Major Change in the Works for Texas Franchise Tax Cost of Goods Sold Rules

Last Friday, the Texas Comptroller posted to the Texas Register a proposed revision to her Rule 3.588, which explains how to calculate COGS (cost of goods sold) for Texas franchise tax purposes. The Comptroller appears ready to significantly expand which costs are included in the cost of goods sold deduction.

The Way Things Were

If an entity qualifies for the COGS deduction, the Tax Code allows the taxpayer to deduct the “direct labor costs” necessary to produce or acquire the good sold. Until now, the Comptroller’s Rules did not include a definition of “direct labor costs.” But over the years the Comptroller has published several letters stating what she does not consider to be direct labor costs:

“Direct labor costs for cost of goods sold include only the labor of those persons who physically produce a good . . . Supervisory labor does not qualify as a direct cost.”  (Letter No. 201112315L)

In other words, the Comptroller’s position was that while the compensation paid to the person drilling holes in a widget was includable as a direct cost, the wages paid to that person’s supervisor was not includable as a direct cost, even if the supervisor spent his whole day on the factory floor.

In another letter, the Comptroller issued guidance to the construction industry:

“In the construction industry, direct labor will include only the labor of those individuals that make a physical change to the real property. Supervisory labor, therefore, does not qualify as a direct cost. It is an indirect cost . . .” (Letter No. 201108182L)

The Way That Things Now Appear to Be

This new proposed rule appears to change all of that. The new rule states that deductible labor costs:

“are of the type subject to capitalization or allocation under Treasury Regulation Sections 1.263A-1(e) or 1.460-5 as direct labor costs, indirect labor costs, employee benefit expenses or pension and other related costs.”

Therefore, the Comptroller appears ready to piggyback much more off of the federal tax regulations. The new Rule apparently states that if  a cost for federal tax purposes is subject to capitalization as inventory,  or subject to allocation under the percentage-of-completion method, it’s included in the cost of goods sold deduction (unless an exception applies). Because supervisory labor (and many other costs) are capitalized under the federal regulations, this suggests that the Comptroller will soon reverse her position regarding supervisory labor.

The Rule is still in proposed form. The public has until April 12 to make comments regarding the Rule. I’ll post more analysis here once the rule is in final. In the meantime, those entities that qualify for the cost of goods sold deduction should take a close look at previous year calculations and consider refund claims.

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