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State & Local Tax Tax

Texas Franchise Tax: What are COGS?

With advance tax planning, it is often possible to avoid the Texas franchise tax. If the tax does apply, it can often be minimized by a close reading and application of the rules. The recent Sunstate Equipment Co., LLC vs. Comptroller of Public Accounts, No. 17-0444 (Tex. 2020) case provides an opportunity to consider when the subtraction for the cost of goods sold can be used to minimize the tax due.

Facts & Procedural History

The taxpayer was headquartered in Arizona. It rents out heavy construction and industrial equipment to customers throughout Texas.

In computing its Texas franchise tax, it subtracted as cost of goods sold (“COGS”) delivery costs for delivering its rental property to job sites.

The Texas Comptroller audited the returns and disallowed the COGS subtraction. Litigation ensued and the taxpayer prevailed. The Texas Comptroller appealed to the Texas Supreme Court.

About the Texas Franchise Tax

The Texas franchise tax is imposed on entities organized in Texas and on out-of-state entities that operate in Texas.

Unlike the Federal income tax or the income taxes imposed by most states, the Texas franchise tax is not imposed on income. Rather, the tax is imposed on the “taxable margin.”

The taxable margin is generally gross receipts less:

  1. 70 percent of the taxable entity’s total revenue or
  2. Either the taxable entity’s total revenue minus:
    • the COGS or
    • compensation paid to the officers

Taxpayers often deduct COGS, as it results in less tax. But what qualifies as COGS for the Texas franchise tax is not all that clear.

COGS for Texas Franchise Tax

Texas Tax Code § 171.1012 describes what counts as COGS for the Texas franchise tax. This statute is lengthy and nuanced.

It starts with the general rule that COGS includes:

  1. All direct costs of acquiring or producing goods and
  2. Certain indirect costs that are in relation to the taxable entity’s goods.

Goods mean real or tangible personal property sold in the ordinary course of business. It also excludes services.

There is a list of 24 items that are included in COGS. There is also a list of 14 items that are excluded.

Construction Rental or Leasing Costs

As relevant here, the list of excluded items allows taxpayers who rent or lease personal property to exclude as COGS the a heavy construction equipment rental or leasing company costs. But this exception is limited:

A taxable entity may make a subtraction under this section in relation to the cost of goods sold only if that entity owns the goods. The determination of whether a taxable entity is an owner is based on all of the facts and circumstances, including the various benefits and burdens of ownership vested with the taxable entity. A taxable entity furnishing labor or materials to a project for the construction, improvement, remodeling, repair, or industrial maintenance (as the term “maintenance” is defined in 34 [TEX. ADMIN.CODE] Section 3.357) of real property is considered to be an owner of that labor or materials and may include the costs, as allowed by this section, in the computation of cost of goods sold.

Thus, the taxpayer that rents or leases equipment has to own the equipment. If they do, they can deduct as COGS the maintenance costs associated with the property.

But What about Delivery Costs?

In the present case, the taxpayer deducted as COGS the labor, fuel, depreciation, maintenance, and property tax costs related to its delivery and pick-up of equipment. The appeals court concluded that the rules provided above allow taxpayers to deduct costs to deliver equipment to and pick the equipment up from job sites.

On review, the Texas Supreme Court noted that the rules summarized above create an exception to the statute whereby heavy construction equipment rental or leasing companies can subtract COGS despite not actually selling their equipment.

The Court did not read the construction or rental cost exception as creating a new type of expense that can be subtracted as COGS. According to the court, one still has to go back to the list of costs that are specifically allowed to be able to deduct the costs.

Since there is no provision for delivery costs, even taxpayers who are in the construction rental or leasing business cannot subtract these costs as COGS.

So taxpayers are limited to the a list of 24 items that are included in COGS in the statute, less the 14 items that are excluded.

The Takeaway

Taxpayers who sell tangible property in Texas should review their Texas franchise tax returns. We often see taxpayers who fail to take steps to avoid the tax in the first place. Even when the tax applies, they fail to take advantage of the COGS subtraction. This is an area where advance tax planning can reduce the taxes owed. This is true even with the more narrow reading for construction rental or leasing companies.

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