In 2006, a special legislative session ordered by the governor of Texas passed House Bill 3 (2006 TX H.B. 3), also known as the “revised franchise tax” or “margin tax,” which made sweeping changes to the business tax structure in Texas.
A current movement in state taxation is the introduction of a gross receipts or modified gross receipts tax in place of a net income tax. For example, Ohio, Kentucky, and New Jersey have all enacted some form of gross receipts tax in this decade. By joining this select crowd, Texas modified its old franchise tax, which was based on the capital or earned surplus of corporations and limited liability companies (LLCs) conducting business in Texas.
Under the new law, the franchise tax is based on a taxpayer’s margin, which is calculated as total revenue less the greatest of three deductions, as elected by the taxpayer on an annual basis (TX Tax Code §171.101(d)). The three deductions are cost of goods sold, compensation and benefits, and 30% of revenue (the margin cannot exceed 70% of total revenue) (TX Tax Code §171.101(a)(1)).
In addition, taxable entities include not only corporations and LLCs, but generally any entity with limited liability protection. Also introduced for the first time in Texas is the idea of unitary filing, something very alien to Texans. The only things that did not change are the due date of the tax, May 15 of each year, and the tax’s accounting period rules.
Incredibly, H.B. 3 was passed by both the Texas House and Senate on its first draft. However, the law as passed caused confusion and introduced contradictory language into the statutes. The legislature in its next normal legislative session passed a technical corrections bill (2007 TX H.B. 3928). H.B. 3928 was volleyed back and forth between the House and the Senate, with hefty changes being demanded by both sides. By the time the amendment was passed, the margin tax had three possible rates: 0.575% under the E-Z computation method, 0.5% for wholesalers and retailers, and 1% for everyone else.
On December 11, 2007, the Texas comptroller’s office adopted 15 agency rules concerning the new margin calculation (34 TX Admin. Code §§3.581–3.595). These rules (and the new tax) became effective on January 1, 2008. Some of the rules restate the statutory language of H.B. 3 and H.B. 3928, while others substantially diverge from the statutory language.
Actual forms for reporting the new tax were released on March 31, 2008. Due to the late release of the forms and the complexity of the tax, the comptroller’s office extended the due date of the franchise tax for both initial and annual filers from May 15 to June 16. The tax is still technically due on May 15, but the penalty is waived for this one-month period.
Entities Subject to Tax
Essentially, any entity that has limited liability protection and conducts business in Texas is subject to the revised tax. Previously, the only taxable entities were corporations and LLCs. The new tax now applies to corporations (both S and C), partnerships, limited liability partnerships, LLCs (including single-member LLCs), professional associations and professional corporations, business trusts, joint ventures, holding companies, and other legal entities (TX Tax Code §171.0002(a)).
Entities not subject to the tax include sole proprietorships, general partnerships owned entirely by natural persons, passive entities defined under Texas law, grantor trusts, estates of natural persons, and escrows (TX Tax Code §171.0002(b)). For Texas purposes, grantor trusts are defined by Secs. 671 and 7701(a)(30)(E). The term “natural persons” does not include trusts (TX Tax Code §171.0001(11-a)).
One of the most important exemptions for the Texas franchise tax is the exempt passive entity. Exempt passive entities will be required to file annual information statements to verify that the passive entity qualifications are met, but they will owe zero tax. To qualify as a passive entity, three factors must be met under TX Tax Code §171.0003:
The entity type must be either a limited partnership, a general partnership (which includes limited liability partnerships), or a trust (other than a business trust);
- At least 90% of the entity’s federal gross income must be derived from specified passive sources; and
- No more than 10% of the entity’s federal
gross income can be derived from conducting an active
trade or business.
“Passive income” includes items such as dividends and interest; income from LLCs; distributive share of partnership income; capital gain from the sale of real property, gain from the sale of commodities traded on commodities exchange, and gain from the sale of securities; and royalties, bonuses, or delay rental income from mineral properties and income from nonoperating mineral interests (TX Tax Code §171.0003(a)(2)).
The most unsettled part of the passive entity test is the active income test. An active trade or business is conducted if the activities include one or more active operations that form part of the process of earning income or profit, and the entity performs active management and operational functions (TX Tax Code §171.0004(a)). A potential problem arises for holding companies whose active trade or business is the receipt of passive income sources. With no clear explanation from the comptroller, tax exposure exists for these types of entities.
Practice tip: For businesses selling real estate, one strategic plan is to form the entity as a partnership in order to gain passive entity status. Real estate entities should be passive entities as long as the sale of real estate results in a capital gain. Note that entities receiving real estate rental income should also be partnerships in case the real estate is sold for a capital gain. If a rental property is sold, it should be sold in the beginning of the year in order for the rental income to not be more than 90% of the total passive income for the tax year.
The revised tax base is the taxable entity’s margin. Margin is determined by calculating total revenue and subtracting the greatest of three possible deductions: (1) cost of goods sold, (2) compensation, or (3) 30% of total revenue (TX Tax Code §171.101(a)).
