Cost of Goods
Cost of Goods Sold. The general rules for determining cost of goods sold are the cost of goods sold includes all direct costs of acquiring or producing the goods, including:
(1) labor costs including W-2 wages, IRS Form 1099 wages, temporary labor, payroll taxes and benefits;
(2) cost of materials that are an integral part of specific property produced;
(3) cost of materials that are consumed in the course of performing production activities;
(4) handling costs, including costs attributable to processing, assembling, repackaging, and inbound transportation;
(5) storage costs, including the costs of carrying, storing, or warehousing property;
(6) depreciation, depletion, and amortization, reported on the federal income tax return on which the report under this chapter is based, to the extent associated with and necessary for the production of goods, including recovery described by Internal Revenue Code, §197, and property described in Internal Revenue Code, §179;
(7) the cost of renting or leasing equipment, facilities, or real property used for the production of the goods, including pollution control equipment and intangible drilling and dry hole costs;
(8) the cost of repairing and maintaining equipment, facilities, or real property directly used for the production of the goods, including pollution control devices;
(9) costs attributable to research, experimental, engineering, and design activities directly related to the production of the goods, including all research or experimental expenditures described by Internal Revenue Code, §174;
(10) geological and geophysical costs incurred to identify and locate property that has the potential to produce minerals;
(11) taxes paid in relation to acquiring or producing any material, or taxes paid in relation to services that are a direct cost of production;
(12) the cost of producing or acquiring electricity sold; and
(13) a contribution to a partnership in which the taxable entity owns an interest that is used to fund activities, the costs of which would otherwise be treated as cost of goods sold of the partnership, but only to the extent that those costs are related to goods distributed to the contributing taxable entity as goods-in-kind in the ordinary course of production activities rather than being sold by the partnership.
(e) Additional costs. In addition to the amounts includable under subsection (d) of this section, the cost of goods sold includes the following costs in relation to the taxable entity’s goods:
(1) deterioration of the goods;
(2) obsolescence of the goods;
(3) spoilage and abandonment, including the costs of rework, reclamation, and scrap;
(4) if the property is held for future production, preproduction direct costs allocable to the property, including storage and handling costs, as provided by subsection (d)(4) and (5) of this section;
(5) postproduction direct costs allocable to the property, including storage and handling costs, as provided by subsection (d)(4) and (5) of this section;
(6) the cost of insurance on a plant or a facility, machinery, equipment, or materials directly used in the production of the goods;
(7) the cost of insurance on the produced goods;
(8) the cost of utilities, including electricity, gas, and water, directly used in the production of the goods;
(9) the costs of quality control, including replacement of defective components pursuant to standard warranty policies, inspection directly allocable to the production of the goods, and repairs and maintenance of goods; and
(10) licensing or franchise costs, including fees incurred in securing the contractual right to use a trademark, corporate plan, manufacturing procedure, special recipe, or other similar right directly associated with the goods produced.
(f) Indirect or administrative overhead costs. A taxable entity may subtract as a cost of goods sold indirect or administrative overhead costs that it can demonstrate are allocable to the acquisition or production of goods. This amount may not exceed 4.0% of total indirect or administrative overhead cost.
(1) Indirect or administrative overhead costs include, but are not limited to, all mixed service costs, such as security services, legal services, data processing services, accounting services, personnel operations, and general financial planning and financial management costs.
(2) Any costs already subtracted under subsections (d) or (e) of this section, may not be subtracted under this subsection.
(3) Any costs excluded under subsection (g) of this section, may not be subtracted under this subsection.
(g) Costs not included. The cost of goods sold does not include the following costs in relation to the taxable entity’s goods:
(1) the cost of renting or leasing equipment, facilities, or real property that is not used for the production of the goods;
(2) selling costs, including employee expenses related to sales;
(3) distribution costs, including outbound transportation costs;
(4) advertising costs;
(5) idle facility expenses;
(6) rehandling costs;
(7) bidding costs, which are the costs incurred in the solicitation of contracts ultimately awarded to the taxable entity;
(8) unsuccessful bidding costs, which are the costs incurred in the solicitation of contracts not awarded to the taxable entity;
(9) interest, including interest on debt incurred or continued during the production period to finance the production of the goods;
(10) income taxes, including local, state, federal, and foreign income taxes, and franchise taxes that are assessed on the taxable entity based on income;
(11) strike expenses, including costs associated with hiring employees to replace striking personnel, but not including the wages of the replacement personnel, costs of security, and legal fees associated with settling strikes;
(12) officers’ compensation;
(13) costs of operation of a facility that is:
(A) located on property owned or leased by the federal government; and
(B) managed or operated primarily to house members of the armed forces of the United States;
(14) any compensation paid to an undocumented worker used for the production of goods; and
(15) costs funded by a partnership contribution, to the extent that the contributing taxable entity made the cost of goods sold deduction under subsection (d)(13) of this section.
