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Thursday, 23 September 2010 16:20

ASA Texas Warns COGS Excludes Labor Featured

ASA Texas is warning shops that labor and other services are disallowed in calculating cost of goods sold for tax purposes. All shops are allowed to claim is the actual parts used for the repair. However, because this is such a common “error” in filing among auto repairers, Texas tax authorities are going to target auto repair shops in particular. The Comptroller’s office announced it will audit 29,000 businesses for the 2008 year. It has hired, or plans to hire, almost 500 auditors.

A shop owner in Tomball who was going through a franchise tax audit was unaware of this exclusion and after his CPA did recalculation of his tax liability, discovered it would cost him an additional $7300.
The Texas comptroller website has posted the following message:

“Franchise tax audits for report years 2008 and 2009 are now in full swing, and we’ve noticed that many entities in the service industry are incorrectly electing to use the cost of goods sold deduction to determine margin.

“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.

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.

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.”

ASA wants to address this interpretation of cost of goods sold by contacting the Ways and Means Committee of the Texas House and our representatives. Contact Charles Parker, Director, ASA Texas at

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