Texas Franchise Tax: Cost of Goods Sold, Compensation or 70%

How is Texas franchise tax calculated?

Texas franchise tax, also called the Texas margin tax, is charged on "margin": the smallest of four amounts (Tax Code 171.101). The report asks for all four and takes the lowest (Form 05-915, Items 19–23).

The order of the math:

1. Total revenue starts from specific lines of the federal return, then removes items Texas excludes, such as qualifying subcontractor payments on real property projects (below).
2. Margin is the smallest of the four amounts.
3. Margin is apportioned to Texas by Texas gross receipts over gross receipts everywhere. Goods delivered to a Texas buyer and services performed in Texas are Texas receipts, but Internet hosting receipts are Texas receipts only when the customer is located in Texas (Form 05-915); see Business income tax in other states.
4. The result is taxed at 0.75%, or 0.375% for a company primarily engaged in retail or wholesale trade (Comptroller).

Because the statute takes the lesser amount, a weak deduction cannot push margin above 70% of revenue.

A company whose total revenue is $20 million or less may instead elect the EZ computation: 0.331% of apportioned total revenue, with no deductions and no credits (Tax Code 171.1016).

To compare the methods you need the federal return, W-2 box 5 totals per person and owners' K-1s, a list of production costs and production assets, subcontract agreements, and receipts by delivery address or place of work.

Who files, the $2,650,000 no-tax-due threshold, due dates and penalties are in Texas franchise tax.

Which deduction fits which data center business?

Which deduction gives the lowest tax, and when is EZ lower?

The lowest method can change from year to year, so the table above is only a starting point. Cost of goods sold tends to win for makers and contractors, compensation for service companies with large payrolls, and the 70% method when neither deduction is large. Revenue minus $1 million is lowest only for a small company, where $1 million is more than the share of revenue the 70% method leaves out.

EZ ignores costs, so it wins when margin divided by revenue is above 0.331% divided by 0.75%. For a company taxed at 0.375%, EZ is never lower: even the highest margin, 70% of revenue, taxed at that rate costs less than 0.331% of revenue. EZ also gives up any credits.

Who can use cost of goods sold, and why can't a GPU cloud?

Only a company that sells goods: real or tangible personal property sold in the ordinary course of business. Services and intangibles are not goods; a computer program is (Tax Code 171.1012(a)). A service business generally has no qualifying cost of goods sold (Form 05-915).

• Renting equipment is not a sale. Only motor vehicle, heavy construction equipment and railcar rental companies may count costs of property they rent out (Rule 3.588(c)(13)). A GPU cloud selling compute by the hour or renting dedicated servers has no cost of goods sold, and the federal bonus depreciation on its servers reduces none of its margins.
• The company must own the goods. Legal title is presumed to show ownership (Rule 3.588(c)(11)). Labor on equipment the customer owns is a service (STAR 202106022H), so labor on a maintenance contract for a customer's servers or cooling units does not count.
• Mixed bills count only the goods. Only the costs of the goods count, never the service labor (Rule 3.588(c)(9); COGS FAQ).

Whether a software subscription is a sale of a computer program is not settled by these sources; get advice before counting its costs.

What counts as cost of goods sold for a maker, reseller or rack integrator?

Direct costs of making or buying the goods count; selling, financing and executive costs do not (Tax Code 171.1012(c)–(f); Rule 3.588(d)–(g)).

Overhead such as legal, accounting, personnel and data processing counts only to the extent allocable to the goods, and never more than 4% of total indirect and administrative overhead (Rule 3.588(f)).

For a rack integrator, assembling racks is a handling cost and burn-in testing is quality control. Installing servers or racks at the customer's data center is not production, unless the job is construction or improvement of real property (COGS FAQ; Rule 3.588(b)(8)).

Texas cost of goods sold will not match federal Form 1125-A; it is its own worksheet. The yearly choice to capitalize or expense costs is fixed once the later of the due date or filing date passes, and switching drops earlier periods' costs (Rule 3.588(c)(3)).

