Article

Texas deduction for aerospace government contractors increases in 2022

Jul 19, 2022
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State & local tax Business tax Government contracting

In June of 2019, Texas enacted an important tax break for government contractors in the aerospace industry subject to the state’s franchise tax. As the provisions of House Bill 1607 (2019) continue to phase in through the end of next year, it is important that affected taxpayers ensure they are taking full advantage of the new rules surrounding deductible aerospace costs.

Aerospace costs included as new category of deductible costs        

Historically, taxpayers in the aerospace industry subject to the Texas franchise tax have been able to deduct the greater of eligible cost of goods sold (COGS) expenses or total eligible compensation expenses in the computation of total income subject to tax. Texas has complex rules related to the computation of COGS expenditures eligible for deduction, which are different from the rules for federal tax purposes. Further, the proper treatment of mixed costs—costs that relate partially to the sale of tangible personal property and partially to the sale of a service—is an area that has been ambiguous and evolving as litigation on the issue has progressed over recent years.

Taxpayers in the aerospace industry tend to have a large number of mixed costs, given their involvement in government contracts that call for both manufacturing activity and service components. Typically, only those costs directly related to manufacturing activities or the sale of tangible property have been eligible for inclusion in the Texas COGS deduction. On the other hand, the available Texas compensation deduction captures some of the service revenue costs and manufacturing labor but leaves out much of the other costs of sales. To more completely capture costs associated with aerospace government contracts as deductible for Texas purposes, House Bill 1607 created a new category of aerospace costs that are eligible for deduction.

Eligibility and deduction phase-in schedule

The new aerospace costs category applies to all costs not already captured in either the COGS or compensation deductions that are expenditures subject to the requirements of Title 48 of the Code of Federal Regulations as costs incurred in connection with contracts or subcontracts for the sale of goods and services by an aerospace company to the federal government. Additionally, the costs must relate to activities described by one of the following North American Industry Classification System (NAICS) codes: 334511 (search, Detection, Navigation, Guidance, Aeronautical, and Nautical System and Instrument Manufacturing); 3364 (aircraft manufacturing, engine parts manufacturing); 3399 (miscellaneous manufacturing); 5413 (engineering services); 5415 (computer-related systems); 5416 (scientific and technical consulting services, other management consulting services); or 5419 (all other professional, scientific and technical services).

The deduction for these aerospace costs has been phasing in over the past two years and will fully phase in for reports due in 2024. For reports due in calendar year 2022, a deduction is allowed for 60% of these aerospace costs; an 80% deduction will be allowed for reports due in calendar year 2023.

Finally, it should also be noted that the Texas comptroller has not yet released any guidance or regulations addressing this particular deduction and that taxpayers should understand that future rulemaking may affect the deduction. For example, beyond the references to federal code, there is no state definition of a qualifying aerospace taxpayer or description of the aerospace industry.

COGS and navigating the aerospace deduction phase-in years

As previously noted, the proper treatment of mixed costs from a Texas COGS deduction perspective continues to be a complex technical area. A full review of a company’s current COGS calculation can identify potential opportunities for additional deductions or identify where recent developments may have created risk associated with historical calculation methods. Given the developments in this area in recent years, it may be prudent for aerospace taxpayers to revisit their COGS computations to ensure they are mitigating risk and maximizing benefit as they await the full phase in of the aerospace cost deduction.

Takeaways

Texas taxpayers in the aerospace industry servicing government contracts have historically faced COGS and compensation deduction rules that left a significant portion of their costs of sales as nondeductible in the computation of the state’s franchise tax. The state’s aerospace cost rules aim to ease the tax burden for the industry’s taxpayers; however, given the five-year phase-in schedule associated with the new deduction, many taxpayers may not have invested significant effort to fully examine the scope of expenses eligible for the aerospace cost deduction. As the phase-in tips over 50% in 2022, affected taxpayers should consider consulting a Texas state tax professional to ensure they are fully capturing the potential benefits associated with this industry tax break. Additionally, a thorough reexamination of costs eligible for the state’s COGS deduction can ensure taxpayers are capturing the maximum tax benefit possible through 2023 as aerospace costs remain less than 100% deductible. 

RSM contributors

  • Chris Gorman
    Senior Manager
  • Anna Cronic
    Senior Manager