Major Change to Texas Franchise Tax Cost of Goods Sold Rule Finalized

The Texas Comptroller just adopted a major revision to the Texas franchise tax cost of goods sold rule.  The final rule the Texas Comptroller adopted is basically the same as the proposed cost of goods sold rule Michael described in his earlier post.  I’ll describe the ways the Texas Comptroller’s final cost of goods sold rule differs from the proposed version below.  The changes are all fairly minor and technical in nature. The rule still significantly expands the costs taxpayers may include in their Texas franchise tax cost of goods sold deduction, particularly for taxpayers in the construction industry.

Service Costs Includible in the Cost of Goods Sold Deduction

The Texas Comptroller revised the proposed Texas franchise tax cost of goods sold rule to add examples of the types of “service costs” that a taxpayer may include in its cost of goods sold deduction.  These “service costs” are some of the “indirect and administrative overhead” costs that a taxpayer may include in its cost of goods sold deduction, subject to a four-percent limitation.  The Texas Comptroller made this change to the proposed cost of goods sold ruled in response to comments from the State Tax Committee of the Texas Society of Certified Public Accountants and the Section of Taxation of the State Bar of Texas expressing concern that the proposed definition of the term “service costs” could be read to mean that a taxpayer could not include indirect and administrative overhead costs other than labor costs in its cost of goods sold.

Switching Among Cost of Goods Sold, Compensation, and Other Franchise Tax Computations

The Texas Comptroller also revised the proposed Texas franchise tax cost of goods sold rule to clarify the circumstances under which a taxpayer may switch among the cost of goods sold method, compensation method, and other Texas franchise tax computations.  The final version of the rule clarifies that taxpayers may switch to the cost of goods sold method from other methods at any time while the statute of limitations is open.  The final version of the rule also clarifies that taxpayers may switch Texas franchise tax computation methods during an audit.  The Texas Comptroller made these changes in response to comments from the Section of Taxation of the State Bar of Texas.  These comments expressed concern that the rule, as written, may not have allowed taxpayers to switch to cost of goods sold from other methods and that the rule may not have allowed taxpayers to switch computation methods during an audit.

Direct Labor Costs Includible in the Cost of Goods Sold Deduction

The Texas Comptroller also revised the proposed Texas franchise tax cost of goods sold rule to state more clearly the types of direct labor costs a taxpayer may include in its cost of goods sold deduction. It clarifies the nature of these deductible direct labor costs in two ways.  First, in response to comments from the Section of Taxation of the State Bar of Texas, the Texas Comptroller revised the proposed rule to clarify that taxpayers may deduct direct labor costs without regard to whether the taxpayer is required to or actually capitalizes such costs for federal income tax purposes.

Second, in response to comments from the State Tax Committee of the Texas Society of Certified Public Accountants and the Section of Taxation of the State Bar of Texas, the Texas Comptroller revised the definition of “labor costs” for cost of goods sold purposes to be slightly broader in scope.  It now reads: “For purposes of this section, labor costs include W-2 wages, IRS Form 1099 payments for labor, temporary labor expenses, payroll taxes, pension contributions, and employee benefits expenses, including, but not limited to, health insurance and per diem reimbursements for travel expenses.”

Property Taxes in Cost of Goods Sold

The Texas Comptroller also revised the proposed cost of goods sold rule to clarify that property taxes paid on buildings and equipment used in the manufacturing process or in the acquisition or storage of goods may be included in a taxpayers cost of goods sold deduction.

Conclusion

The final cost of goods sold rule is essentially the same as the rule the Texas Comptroller initially proposed.  As a result, it marks a huge shift from the Texas Comptroller’s prior cost of goods sold policy.  It may be a good idea for taxpayers to review the new rule and consider the potential refund claims they may have.  A tax professional, such as a Texas tax attorney, may be able to assist taxpayers in identifying these refund claims.

 

 

 


2 Comments

  • Sheila Rao says:

    Is interest paid to a bank includible in the 4% of administrative costs – do you know?


  • Michael Seay says:

    That’s a very good question. As you are probably aware, the law forbids a taxpayer from actually subtracting interest as a cost of goods sold, even if the interest is related to production. It is an “excluded cost” according to section 171.1012(e)(9) of the Tax Code.

    However, your question pertains to whether interest can be included in “total indirect or administrative overhead costs.” The statute tells us to take this amount, multiply it by 4%, and the resulting amount is the maximum overhead that can be included in COGS. Since a taxpayer will almost always have enough allocable overhead to reach this cap, it’s really the total overhead amount that’s important.

    To my knowledge, the Comptroller has published no guidance that directly addresses your question. If my memory serves me correctly, Comptroller auditors and tax policy employees would often take the position that “total indirect or administrative overhead costs” could NOT include specifically included costs, like interest. But a plain reading of both the statute and the Comptroller’s rule supports the position that “total indirect or administrative overhead costs” means exactly what it says it means–TOTAL overhead, not overhead after excluding certain costs.

    The Comptroller may currently be developing a “formal” answer to this question. If a significant amount of tax is at issue, please feel free to give us a call.


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