United States: Texas Appellate Court Rules Subcontractor Payments For Transportation Services Excluded From Total Revenue

The Texas Court of Appeals recently held that a company which subcontracted transportation services to deliver "aggregate" (a construction material) to construction sites could exclude payments to their subcontractors from total revenue, and therefore was entitled to receive a Revised Texas Franchise Tax (RTFT) refund.1 Reversing a lower court determination, the Court of Appeals determined that the company's delivery services were "logically and reasonably" connected with the construction projects despite the fact that they were not "construction" services, and the services were not performed by a "construction" company. Upon this determination, the Court of Appeals declared that the subcontractor payments could be excluded from total revenue under Tex. Tax. Code Ann. Section 171.1011(g)(3).


Titan Transportation, LP is a licensed motor carrier that transports and deposits aggregate2 at construction sites. These services are often performed through subcontractors to whom Titan is contractually obligated to pay a percent of the revenue earned. Titan does not take legal ownership of the aggregate it supplies to construction sites.

In Titan's 2008 RTFT report, Titan claimed an exclusion from total revenue for certain flow-through payments that were mandated by contract and distributed to third-party entities.3 Specifically, Titan claimed exclusion of the payments made to the subcontractors pursuant to Section 171.1011(g)(3), which contains an exclusion from a taxable entity's total revenue for "subcontracting payments handled by the taxable entity to provide services, labor, or materials in connection with the actual or proposed design, construction, remodeling, or repair of improvements on real property or the location of the boundaries of real property."

Upon review, the Texas Comptroller determined that this exclusion was incorrectly taken and recalculated Titan's tax due. Titan filed suit in protest of the Comptroller's assessment and argued that the exclusion should have been allowed as claimed. Titan also asserted that if the exclusion from revenue was not allowed, then Titan should be allowed to use the cost of goods sold (COGS) deduction and include the subcontractor payments in its COGS calculation, pursuant to Tex. Tax Code Ann. Section 171.1012(i).4 The trial court held that Titan was not entitled to the claimed revenue exclusion or the COGS deduction. Titan appealed this determination to the Texas Court of Appeals.

Computation of the RTFT

For reports due on or after January 1, 2008, the RTFT is imposed on a combined unitary basis.5 The tax base is generally total revenue reported for federal income tax purposes (less some possible exclusions) less the highest of three potential deductions: (i) 30 percent of total revenue; (ii) compensation; or (iii) COGS.6 The tax base is apportioned to Texas by a single sales factor.7 The general tax rate is 1.0 percent with a 0.5 percent tax rate available for certain taxpayers, primarily retailers and wholesalers.8

Court of Appeals Broadens Applicability of Subcontracting Exclusion

In finding for Titan, the Court of Appeals rejected several of the Comptroller's assertions limiting the availability of the subcontracting payment exclusion contained in Section 171.1011(g)(3) on the grounds that they were "extra-textual and to alter the statute's plain meaning."

The Court concluded that the services, labor, or materials provided to a real property project do not have to be "construction" services, labor, or materials in order to qualify for the exclusion. Instead, such items are only required to be logically and reasonably connected to the appropriate types of work. The services need not have to result in a physical change to the property. In reaching this conclusion, the Court rejected the Comptroller's argument that "transportation" companies are automatically restricted from claiming the exclusion. The Court found that the services provided by Titan were reasonably connected to the construction of improvements on real property for the following reasons:

  • The use of aggregate is a required component of the projects to which Titan provides delivery services;
  • Titan uses specialized trucks to deposit the aggregate where directed by the general contractor or site foreman;9
  • The services Titan provides in picking up, transporting, and depositing the aggregate saves the construction companies from having to use additional labor to put the aggregate to a useful purpose; and
  • The construction of improvements to real property performed by the construction companies absolutely necessitated the pickup and transport of the aggregate to the appropriate site. 10

The statutory requirement that the subcontractor payments be contractually obligated to a party other than the taxpayer was satisfied by contracts with the subcontractors. The Comptroller unsuccessfully argued that a taxpayer must have a contract with its customer that requires the taxpayer to use subcontract work to complete the task at hand. Titan did not have written contracts with its customers. The Court stated that "[a] manifest purpose of excluding 'flow through funds' is to except from taxation gross receipts that do not constitute actual gain or income to the taxpayer." The characterization of payments as "flow-through" funds was not constrained by the specific timing of the payments. Titan often paid subcontractors their portion of the revenue from a delivery order before Titan had received payment from its customers. The Comptroller asserted that this practice resulted in the funds not being classified as flow-through funds. The Comptroller contended that taxpayers should use what Titan characterized as a "segregate, wait, and trace" approach for their flow-through payments. The Court determined that the timing of the flow of money was immaterial and that, under the accrual method of accounting, the impact of these payments followed the concept of a flow-through payment and, therefore, the payments qualified for this exclusion.

Finally, the Court did not address Titan's alternative argument that the amounts at issue could be included in the COGS calculation if the exclusion had been denied. To the extent the flow through funds are excluded from Total Revenue, the expenses may not qualify for the COGS or compensation deductions (to prevent a double benefit).11


The Court of Appeals' determination could present refund opportunities for taxpayers who engage subcontractors to provide services "logically and reasonably" connected with construction projects and activities. As the Court of Appeals determined that the services, labor, or materials need only be logically and reasonably connected to the construction, remodeling, design, or repair work, many taxpayers may be able to argue that their subcontracting payments qualify for the same revenue exclusion that Titan received. Taxpayers should review their subcontracting payments with this in mind and consider whether their activities would be considered logically and reasonably connected to any of these types of work. Furthermore, while it appears that the subcontractors involved in this case were "owner-operators," other independent contractors and truckers might also qualify for the exclusion allowed in this case. In addition to businesses in the transportation and construction industries, opportunities may also be available for businesses in other industries, including installers of building materials and retailers that enter into subcontracting arrangements with installers.