Can an electrical or cooling contractor include its labor and subcontractor payments?

Yes, when the work is on real property. A company furnishing labor or materials to a project for the construction, improvement, remodeling, repair or industrial maintenance of real property is treated as owning them, so it may count them as cost of goods sold (Tax Code 171.1012(i)). An electrical contractor wiring switchgear, busway and UPS into a data center building qualifies even though it "sells installation". Contractors who think of themselves as selling installation can overlook it.

It covers labor in the direct work of the project, machinery and fixtures built in, construction equipment rented for the site, and power and fuel used on the job (Rule 3.588(c)(11)(B)).

Subcontractor payments on such a project can be subtracted once, never twice (COGS FAQ; Tax Code 171.1011(j)):

• Excluded from total revenue as flow-through funds, on design, construction, remodeling, remediation or repair work, not maintenance (Tax Code 171.1011(g)(3)). Under Rule 3.587, your customer must obligate and pay you to provide the work, you must owe the subcontractor under contract, and the link to the real property work must be more than tangential.
• Included in cost of goods sold.

Excluding them lowers revenue under every method, including EZ, and can bring revenue under the $20 million EZ line.

Whether a cooling or power installation is real property work is a question of fact. Texas draws a similar but separate line for sales tax: see Sales tax on installed cooling and power equipment.

Does bonus depreciation count in Texas cost of goods sold from the 2026 report?

Yes, for production assets. From the 2026 report, depreciation in cost of goods sold follows the federal return, including bonus depreciation and Section 179 expensing, to the extent tied to producing the goods (Rule 3.588(d)(6)(A); STAR 202603002M). The Comptroller's memo describes that bonus depreciation as claimed on assets placed in service on or after January 19, 2025; older production assets are reached through the one-time adjustment below. Earlier reports used the federal code as it stood at the start of 2007: no bonus depreciation and a much smaller Section 179 limit.

The 2026 report alone also allows a one-time net depreciation adjustment for production assets placed in service before that report's accounting year began and not disposed of before that date. It is the sum, for each asset, of each year's federal depreciation minus the depreciation claimed in Texas cost of goods sold, never below zero. A year in which the company did not claim depreciation in Texas cost of goods sold adds nothing. It cannot take margin below zero, and any unused part carries to later reports. Amortization of intangibles under Section 197 stays on the 2007 code.

Federal rules: Writing off GPU servers.

What counts in the compensation deduction, and what is the limit per person?

Compensation is W-2 Medicare wages (box 5) plus stock awards and options deducted federally, capped at $480,000 per person per 12 months, plus benefits with no cap (Tax Code 171.1013; Form 05-915, Items 15–16).

• Owners. Partnerships, LLCs (including a single-member LLC owned by one person) and S corporations add each individual owner's net distributive income, the owner's share of profit or loss on the K-1, even when it is a loss. A person paid by W-2 and K-1 gets one cap (Compensation FAQ).
• Short years. The cap is prorated.
• Benefits. Health care, retirement, workers' compensation and health savings account contributions, to the extent federally deductible.
• Staff abroad. Wages paid abroad on forms substantially equivalent to a W-2 count (Rule 3.589(b)(9)), such as a GPU cloud's engineers in Canada.
• Excluded. 1099 contractors and the employer's share of payroll taxes (Rule 3.589(d)).

Does a reseller get the lower retail or wholesale rate?

Only if it passes three tests (Tax Code 171.002(c); Rule 3.584(b)):

1. Revenue from retail and wholesale trade is more than revenue from all other activities.
2. Less than 50% of that trade revenue comes from products the company or its affiliated group produces.
3. It does not provide utilities, including telecommunications.

"Produce" is broad. A company produces a product if it or an affiliate asserts a patent or software copyright in the product or a component, or adds a component or modifies the product, unless it shows the change raises the sales price by no more than 10%.

• A Texas sales subsidiary reselling servers made by its own parent abroad usually fails the second test and pays 0.75%.
• A rack integrator that adds parts to servers it resells may become a producer of them.
• Makers, contractors and GPU clouds usually fail the first or second test and pay 0.75%.