No tax is due if the total revenue after revenue exclusions is less than $300,000 (TX Tax Code §171.002(d)). Due to the interaction between the small business discount and the E-Z computation, a taxable entity will owe zero tax with reportable revenue of $434,782 or less.
Total revenue is determined by extracting revenue from specific lines on the federal income tax forms (TX Tax Code §171.1011(c)(1)(A)). Next, total revenue is reduced by applicable exclusions per Texas law. Exclusions tend to be based on industry, such as medical, legal, staff leasing services, and management companies (TX Tax Code §171.1011). Other exclusions include bad debt, income attributable to a disregarded entity, and net distributive income from partnerships and flowthrough partnerships (TX Tax Code §171.1011(c)(1)(B)).
Note that for net distributive income (i.e., passthrough income) to be excluded, it must be from a taxable entity treated as a partnership or an S corporation for federal income tax purposes. Passthrough income from an exempt entity (including passive entities) generally cannot be excluded from total revenue. The reason for this special exclusion is to prevent double taxation.
Flowthrough funds mandated by law to be distributed to other entities (e.g., sales tax collected) are excluded from total revenue. The following flowthrough funds mandated by contract to be distributed to other entities are also excluded from revenue: sales commissions to nonemployees, including split-fee real estate commissions; tax basis of securities underwritten; and 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 (TX Tax Code §171.1011(g)).
Intercompany revenue from affiliated entities is excluded from total revenue if the entities are part of a filing unitary group (TX Tax Code §171.1014(c)). Note that a corresponding deduction may need to be made in the cost of goods sold (COGS) deduction or compensation deduction if the revenue is directly related to those costs.
Staff leasing services, including temporary staff services, exclude payments received from a client company for wages, payroll taxes on those wages, employee benefits, and workers’ compensation benefits for the assigned employees of the client company (TX Tax Code §171.1011(k)). Similarly, a management company may exclude reimbursements of specified costs incurred in its conduct of the active trade or business of a managed entity, including wages and compensation (TX Tax Code §171.1014(m-1)).
Texas Cost of Goods Sold
In comparing the allowable deductions, it becomes apparent that the franchise tax is industry favored based upon the COGS deduction. It contains items that are not included in compensation, such as payments made to independent contractors and payroll taxes (34 TX Admin. Code §3.588(d)(1)).
Cost of goods sold for Texas franchise tax purposes is not the same as cost of goods sold for federal tax purposes. The comptroller has stated several times that federal COGS will never equal Texas COGS (though that is not entirely true). A taxpayer using the COGS deduction must be aware of approximately 40 specific Texas rules detailing the makeup of the deduction (TX Tax Code §171.1012). These rules are broken up into the categories of direct costs, other costs, indirect costs, and disallowed costs. For Texas purposes, COGS includes the costs of acquiring or producing goods. In addition, the taxpayer must be selling real or tangible personal property in the ordinary course of business and not intangible property. Services are specifically excluded from COGS. A company must generally own the goods in order to utilize the COGS deduction. “Production” includes construction, installation, manufacturing, development, mining, extraction, improvement, creation, raising, and growth (TX Tax Code §171.1012(a)(2)).
A taxable entity may subtract as COGS indirect or administrative overhead costs that are allocable to the acquisition or production of the goods. These indirect costs are limited to only 4% of the total overhead costs (TX Tax Code §171.1012(f)). Examples of such costs include security services, legal services, data processing services, accounting services, personnel operations, and general financial planning and financial management costs.
Specific costs not allowed as COGS are costs of renting or leasing equipment, facilities, or real property that is not used for the production of the goods; selling costs; outbound transportation; advertising costs; interest; income taxes and franchise taxes based on income; and officers’ compensation.
A taxable entity subject to Secs. 263A, 460, 471, or 472 may elect to capitalize or expense the costs allowed for franchise tax reporting in computing COGS (TX Tax Code §171.1012(g); 34 TX Admin. Code §3.588(c)(2)). The election to capitalize or expense is made by filing the franchise tax report using one method or the other and is effective for the entire period upon which the report is based; it may not be changed after the report’s due date. A taxable entity that elects to capitalize allowable costs for COGS must capitalize all allowable costs for franchise tax reporting that it capitalized for federal tax purposes. Any allowable costs for franchise tax reporting that were not capitalized for federal tax purposes must be expensed in computing COGS. Any costs not allowed under TX Tax Code §171.1012 may not be included in COGS even if the entity capitalized the cost for federal tax purposes.
The rules also allow for a few small exceptions to the general Texas COGS. First, if an entity qualifies as a lending institution, that taxable entity may elect to use as COGS an amount equal to its interest expense (TX Tax Code §171.1012(k)). Certain rental companies are also entitled to the Texas COGS deduction: motor vehicle renting or leasing companies that remit a tax on gross receipts imposed under Texas Tax Code §152.026; heavy construction equipment rental or leasing companies; or railcar rolling stock rental or leasing companies (TX Tax Code §171.1012(k-1)).
