in COGS the cost of chemicals used in the performance of the service as part of COGS. Aviation fuel, labor, airplane rental, etc. would not be allowed as part of COGS.
  • Veterinary Service: A taxable entity that performs veterinary services may include as COGS the pharmaceuticals and supplies sold to customers (splints, collars, prescription drugs, etc.). Labor costs, and pharmaceuticals and supplies consumed in rendering a service (anesthesia, cotton swabs, needles, etc.) are not allowed as COGS.
Can the labor to install tangible personal property be included in COGS?

Labor to install tangible personal property outside of the manufacturing process, unless part of construction, improvement, remodeling, repair or industrial maintenance of real property, is not allowed as part of the COGS deduction. See Rule 3.588(b)(7).

Are the compensation and benefits of a salesperson included in COGS?

No, these are considered a selling cost and cannot be included in COGS.

Can a motor vehicle sales finance company deduct interest expense as a cost of goods sold?

A lending institution that offers loans to the public may subtract as COGS an amount equal to interest expense. A motor vehicle sales finance company is considered to be offering loans to the public and, if it otherwise qualifies as a lending institution, may include an amount equal to interest expense as COGS.

Can a limited partnership elect to amortize intangible drilling costs (IDC) over 60 months instead of expensing these costs?

No. This election is not available to a partnership. IDC are a part of the COGS deduction. A taxable entity that elects to capitalize its allowable COGS under TTC Section 171.1012(g) must capitalize those costs in the same manner and to the same extent they are capitalized on the taxable entity's federal income tax return. For federal tax purposes, the 60-month IDC amortization election is made at the partner level rather than by the partnership. Therefore, a partnership must expense its IDC in the year incurred for the COGS deduction.

Can a partnership or S corporation include depletion in COGS?

Depletion reported on the federal income tax return, to the extent associated with production, is included in COGS. See TTC 171.1012 (c)(6).

A pass-through entity, such as a partnership or S corporation, may include as COGS the oil and gas depletion it calculates and separately reports to its owners for federal tax purposes. Because the pass-through entity includes the allowable depletion in its COGS, the owners of the pass-through entity may not include in COGS the depletion reported to them.