Texas Comptroller Issues New Guidance on Franchise Tax COGS
The Texas Comptroller recently released new guidance clarifying several Texas franchise tax Cost of Goods Sold (COGS) issues that frequently trip up taxpayers. The guidance comes in the form of updated Frequently Asked Questions (FAQs) and addresses a range of practical concerns businesses face when calculating their COGS deduction.
The FAQs cover topics such as how to properly calculate COGS, which labor and other expenses qualify for subtraction across different industries, how mixed transactions are treated, and how federal concepts like IRC Section 179 and bonus depreciation apply (or don’t apply) for Texas franchise tax purposes. The guidance also provides helpful reminders about when costs must be capitalized versus expensed.
One key takeaway up front: Texas COGS is calculated independently of federal tax reporting and industry-specific accounting methods. Only costs that are specifically listed in Texas Tax Code § 171.1012 may be subtracted.
The Comptroller’s FAQs provide guidance on whether specific costs qualify for the COGS deduction:
- Contractor payments to subcontractors – Qualify if related to real property construction, improvement, remodeling, repair, or industrial maintenance.
- Oil and gas drilling costs – Qualify, as oil and gas extraction constitutes “production” under the statute.
- Flow-through funds excluded from revenue – Do not qualify.
- Retail labor (store stockers) – Qualify until goods are displayed for sale; costs incurred afterward generally do not qualify.
- Restaurant labor – Labor costs for cooks qualify; waitstaff labor does not.
- Fulfillment center labor – Qualifies until goods are available to fulfill specific orders; post-availability costs generally do not qualify.
- Installation labor for tangible personal property – Generally does not qualify unless tied to qualifying real property activities.
- Sales personnel compensation and benefits – Do not qualify.
- Motor vehicle sales finance company interest expense – May qualify if the entity is a lending institution.
- Oil and gas depletion (partnerships and S corporations) – May qualify if related to production and reported to owners for federal purposes, but owners may not also include the same depletion in their own COGS.
Section 179 and Bonus Depreciation Limits
The Comptroller confirmed that IRC Section 179 limitations and bonus depreciation must be determined under federal law in effect on January 1, 2007, Texas’s fixed conformity date. As a result:
- Section 179 deductions are capped at $25,000, with a $200,000 acquisition threshold.
- Federal bonus depreciation is not permitted in the Texas COGS calculation.
Capitalization vs. Expensing of Costs
Taxable entities generally must capitalize allowable COGS costs but may elect to expense them. This election is made annually and applies consistently for that reporting period.
- Entities electing capitalization must follow their federal capitalization method, excluding costs disallowed under Texas law.
- A change between capitalization and expensing does not allow inclusion of costs incurred before the beginning of the report period, including prior-year inventory.
Intangible Drilling Costs (IDCs)
Limited partnerships may not elect to amortize IDCs over 60 months for Texas COGS purposes. The amortization election must be made at the partner level. Accordingly, partnerships must deduct IDCs in the year incurred when calculating the COGS subtraction.
Mixed Transactions
For transactions involving both the sale of tangible personal property and services, only costs attributable to the tangible personal property may be included in COGS. Labor and other service-related costs must be excluded.
Action Items for Taxpayers
Taxpayers should review their Texas franchise tax COGS calculations to confirm compliance with the Comptroller’s guidance, particularly with respect to labor costs, depreciation limits, and capitalization elections.
How COGS applies to Texas Franchise Tax