Texas allows businesses to reduce their Franchise Tax by deducting Cost of Goods Sold (COGS) , but what counts as COGS for software developers, SaaS firms, and digital product sellers? The answer lies in Texas Administrative Code Rule 3.588, which offers specific guidance for tech-based companies. Here’s how to apply it in 2025.
What Is COGS for Texas Franchise Tax?
Under Texas Tax Code §171.1012, businesses may deduct costs directly related to producing goods. For software companies, “goods” can include:
- Tangible media (CDs, drives)
- Digitally delivered software (if custom or non-downloadable SaaS)
- Products where a customer gains permanent use
Rule 3.588 provides the interpretive framework for what qualifies and what doesn’t.
What Qualifies as COGS for Software Companies?
Eligible Costs (per Rule 3.588):
- Wages of developers working on the software product
- Direct materials or licenses used to develop the code
- Server and cloud costs used in delivery (if part of product delivery)
- Amortization of software development costs
- Royalties paid for IP used in the product
These must be directly tied to the final product being sold or licensed.
Ineligible Costs:
- General administrative salaries
- Marketing, customer support, or sales expenses
- Hosting unrelated to product delivery
- Maintenance or support contracts (unless bundled into product)
Example: SaaS Product with Eligible COGS
Business: CodePilot AI
Product: Subscription-based code optimization tool
Revenue (2024): $3 million
Eligible COGS:
- Developer W-2 wages: $500,000
- AWS cloud delivery: $120,000
- Royalty payments to embedded library: $80,000
- Amortized development costs: $100,000
- Total COGS: $800,000
This amount is deducted from total revenue when calculating margin for franchise tax.
COGS vs Compensation: Which Method to Use?
| Compensation Deduction | COGS Deduction |
|---|---|
| Capped at $370,000/person | No per-employee cap |
| Excludes contractors | Includes contractor costs (if direct) |
| Must be W-2 wages | Can include 1099 vendors |
| Common in professional services firms | Ideal for product-based tech firms |
Tip: Software firms that invest in product development may benefit more from the COGS method.
Step-by-Step: Applying the COGS Method in 2025
- Classify your revenue model: Are you delivering a product or service?
- Identify direct costs: Track dev wages, licensing, cloud infrastructure, and royalties.
- Segregate non-eligible costs: Remove marketing and admin expenses.
- Use Form 05-158-A (Long Form) to claim COGS deduction.
- Maintain documentation for all items deducted , Texas audits this carefully.
Conclusion
Texas Rule 3.588 allows tech companies to claim product-based deductions that reduce franchise tax. If your SaaS or software business builds and delivers digital goods, carefully tracking eligible COGS can save you thousands. In 2025, align your accounting systems with the rule to stay compliant and tax-efficient.
Call to Action
Schedule a deduction strategy call with Anshul Goyal, CPA, EA, FCA to review your revenue model and determine if the COGS method under Rule 3.588 can reduce your Texas Franchise Tax burden.
Disclaimer:
This blog is intended for informational purposes only. Texas COGS rules under Rule 3.588 require strict documentation and can vary by business model. Always seek professional advice before applying deductions.
Top 5 High-Searched FAQs
1. Can software companies use COGS in Texas?
Yes, if they develop and deliver a digital product.
2. Is SaaS eligible for COGS deduction?
Yes, if the SaaS is part of the final delivered product.
3. Are contractor costs included in COGS?
Yes, if directly tied to software production.
4. How does Rule 3.588 define eligible costs?
It includes costs “essential and direct” to product development and delivery.
5. Should I choose COGS or compensation method?
Depends on your business , product firms often benefit more from COGS.
About Our CPA
Anshul Goyal, CPA, EA, FCA is a tax strategist for tech startups, SaaS founders, and product-driven businesses across Texas. He advises on entity setup, cost allocation, and audit-proof tax reduction strategies under Texas Franchise Tax rules and IRC standards.