According to a recent Texas Tax Policy News, Texas is auditing 2008 and 2009 franchise tax returns and finding that service companies are taking the "cost of goods sold" deduction. Unfortunately, service businesses generally do NOT quality to take the cost of goods sold deduction. Therefore, all service companies that have taken the cost of goods sold deduction may have tax risk or exposure.
COGS Deduction Not Allowed for 100% Service Businesses
Section 171.1012 of the Texas Tax Code specifically provides that, in determining the cost of goods sold, the term “goods” means real or tangible personal property sold in the ordinary course of business and does not include services. The Tax Code does not allow a cost of goods sold deduction for entities that provide services such as dry cleaners, law firms, parking facilities, rental services, towing companies, etc.
COGS Deduction May Be Allowed for Mixed Transactions
Franchise Tax Rule 3.588(c)(8) does allow a cost of goods deduction for transactions that contain elements of both a sale of tangible personal property and a service; however, an entity may only subtract as cost of goods sold the costs otherwise allowed in relation to the tangible personal property sold.
For example, an auto body shop offers the service of car repair and in the process of the repair, replaces some of the car's parts. If the auto body shop elects to use the cost of goods sold to determine margin, the shop can only deduct the cost of the car parts. The labor related to the repair of the car is not allowed as a cost of goods sold.
Amended Returns Required? Deduction May Be Limited!
If an entity that is not eligible for the cost of goods sold deduction elected to use this method for prior years' reports, the entity must amend the reports. The compensation deduction, however, is not available for the prior years' reports. The election language in Tax Code Section 171.101(d) does not allow a change in the method of computing margin to a cost of goods sold or compensation deduction after the due date of the report.
These entities that originally elected to use the cost of goods sold method must amend and use the 70 percent method to determine margin or, if total revenue is not more than $10 million, may use the E-Z Computation to determine tax due. The E-Z Computation does not allow a cost of goods sold or compensation deduction in computing margin but instead applies a lower tax rate of 0.575 percent directly to apportioned total revenue.
In future years, entities that do not sell real or tangible personal property in the ordinary course of business may choose the compensation deduction over the 70 percent method or the E-Z computation. The compensation deduction, detailed in Franchise Tax Rule 3.589, includes W-2 wages and cash compensation paid, net distributive income reported to natural persons and employee benefits provided. (Note: Internal Revenue Service Form 1099 wages cannot be included in the compensation deduction.)