Texas Comptroller of Public Accounts    STAR System


201307727L



DATE:   July 16, 2013
TO:  Tony Luna, Audit Division
FROM:  Teresa Bostick, Tax Policy Division
SUBJECT:  Cost of Goods Sold (COGS) Deduction – Revisions to Rule 3.588


I. OVERVIEW

This memo explains the recent revisions to Rule 3.588, focusing mainly on the 
changes to the treatment of labor costs for purposes of the COGS deduction.  
These changes result in the franchise tax following the Internal Revenue Code 
(IRC) more closely.  Although federal COGS and Texas COGS are still not 
identical, these revisions should simplify many audits. 

II. CHANGES IN THE DEFINITION OF LABOR COSTS – RULE 3.588(D)(1)

PRIOR POLICY
Initially, we only allowed a COGS deduction for DIRECT labor costs, meaning 
wages and benefits paid to individuals who physically produced or acquired 
goods.  Because supervisory labor is an INDIRECT labor cost, due to the fact 
that supervisors do not directly “touch” the goods, supervisory labor costs 
were only allowed under 3.588(f) as indirect or administrative overhead costs 
subject to the 4% cap.  

NEW POLICY
Under the revised rule, labor costs include: (A) direct labor costs, or labor 
costs for individuals who actually touch the goods, and (B) indirect labor 
costs, or labor costs, other than service costs, that can be directly 
attributed to production or resale activities.  Labor costs for production 
supervisors or project managers are examples of indirect labor costs.  

This approach is based on IRC Section 263A, which requires taxpayers to 
capitalize into inventory both direct labor and materials costs and certain 
indirect costs that “directly benefit, or are incurred by reason of, the 
performance of production or resale activities.”  (For federal purposes, 
taxpayers may deduct these capitalized expenses when the product produced or 
acquired is sold.)

Rule 3.588(d)(1) now states:

A taxable entity may include in its cost of goods sold calculation labor costs, 
other than service costs, that are properly allocable to the acquisition or 
production of goods and are of the type subject to capitalization or allocation 
under Treasury Regulation Section 1.263A-1(e) or 1.460-5 as direct labor costs, 
indirect labor costs, employee benefit expenses, or pension and other related 
costs, WITHOUT REGARD TO WHETHER THE TAXABLE ENTITY IS REQUIRED TO OR ACTUALLY 
CAPITALIZES SUCH COSTS FOR FEDERAL INCOME TAX PURPOSES.

The CAPITALIZED phrase above is significant because certain taxpayers eligible 
to use the COGS method for franchise tax are not subject to IRC Section 263A. 
Others, like retailers or wholesalers whose average annual gross receipts for 
the previous three years are $10,000,000 or less, are not required to 
capitalize as many costs into inventory.  Rule 3.588 clarifies that “labor 
costs” are expenses of the TYPE that are subject to capitalization under IRC 
Section 263A, WITHOUT REGARD TO WHETHER A TAXABLE ENTITY ACTUALLY CAPITALIZED 
THOSE EXPENSES ON ITS FEDERAL RETURN.  Consequently, although small resellers 
have a smaller set of required capitalized costs for federal income tax 
purposes, they may include all of the applicable direct and indirect labor 
costs (other than service costs) identified in IRC Section 263A in their COGS 
calculation for franchise tax purposes.

In addition, the recent district court decision in WINSTEAD expanded the pool 
of costs that qualify as benefits expenses.  Expenses such as job-related 
education, business use of a company car, out-of-town travel/meal 
reimbursements, and per diem payments may now be included in a taxpayer’s labor 
cost when the labor to which the benefits correspond is includable in COGS.  
Rule 3.588(d)(1)(A) now states: 

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, to the extent 
deductible for federal tax purposes.

As under prior policy, costs excluded under 3.588(e) cannot be included in COGS 
regardless of how the costs are treated for federal tax purposes.

III. CHANGES IN INDIRECT AND ADMINISTRATIVE OVERHEAD COSTS–RULE 3.588(F)

The revised rule includes a new defined term: service costs.  Rule 3.588(b)(9) 
defines “service costs” for franchise tax purposes as: 

“Indirect costs and administrative overhead costs that can be identified 
specifically with a service department or function, or that directly benefit or 
are incurred by reason of a service department or function.  For purposes of 
this section, a service department includes personnel (including costs of 
recruiting, hiring, relocating, assigning, and maintaining personnel records or 
employees); accounting (including accounts payable, disbursements, and payroll 
functions); data processing; security; legal; general financial planning and 
management; and other similar departments or functions.”

INCLUDABLE SERVICE COSTS
All service costs are “indirect or administrative overhead costs” subject to 
allocation under 3.588(f).  Service costs that are demonstrably allocable to 
the acquisition or production of goods are includable in the COGS deduction, 
SUBJECT TO THE 4% CAP.  (This is a departure from the federal approach which 
includes the indirect and administrative costs directly allocable to production 
or acquisition as a capitalizable cost recoverable as goods are sold, WITHOUT 
LIMITATION.)  Service costs that are not allocable to the acquisition or 
production of goods may not be included in a taxpayer’s COGS deduction, but are 
used to calculate the 4% cap.  For example, legal services provided by a 
taxpayer’s general counsel are indirect or administrative overhead costs that 
must be allocated under 3.588(f).  The legal department might prepare and 
review all contracts for the production department, give tax advice to the tax 
department, and review all sales contracts for the sales department.  All of 
the legal service costs become part of the computation of the 4% cap under 
3.588(f), but only the legal services costs allocable to the preparation and 
review of production department contracts are includable in COGS as “indirect 
or administrative overhead costs." 

INDIRECT LABOR COSTS & SERVICE COSTS
Indirect labor costs may also be service costs.  Indirect labor costs that 
directly relate to production or acquisition and resale activities – and are 
NOT service costs – may be fully included in COGS under 3.588(d)(1).  An 
example is the salary and benefits paid to the head of a production division at 
a plant.  In contrast, indirect labor costs that directly relate to production 
or acquisition and resale activities – and are service costs – may not be fully 
included in COGS under 3.588(d)(1) but are instead subject to the 4% cap under 
3.588(f).  In other words, all service costs, even those that might also be 
categorized as labor costs or other types of includable expenses, fall under 
3.588(f) and are subject to the 4% cap.  For example, the accounting services 
provided at a construction job site may be included in COGS, but will be 
subject to the 4% cap. 

Table 1-A and 1-B, attached to this memo, provide examples of service costs and 
illustrate how to calculate the portion of these service costs that may be 
included in COGS as required by 3.588(f).


IV. ADDITIONAL CHANGES

COGS ELECTION
The previously-announced policy allowing a taxable entity to change its method 
of computing margin is now part of the revised rule.  A taxable entity may 
change the method it originally elected by filing an amended report within the 
time allowed under Tax Code 111.107.  The rule also states that an election may 
be changed as part of an audit. 

PROPERTY TAXES
Section 3.588(d)(11) is revised to include in direct costs property taxes paid 
on buildings and equipment.  The section now reads: “A taxable entity may 
include in its cost of goods sold calculation taxes paid in relation to 
acquiring or producing any material, including property taxes paid on buildings 
and equipment, and taxes paid in relation to services that are a direct cost of 
production.”


Table 1-A Franchise Tax COGS - Guide to Catergorizing Total Costs

Table 1-B Franchise Tax COGS - Guide to Catergorizing Total Costs ACCESSION NUMBER: 201307727L SUPERSEDED: N DOCUMENT TYPE: L DATE: 07/16/2013 TAX TYPE: Franchise