This ruling also holds some supporting arguments for a COGS deduction for labor or materials furnished to a construction project. Although the Court did not directly address Titan's alternative COGS argument, several of the findings and the legal and factual analyses above could be used as support for the COGS deduction. It should be noted that the provision allowing the COGS deduction to "[a] taxable entity furnishing labor or materials to a project for the construction..."12 is not written parallel to the revenue exclusion at issue and may be interpreted in a more restrictive manner to most taxpayers. However, the phrase "furnishing labor or materials to a project for the construction . . ." is not clearly defined and therefore is subject to interpretation similar to the "in connection with" phrase that was analyzed by the Court with respect to Titan.

It should be noted that the Comptroller may appeal the Court's decision to the Texas Supreme Court within 30 days from the date the decision was issued. To date, the Comptroller has not publicly announced whether an appeal is intended.

For reports due on and after January 1, 2014, new legislation has been enacted to prevent taxpayers in situations similar to the fact pattern addressed in this case from having to pay franchise taxes based on revenues that are not reduced by subcontractor payments. First, the subcontractor payment exclusion statute at issue in this case has been amended to specifically state that subcontracts count for the contractual obligation requirement of this exclusion.13 Second, a new statutory provision specifically allows taxpayers in the business of transporting aggregate to exclude payments to subcontractors for deliveries made on the taxpayer's behalf.14 The Court noted that according to the relevant bill analyses, these changes were prompted by the Comptroller's historically restrictive interpretation of the Texas Tax Code provisions and case-by-case approach on these issues.15


1 Titan Transportation, LP v. Combs, Texas Court of Appeals, Third District, at Austin, No. 03-13-00034-CV, Mar. 14, 2014.

2 The Court of Appeals explained that aggregate is "a combination of rock or gravel and dirt, sand, or 'fines' (dirt that comes off crushed rock)," and is "used as an ingredient in concrete or as a foundation for the construction of roads, buildings, and parking lots."

3 TEX. TAX CODE ANN. § 171.1011(g).

4 TEX. TAX CODE ANN. § 171.1012(i) reads in part that "a taxable entity furnishing labor or materials to a project for the construction, improvement, remodeling, repair, or industrial maintenance... of real property is considered to be an owner of that labor or materials and may include the costs... in the computation of cost of goods sold."

5 TEX. TAX CODE ANN. § 171.1014(a).

6 TEX. TAX CODE ANN. § 171.101. Note that this statute has been amended effective January 1, 2014 to provide a permanent exemption for taxpayers with a taxable margin of $1 million or less.

7 TEX. TAX CODE ANN. § 171.106(a).

8 TEX. TAX CODE ANN. § 171.002. For RTFT reports due in 2014, the rates are temporarily reduced to 0.975 percent and 0.4875 percent. If certain state revenue targets are met, the rates will be further reduced to 0.95 percent and 0.475 percent for RTFT reports due in 2015. If the state revenue targets are not met, the rates will revert to 1.0 percent and 0.5 percent for RTFT reports in due in 2015. In addition, without further action by the Texas legislature, the tax rates will revert to 1.0 percent and 0.5 percent for RTFT reports due in 2016 and beyond. TEX. TAX CODE ANN. §§ 171.0022; 171.0023.

9 The construction companies are not necessarily Titan's customers. Titan's customer is sometimes a quarry.

10 This fact was colorfully bolstered by direct testimony of a Titan customer, who testified that "[Titan] would bring a trailer [of] rock, however many a day as I want, and space them out on a pad to save me labor... If you've got drivers that will put material where you need it as opposed to just piling it up somewhere and leaving, it saves me time and money and labor." He also said "[Titan] help[s] installation... because they're putting [the aggregate] where I need it."

11 TEX. TAX CODE ANN. § 171.1011(j).

12 TEX. TAX CODE ANN. § 171.1012(i).

13 See TEX. TAX CODE ANN. § 171.1011(g), which allows for the exclusion of "flow-through funds that are mandated by contract or subcontract to be distributed to other entities" that are "subcontracting payments made under a contract or subcontract entered into by the taxable entity to provide services, labor, or materials in connection with the actual or proposed design, construction, remodeling, remediation, or repair of improvements on real property or the location of the boundaries of real property."

14 See TEX. TAX CODE ANN. § 171.1011(g-8), which states: "A taxable entity that is primarily engaged in the business of transporting aggregates shall exclude from its total revenue... subcontracting payments made by the taxable entity to independent contractors for the performance of delivery services on behalf of the taxable entity."

15 See Senate Research Ctr., Bill Analysis, Tex. H.B. 2766, 83d Leg., R.S. 2013; House Ways & Means Comm., Bill Analysis, Tex. H.B. 1733, 83d Leg., R.S. 2013; and House Research Org., Bill Analysis, Tex. H.B. 500, 83d Leg., R.S. 2013. Interestingly, the Court did not state the weight, if any, given to the developments in arriving at its decision.

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