The Texas Third Court of Appeals recently held in Hegar v. Sunstate Equipment Co., LLC, that a company that leased heavy equipment to contractors could not include its delivery and pick-up fees for the equipment in its cost of goods sold deduction for Texas franchise tax COGS deduction purposes. In doing so, the Third Court of Appeals overturned a trial court decision in the company’s favor. The Third Court of Appeals found that the company could neither deduct its delivery and pick-up fees under the provision that allows heavy equipment rental companies to deduct as cost of goods sold costs associated with the property they lease, nor under the provision that allows those who provide labor or materials to real property construction projects to deduct as cost of goods sold the labor and materials. We discuss the opinion and its implications for taxpayers in more detail below.
Background
The Texas Tax Code generally only allows taxpayers to deduct as cost of goods sold costs associated with goods the taxpayer owns and sells. The Texas Tax Code provides an exception to this rule for companies that lease heavy machinery. It allows these companies to deduct costs otherwise allowed that are “in relation to” equipment that they “rent or lease in the ordinary course of business.”
Another provision provides another exception for taxpayers who work on real property construction projects. This statute states that an “entity furnishing labor or materials to a project for the construction, improvement, remodeling, repair, or industrial maintenance . . . of real property” is considered to be the owner of the labor or materials and may include the costs allowed by the tax code in its cost of goods sold deduction.
In general, the Texas Tax Code allows taxpayers to deduct all costs of acquiring and producing the goods they sell as part of cost of goods sold, as well as certain other costs specified by the statute.
Sunstate Equipment Co. rents heavy machinery, typically to construction contractors. Most of the time, Sunstate employees delivered the equipment to the construction sites and picked it up at the end of the lease term. Sunstate charged delivery and pick-up fees to its customers for doing this. The parties stipulated for the purposes of this case that if Sunstate had not delivered or picked up the equipment, it wouldn’t have made any rental revenues on that equipment, and that this delivery and pick-up was an “integral part” of Sunstate’s business operations.
Sunstate argued that it should be allowed to include its delivery and pick-up fees in its cost of goods sold deduction as costs in relation to the equipment it rented, or, alternatively, as labor provided to a construction project. The Texas Comptroller disagreed. The trial court found in Sunstate’s favor.
The Third Court of Appeals’ Opinion
The Third Court of Appeals held that Sunstate could not include its delivery and pick-up fees in its cost of goods sold deduction. The court said that, based on its reading of the statute, the Texas Legislature generally intended for taxpayers to include in cost of goods sold costs associated with acquiring and producing goods, not with selling or distributing them. The Third Court of Appeals considered the delivery and pick-up fees to be a cost of selling or distributing goods, not of acquiring or producing them. It wrote that it saw no reason for taxpayers who lease goods to deduct selling or distribution costs while taxpayers who sold goods outright could not.
The Third Court of Appeals also held that Sunstate could not include its delivery and pick-up costs in its cost of goods sold deduction under the exception for real property contractors because the labor associated with the delivery and pick-up fees was not “an essential or direct component” of the real property construction project. The Third Court of Appeals wrote that it did not feel that delivering equipment that others would use in a construction project was the direct provision of labor to the project, nor was it an essential component of the project.
Conclusion
We note that the Third Court of Appeals’ decision is not yet final. The deadline for either party to file a Motion for Rehearing has been extended to February 21, 2017, and a Petition for Review may still be filed with the Texas Supreme Court.
Assuming this decision becomes final, it is one of the first Third Court of Appeals cases to expressly find that labor provided to a construction project was not “an essential or direct component” of the project. The reasoning provided, especially when contrasting with other cases such as Newpark Resources, is a bit vague and unclear. So, it seems that further litigation may be necessary to clearly define the boundaries of what labor costs may be deduction under this section.
In the wake of this decision, taxpayers who find themselves uncertain of their Texas sales tax obligations may wish to seek the advice of a Texas tax professional, such as a Texas tax attorney, in order to clarify their obligations.
