Frequently Asked Questions
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Note: TTC means Texas Tax Code and IRC means Internal Revenue Code
Cost of Goods Sold (COGS)
- 1. What is the definition of "goods?"
- Goods are defined as real or tangible personal property sold in the ordinary course of business. Tangible personal property includes computer programs as well as films, sound recordings, videotapes, live and prerecorded television and radio programs, books, and other similar property. Tangible personal property does not include items that are rented in the ordinary course of business, intangible property or services. There is an exception however for a taxable entity renting motor vehicles, heavy construction equipment or railcar rolling stock and certain financial institutions.
- 2. Are service industries such as a transportation company allowed COGS?
- Generally a taxable entity in the service industry will not have COGS as they do not sell tangible personal property or real property in the ordinary course of business. TTC 171.1012.
- 3. Is the calculation for COGS like the federal reporting and industry calculations?
- No, allowable costs to be included in COGS are specifically defined for franchise tax reporting purposes in TTC 171.1012.
- 4. What costs are included in the computation of COGS?
- Allowable costs for COGS generally include costs related to the acquisition and production of tangible personal property or real property. See Rule 3.588 for detailed listing of costs that may be included in COGS.
- 5. What costs are not allowed in the computation of COGS?
- COGS does not include selling costs, distribution costs, advertising costs, officer compensation and payments made to undocumented workers. See Rule 3.588 for detailed listing of costs that are not included in COGS.
- 6. Can IRS Form 1099-MISC nonemployee compensation be included in the computation of COGS?
- All direct labor costs, including amounts reported on IRS Form 1099-MISC nonemployee compensation, are part of COGS when calculating margin.
- 7. Can flow-through funds excluded from gross revenue be included in the computation of COGS?
- No, any amounts excluded from gross revenue cannot be included in COGS. TTC 171.1011(j).
- 8. 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 per TTC Section 171.1012(i) unless the payment has already been excluded from gross 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). In other words, the same subcontractor payment may only be subtracted once, either as a flow-through fund or as COGS, in the calculation of margin. (Updated 01/26/11)
- 9. Is a store stocker providing labor included in COGS?
- Yes, a store stocker's labor is considered a handling cost and included in COGS.
- 10. Is the labor provided by cooking staff and wait staff 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.
- 11. When must the election for COGS be made and once made, can it be changed?
- The election for COGS must be made by the due date, the extended due date or the date the report is filed, whichever is latest. The election to use COGS is made by filing the franchise tax report and deducting COGS. The report may be amended to calculate margin using compensation, 70% of total revenue or the E-Z computation, if qualified. The amended report must be filed within the statute of limitations (Updated 06/13/12)
- 12. Is there a difference between expensing and capitalizing allowable costs for the computation of COGS?
- A taxable entity that is subject to IRC Sections 263A, 460, 471 or 472 may elect to capitalize or expense the costs allowed for franchise tax reporting in computing COGS. The election to capitalize or expense is made by filing the franchise tax report using one method or the other and is effective for the entire period upon which the report is based and may not be changed after the due date of the report.
- 13. 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.
- 14. Can an entity use its beginning inventory for federal income tax purposes if the entity capitalizes allowable costs for COGS?
- A taxable entity that elects to capitalize allowable costs on its first report due on or after January 1, 2008, may only include in beginning inventory costs allowed under TTC 171.1012 that would be in beginning inventory for federal income tax purposes. Any costs in beginning inventory for federal tax purposes that are not allowable costs under TTC 171.1012 may not be included in beginning inventory for franchise tax reporting purposes.
- 15. Can an entity switch from capitalizing allowable costs for COGS to expensing allowable costs for COGS?
- The election to capitalize or expense 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.
- 16. Can an entity switch from expensing to capitalizing allowable costs for COGS?
- The election to capitalize or expense allowable costs for COGS is an annual election. 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.
- 17. Are entities that drill for oil & gas allowed a cost of goods sold deduction?
- Entities that drill for oil & gas are allowed a cost of goods sold deduction for the Texas franchise tax. Oil & gas extraction falls under the definition of production in Tax Code §171.1012(a)(2).
- 18. How are Section 179 expense limitations and federal bonus depreciation amounts determined for Texas COGS?
- Both federal bonus depreciation and Section 179 expense limitations are based on the Internal Revenue Code (IRC) as of Jan. 1, 2007, for Texas franchise tax purposes. See FAQ#1 under Total Revenue Tax Rule 3.587 for the meaning of “Internal Revenue Code.”
