COGS and the Texas franchise tax


How the Real Estate Development Industry Can Apply COGS to Maximize Texas Franchise Tax Deductions

Many taxpayers assume the cost of goods sold (COGS) deduction only applies to taxable entities with inventory like supplies, vehicles, or books. However, for Texas Franchise Tax Reports,Survey steak on a real estate development parcel. taxpayers who own real property are eligible to use the cost of goods sold deduction method.

This article will broadly explore:

  • Who is eligible to utilize the COGS deduction if they own real property.
  • What determines ownership of real property for the purpose of this deduction.
  • Which expenses can be included in the COGS deduction.

The Texas franchise tax applies to taxable entities formed or organized in Texas or conducting business within the state. For federal tax purposes, COGS applies to taxpayers who produce goods. For instance, a television manufacturer would include the costs of the parts that go into making the televisions. For Texas franchise tax purposes, producers of goods goes beyond traditional retail sales.

Getting the Goods on Property

Goods, under the Texas franchise tax, can encompass both real property and tangible personal property. Real property includes land, structures and any improvements embedded into or permanently affixed to the land. Examples for this broad definition include homes, buildings, central air/heating systems (HVAC) floors, windows, and anything that may be considered real property.

According to the Texas Administrative Code, production of goods includes construction, manufacture, installation occurring during the manufacturing or construction process, development, mining, extraction, improvement, creating, raising, or growth. From this list, taxpayers and tax advisors often overlook expenses related to development and improving real estate when calculating COGS.

Per the Texas Code, a taxable entity may consider COGS only if that entity owns the goods. To determine if the taxable entity is the owner, the entity must consider all of the facts and circumstances, including the various benefits and burdens of ownership vested with the taxable entity. The comptroller refers to benefits as the income received from goods, while burdens include costs associated with property like insurance and property taxes.

To twist things a bit, taxable entities who do not own the real property can deduct expenses related to work performed on the real estate. The Texas Code treats taxable entities that furnish labor or materials to a project for the construction, improvement, remodeling, repair, or industrial maintenance of real property to be the owner of that labor or materials and may include the costs, as allowed by this section, in the computation of cost of goods sold.

For the Texas Franchise Report, ownership is more than who legally owns the property. Ownership refers to who physically modifies real property through construction, improvements, or maintenance.

Qualifying Expenses

Contractors and subcontractors that do not own the property or equipment can deduct costs related to the property they are working on. Imagine that Developing, LLC (DEV) owns a plot Several construction workers wearing PPE and working on a commercial construciton site.of land and it is being developed for residential use. DEV contracts with General Co. (GEN) to build a neighborhood on the plot of land. GEN contracts with Olmos, LLC (OLM) to create the wastewater facilities and roads. DEV also contracts Framing Company (FC) and Wiring Company (WC) to build the houses.

DEV is the owner of the real estate. However, GEN is considered the owner of the real estate to the extent GEN contributes labor and materials to the neighborhood. OLM does not literally own the utilities, roads, or land. Regardless, OLM may deduct the costs of purchasing the pipes, running the pipes underground, purchasing and developing the sewer systems, and purchasing and pouring the materials to make the roads. OLM may also deduct expenses related to the rental of heavy construction equipment needed to prepare the roads for use.

FC and WC are also considered owners of the materials and labor they contribute to the housing projects. FC can deduct costs related to labor costs incurred during the framing work performed on the houses.

The payments to subcontractors may be excluded from total revenue if the payments are mandated by contract. If the revenue was excluded, then the taxpayer may not take the COGS for those same subcontractor jobs.

In Sunstate Equipment Co. LLC v Heager (No. 17-0444), the Texas Supreme Court made an important decision for heavy equipment rental companies to consider when computing COGS. Sunstate Equipment Co. LLC subtracted costs related to the delivery and retrieval of heavy equipment to its customers. The Texas Code Sec. 171.1012(k-1) and 171.1012(i) indicated the cost of goods sold subtraction for heavy equipment rental companies was limited to costs associated with the acquisition and production of the equipment that is rented. The delivery and pick-up costs are not eligible for the cost of goods deduction.

Takeaways

The COGS deduction is available to taxable entities that own real property. Expenses related to improvement or maintenance of real property qualify when calculating COGS. It is important to note that the taxable entity performing the labor or supplying the materials for construction or improvement of real property is the entity eligible for the COGS when preparing the Texas Franchise Report.

Final Thoughts

The challenges facing the real estate industry demand a proactive and creative approach to navigate through uncertainty. Leveraging the experience of experienced tax professionals can Andy Najera, CPA, Tax Manager at Sol Schwartz & Associates, a premier CPA and advisory firm founded in 1980 and based in San Antonio, Texas.ensure compliance with ever-changing tax provisions as well as maximization of tax savings opportunities.

The tax professionals at Sol Schwartz & Associates have worked extensively with commercial real estate owners and developers since our firm was founded in 1980. Let us know if you would like us to take a look at your situation. Andy Najera can be reached at 210.384.8000 or axn@SSAcpa.com. Or just leave us your contact information below and we will get back to you promptly.