Two Important Changes in Texas Impacting How COGS (Cost of Goods Sold) Is Calculated

In a Comptroller of Texas Tax Policy Division letter ruling, a physical-change requirement is no longer a determinative factor for subcontractor revenue exclusion and COGS deduction for entities that have “a reasonable nexus” with real property including design, construction, remodeling, repair, or industrial maintenance. In addition, the Comptroller clarifies that construction and other companies involved in real property improvement may deduct cost of goods sold even though they do not own the real property under construction or improvement.

This crucial decision may allow entities with previously revoked exemptions and deductions to request reinstatement of these exemptions and deductions and possibly file refund claims via amended tax returns for open tax years.

Summary of Texas Policy Letter Ruling 2014444406920L (06/10/2014)

1. Revenue exclusion for flow-through payments to certain subcontractors.

Section 171.1011(g)(3) allows taxpayers to exclude from their franchise tax revenue certain "flow-through funds that are mandated by contract to be distributed to other entities.”

Under the prior policy and before this ruling, the Comptroller required an entity to meet three conditions before it qualified for the revenue exclusion:

  1. The entity must have a contract with its customer that states that subcontractors will be used and that payment to the subcontractors will be made by the entity from the funds paid by the customer;
  2. The entity pays the subcontractor only after receiving the “flow-through” funds from its customer; and
  3. The entity is physically engaged in the design, construction, remodeling or repair of real property.

The recent policy change eliminates the third condition. Now, instead of “physical-change” requirement, an entity’s subcontracted activity must merely “have a reasonable nexus” with a design, construction, remodeling, or repair activity. As the result, the Comptroller concedes that those entities that paid subcontractor drivers to deliver materials to construction sites will now qualify for the revenue exclusion, if they meet the other two requirements.

NOTE: In 2013, the Legislature provides clarity to § 171.1011(g) that now should be read as following: “either the contract with the customers or the subcontractor could mandate the flow-through”. Thus, for report years 2014 and later- the first condition no longer applies and only the second condition remains.

2. Cost of goods sold deduction for real-property construction, maintenance, and repair.

Typically, an entity may only deduct cost of goods sold if it produces or resells a “good” and owns the “good” before selling it. However, real-estate construction, repair and maintenance companies do not usually own the real property they work on, and thus could not deduct labor costs as cost of goods sold.

However, under  § 171.1012(i) “a taxable entity furnishing labor or materials to a project for the construction, improvement, remodeling, repair, or industrial maintenance of real property is considered to be an owner of that labor or material and may include the costs, as allowed by this section, in the computation of costs of goods sold”. All above mentioned entities may deduct cost of goods sold even though they do not own the real property under construction.

Conclusion

(1) An entity is no longer required to physically touch the property or make a change to the property in order to qualify for the COGS deduction.
(2) The entity’s activity must only “have a reasonable nexus” with the construction, repair, or maintenance activity to qualify. What the Comptroller considers “reasonable nexus” will be subject to debate.
(3) The labor and materials at issue need to be “an essential and direct” part of the construction, repair, or maintenance project to qualify.

If you have questions about this revised policy and how it may apply to your business, contact us.