Can we switch deductions each year, or change one after filing?

Yes. The cost of goods sold or compensation election is made on each annual report and covers only that report (Tax Code 171.101(d)). An amended report can change the margin method, or move to EZ if qualified (Rule 3.588(c)(5); Rule 3.584(f)). The deadline is the refund period, which runs until the assessment period ends: generally four years from when the tax was due (Tax Code 111.107 and 111.201).

If an earlier report missed the contractor rule or a cost of goods sold position, an amended report within that period may change the method. In a combined group, one election binds every member, one per-person cap applies across members, and a member may count cost of goods sold on goods another member owns (Tax Code 171.1013(c) and 171.1014(d)–(d-1)).

Example

Illustrative only, in US dollars, each on the 2026 report (accounting year 2025). Rates: 0.75%, EZ 0.331%.

A Dallas switchgear maker

A corporation with total revenue of $30,000,000; 60% comes from lineups delivered to Texas sites. Too large for EZ.

• Cost of goods sold, $21,000,000: materials $15,000,000; production labor with payroll taxes and benefits $4,500,000; factory depreciation, including federal bonus depreciation on new test equipment, $1,000,000; product engineering $400,000; 4% of $2,500,000 overhead, $100,000. Margin $9,000,000.
• Compensation, $6,900,000: Medicare wages of $6,000,000 after capping three officers at $480,000 each, plus $900,000 of benefits. Margin $23,100,000, so 70% ($21,000,000) would apply instead.
• Result: cost of goods sold wins: $9,000,000 × 60% × 0.75% = $40,500, against $94,500 under 70%.
• Left out: officers' pay, sales commissions, outbound freight and line-of-credit interest.

An Austin-area electrical contractor

A corporation installing switchgear, busway and UPS in a data center build, all in Texas. Federal revenue is $24,000,000, of which $8,000,000 is owed to fire-alarm and low-voltage subcontractors under the contract.

• Subcontracts excluded: total revenue drops to $16,000,000, so EZ becomes available.
• Cost of goods sold under the contractor rule, $11,500,000: own field labor (W-2 and 1099, payroll taxes, per diem) $5,000,000; installed materials and equipment $6,000,000; lift and equipment rental at the site $500,000. Margin $4,500,000; tax $33,750.
• Other methods: compensation of $6,500,000 gives $71,250; 70% gives $84,000; EZ gives $52,960.
• Missing both rules: on revenue of $24,000,000, revenue minus compensation is $17,500,000; 70% of revenue, $16,800,000, is lower, so tax is $126,000. Revenue is over the EZ line.

A Dallas GPU cloud

A corporation renting out GPU compute from a Texas colocation data center. Total revenue $12,000,000; assume all receipts are Texas receipts. No cost of goods sold.

• Compensation, $5,200,000: wages of $5,000,000, with two founders paid $600,000 each capped at $480,000, become $4,760,000, plus $440,000 of benefits. Margin $6,800,000; tax $51,000.
• 70%: $63,000.
• EZ: $12,000,000 × 0.331% = $39,720, the lowest. The servers' federal bonus depreciation lowers none of these.

Different for you?

• You may not need to file, or a report is late or forfeited: see Texas franchise tax.
• Your only Texas presence is servers in a colocation data center: see Servers in a data center in another state.
• You sell into other states: see Business income tax in other states, and for Washington, Ohio or Oregon, Gross receipts taxes in other states.
• You want the federal write-off on GPU servers: see Writing off GPU servers.
• You need Texas sales tax on GPU compute or colocation bills: see Sales tax on colocation, hosting and GPU compute.
• Your equipment contracts run past year-end: Texas total revenue follows the federal return; see Long-term contracts for custom equipment.
• You hold obsolete GPUs, boards or cooling units: see Writing off unsold or obsolete inventory.
• You file as a combined group, or missed the contractor rule or subcontract exclusion on past reports: get data center tax help.