Additional Rules for the calculation of Cost of Goods Sold:
For affiliated entities. Notwithstanding any other provision of this section, a payment made by one member of an affiliated group to another member of that affiliated group not included in the combined group may be subtracted as a cost of goods sold only if it is a transaction made at arm’s length.
Capitalization or expensing of certain costs. A taxable entity that is allowed a subtraction by this section for a cost of goods sold and that is subject to Internal Revenue Code, §§263A, 460, or 471 (including a taxable entity subject to §471 that elects to use LIFO under §472), may:
(A) Capitalize those costs in the same manner and to the same extent that the taxable entity capitalized those costs on its federal income tax return, except for those costs excluded under subsection (g) of this section, or in accordance with subsections (d), (e), and (f) of this section. A taxable entity that elects to capitalize costs on its first report due on or after January 1, 2008, may not include any costs incurred prior to the accounting period upon which the report is based.
(i) If the taxable entity elects to capitalize those costs, it must capitalize each cost allowed under this section that it capitalized on its federal income tax return.
(ii) If the taxable entity later elects to begin expensing those costs allowed under this section as a cost of goods sold, the entity may not deduct any cost in ending inventory from a previous report.
(B) Expense those costs, except for those costs excluded under subsection (g) of this section, or in accordance with subsections (d), (e), and (f) of this section.
(i) If the taxable entity elects to expense those costs allowed under this section as a cost of good sold, costs incurred before the first day of the period on which the report is based may not be subtracted as a cost of goods sold.
(ii) If the taxable entity later elects to begin capitalizing those costs allowed under this section as a cost of goods sold, costs expensed on a previous report and costs incurred prior to the accounting period upon which the report is based may not be capitalized.
Exclusions from total revenue. Costs related to any amount excluded from total revenue (see §3.587 of this title (relating to Margin: Total Revenue)) may not be included in the determination of cost of goods sold. Costs related to an amount excluded from revenue must be determined on a reasonable basis.
Film and broadcasting. A taxable entity whose principal business activity is film or television production or broadcasting or the sale of broadcast rights or the distribution of tangible personal property described by subsection (b)(9)(A)(ii) of this section, or any combination of these activities, and who elects to use cost of goods sold to determine margin, may include as cost of goods sold:
(A) the costs described in this section in relation to the property;
(B) depreciation, amortization, and other expenses directly related to the acquisition, production, or use of the property, including
(C) expenses for the right to broadcast or use the property.
Lending institutions. Notwithstanding any other provision of this section, if the taxable entity is a lending institution that offers loans to the public and elects to subtract cost of goods sold, the entity may subtract as a cost of goods sold an amount equal to interest expense.
(A) This paragraph does not apply to entities primarily engaged in an activity described by category 5932 of the 1987 Standard Industrial Classification Manual published by the federal Office of Management and Budget.
(B) For purposes of this subsection, an entity engaged in lending to unrelated parties solely for agricultural production offers loans to the public.
Mixed transactions. If a transaction contains elements of both a sale of tangible personal property and a service, a taxable entity may only subtract as cost of goods sold the costs otherwise allowed by this section in relation to the tangible personal property sold.
Owner of goods. A taxable entity may make a subtraction under this section in relation to the cost of goods sold only if that entity owns the goods. The determination of whether a taxable entity is an owner is based on all of the facts and circumstances, including the various benefits and burdens of ownership vested with the taxable entity.
(A) A taxable entity furnishing labor or materials to a project for the construction, improvement, remodeling, repair, or industrial maintenance (as the term "maintenance" is defined in §3.357 of this title (relating to Nonresidential Real Property Repair, Remodeling, and Restoration; Real Property Maintenance)), of real property is considered to be an owner of the labor or materials and may include the costs, as allowed by this section, in the computation of goods sold.
(B) Solely for the purposes of this section, a taxable entity shall be treated as the owner of goods being manufactured or produced by the entity under a contract with the federal government, including any subcontracts that support a contract with the federal government, notwithstanding that the Federal Acquisition Regulations may require that title or risk of loss with respect to those goods be transferred to the federal government before the manufacture or production of those goods is complete.
Rentals and leases. Notwithstanding any other provision of this section, the following taxable entities may subtract as cost of goods sold the costs otherwise allowed by this section in relation to tangible personal property that the entity rents or leases in the ordinary course of business of the entity:
(A) a motor vehicle rental company that remits a tax on gross receipts imposed under Tax Code, §152.026 or a motor vehicle leasing company;
(B) a heavy construction equipment rental or leasing company; and
(C) a railcar rolling stock rental or leasing company.
Reporting methods. A taxable entity shall determine its cost of goods sold, except as otherwise provided by this section, in accordance with the methods used on the federal income tax return on which the report under this chapter is based. This subsection does not affect the type or category of cost of goods sold that may be subtracted under this section.
Restaurants. Entities engaged in activities described in Major Group 58 of the Standard Industrial Classification Manual may deduct for cost of goods sold only those expenses allowed under subsections (d), (e) and (f) of this section, that relate to the production of food. Any costs related to both the production of food and to other activities must be allocated to production on a reasonable basis.