Kentucky Department of Revenue Issues Guidance on COGS
Co-Author: Kristen Hart
Recently, the Kentucky Department of Revenue issued guidance on which items are included in cost of goods sold (COGS) for purposes of computing the Kentucky Limited Liability Tax (LLET). For any activity other than manufacturing, producing, reselling, retailing, or wholesaling, no costs should be included in COGS. For those taxpayers, Kentucky gross profits will only be reduced by returns and allowances attributable to Kentucky gross receipts for computing Kentucky LLET COGS. Note that Kentucky COGS for the LLET may be different than the federal tax return calculation of COGS.
For those who do engage in manufacturing, producing, reselling, retailing, or wholesaling, the costs to be included in COGS must be directly related to acquiring or producing a tangible product. Direct labor and materials should be the only costs included in the computation of COGS. Direct labor is defined as labor that is involved in the manufacturing/production process and encompasses basic compensation, overtime, vacation, sick pay, etc. (workers compensation, profit sharing, life and health insurance, and membership dues are not included). Direct materials are those that are incorporated into the tangible product sold or manufactured.
The issue lies in deciding whether a cost is indirectly or directly related to the tangible product. Although Kentucky explicitly states that only direct costs are to be included, the federal regulations in the Internal Revenue Code state that there are also indirect costs necessary for production and direct cost necessary for production.
The following are examples of categories of costs that are not allowed in COGS for purposes of computing LLET and are typically listed as indirect costs pursuant to IRC Section 263A:
• Repairs and maintenance;
• Quality control; and
Companies that deliver gasoline and special fuels to consumers are subject to the Kentucky excise tax on fuel and are allowed to include bulk delivery costs in the COGS on their Kentucky LLET return.
Because of the difference in the state and federal calculations of COGS, taxpayers with significant LLET should review their Kentucky LLET COGS calculation for tax minimization planning opportunities.