The annual changes to Section 179 expense limits and property acquisition thresholds are listed in the table at FAQ #24. These changes are based on the inflation-adjusted amounts for the years 2007-2009 as specified in Section 179 per the IRC in effect on 1/1/2007. After 2009, Section 179 of the IRC in effect as of Jan. 1, 2007, sets the Section 179 expense to $25,000 and the property acquisition threshold to $200,000.
Federal bonus depreciation is not part of Texas COGS because the Economic Stimulus Act of 2008, which introduced the current bonus depreciation rules, became part of the Internal Revenue Code after January 1, 2007. (Updated 04/04/12)
- 19. Do movie theaters qualify for cost of goods sold?
- A movie theater qualifies for cost of goods sold for its concession sales. The movie theater is not distributing tangible personal property and therefore does not qualify for cost of goods sold for royalty payments made for the right to use the property. (Updated 06/19/08)
- 20. What is a "mixed transaction" and does it qualify for a cost of goods sold deduction?
- TTC 171.1012 provides that the only taxable entities that are eligible to use COGS in computing margin are those entities that sell real or tangible personal property in the ordinary course of business. This section of the code goes on to confirm that the performance of a service is not considered the sale of tangible personal property. However, we did include a provision in Rule 3.588(c)(6) that reads as follows:
“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 the labor and other costs related to the services performed as a cost of goods sold.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 in COGS the pharmaceuticals. No labor costs or fees would be included.
- 21. Do oil and gas wells constitute real property for purposes of TTC 171.1012(i)?
- Yes, oil and gas wells are considered real property for purposes of TTC 171.1012(i) to the extent the components are real property for sales and use tax purposes after installation. (Updated 09/09/11)
- 22. Can oilfield services that an entity performs be included in COGS?
- The labor and materials used in the construction, improvement, remodeling, repair, or industrial maintenance (as defined in Rule 3.357) of real property are allowed as COGS. Oilfield services that constitute construction, improvement, remodeling, repair, or industrial maintenance of oil and gas wells can be included in COGS for allowable costs under TTC 171.1012. The components of oil and gas wells are real property to the extent they are considered real property for sales and use tax purposes after installation. (Updated 09/09/11)
- 23. 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 cost of goods sold deduction. See Rule 3.588(b)(7). (Updated 06/19/08)
- 24. What is the amount of Section 179 expense deduction that can be included in COGS?
A Section 179 expense deduction is only allowed for taxable entities that elect to use COGS to compute their margin. In general, only taxable entities that sell real or tangible personal property in the ordinary course of business are eligible to use COGS. Allowable costs include depreciation and Section 179 expense deductions that are related specifically to equipment used in the production of goods. The dollar limitation for the Section 179 expense is reduced by the amount by which the cost of Section 179 property placed in service during the taxable year exceeds the property acquisition threshold amount. The table below shows the section 179 limitation and property acquisition threshold for each report year. (See FAQ #18 for general information regarding changes in the report year limitations.)
Fran. Tax Report Yr. For Accting. Yrs. Ending in 179 Dollar Lim. Property Acq. Threshold 2008 2007 $112,000 $450,000 2009 2008 $115,000 $460,000 2010 2009 $120,000 $480,000 2011 and beyond 2010 and beyond $25,000 $200,000
- 25. Are the compensation and benefits of a salesperson included in COGS?
- No, the compensation and benefits of a salesperson are considered a selling cost and cannot be included in COGS. (Updated 09/24/09)
- 26. 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 cost of goods sold an amount equal to interest expense. A motor vehicle sales finance company is not considered to be offering loans to the public unless it offers loans to customers to finance property other than property that it or an affiliated entity sells in the ordinary course of business.(Updated 09/09/11)
- 27. Can a limited partnership elect to amortize intangible drilling costs over 60 months instead of expensing these costs?
- No. The election to amortize intangible drilling costs (IDC) over 60 months is not available to a partnership. IDC are a part of the cost of goods sold (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. (added 01/26/11)
- 28. 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. 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. Since the entity includes the allowable depletion in its COGS, the owners of a pass-through entity may not include in COGS the depletion reported to them. Franchise Tax Rule 3.588(d)(6) has been amended to reflect this policy. (Added 09/09/2011)