An alternative to the COGS deduction is the compensation deduction (TX Tax Code §171.1013). The compensation deduction is made up of wages and benefits. Wages are capped at $300,000 per individual and can only be paid to natural persons (TX Tax Code §171.1013(c)). Conversely, the benefits deduction is not capped. Note that if an officer or employee is employed by multiple entities that are members of a unitary combined group, total compensation paid to such individual is limited to $300,000. Payments made to undocumented workers are not deductible (TX Tax Code §171.1013(c-1)).
The wages and cash compensation deduction is determined by the amount entered in the Medicare wages and tips box of federal Form W-2. Included as cash compensation are wages, salaries, stock awards and options, and net distributive shares from S corporations, partnerships, and LLCs. The compensation can be paid to officers, directors, owners, partners, and employees. If compensation is reported on Form 1099, it cannot generally be included in the compensation deduction (34 TX Admin. Code §3.589(d)).
Benefits are allowed to the extent deductible for federal income tax purposes and include an employer’s cost of retirement benefits, employee health insurance, and cost of workers’ compensation benefits (TX Tax Code §§171.1013(a)–(c)). Benefits do not include working condition amounts provided so employees can perform their jobs. Examples include an employee’s use of a company car for business, job-related education provided to an employee, and travel reimbursement (34 TX Admin. Code §3.589(e)(2)(D)).
Practice tip: A tax planner should also determine if there are employees or workers provided to the taxable entity via a management contract, staff leasing company, or temporary service company. The managed entity (or the entity using the leased or temporary personnel) includes in its compensation deduction salaries to the extent included in costs paid to the management, staff leasing, or temporary service company for assigned employees. Note that payroll taxes and markup may not be included in the compensation deduction taken. In addition, if the entity is a management company or a staff leasing or temporary service company, the compensation deduction must be reduced for amounts paid to individuals sent to work for their clients (TX Tax Code §§171.1013(c)).
Taxable entities that are part of an affiliated group engaged in a unitary business are required to file a combined report (TX Tax Code §§171.0001 and 171.1014). An affiliated group is a group of one or more entities (with or without nexus in Texas) in which a controlling interest (more than 50%) is owned by a common owner (TX Tax Code §§171.0001(1) and (8)). A common owner can include a husband and wife, who are considered to constructively own each other’s stock (34 TX Admin. Code §3.590(4)(E)).
There is a discrepancy between the statutory definition and the comptroller’s rule on affiliated groups. The statutory definition refers to “common owner or owners” (TX Tax Code §171.0001(1)), while the comptroller’s rule refers only to “a common owner” (34 TX Admin. Code §3.590(b)(1)).
There is also no attribution rule under the statute. This gives a tax planner multiple choices on who is included in a unitary group and the ability to choose the most beneficial filing. For example, two brothers that own a group of companies equally and that have intercompany revenue would most likely want to file a unitary return based on the statutory definition as opposed to the comptroller’s rule, under which they would file separate returns.
A unitary business means
a single economic enterprise that is made up of separate parts of a single entity or of a commonly controlled group of entities that are sufficiently interdependent, integrated, and interrelated through their activities so as to provide a synergy and mutual benefit that produces a sharing or exchange of value among them and a significant flow of value to the separate parts. (TX Tax Code §171.0001(17).)
Factors to be considered in determining a unitary business include whether the activities of the members are (1) in the same general line of business, (2) steps in a vertically structured enterprise or process, or (3) functionally integrated through the exercise of strong centralized management.
A positive result from the introduction of unitary groups is the exclusion of intercompany revenue, which prevents tax from being paid by entities that would formerly have reported on a separate basis. But there can also be harsh consequences for filing as a unitary group. For example, assume Company A would benefit from using COGS and Company B would benefit from using compensation for their respective deductions. If COGS is elected as the deduction for the group, B loses the benefit of using the compensation deduction and must pay a higher tax based on COGS.
Tiered Partnerships: Comptroller’s Rule §3.587
A tiered partnership arrangement is an ownership structure in which any of the interests in one taxable entity treated as a partnership or an S corporation for federal income tax purposes (a lower-tier entity) are owned by one or more other taxable entities (an upper-tier entity). This ownership scenario is typically seen in law and medical practices but can also be encountered in real estate ownership structures.
A lower-tier entity may exclude from its total revenue any amount of total revenue reported to an upper-tier entity, as long as the upper-tier entity is subject to the franchise tax (34 TX Admin. Code §3.587(c)(8)). The lower-tier and upper-tier entities must submit a report to the comptroller showing the amount of total revenue that each upper-tier entity should include with the upper-tier entity’s own taxable margin calculation, according to the ownership interest of the upper-tier entity.
There are some limits to the tiered partnership election. First, the tiered partnership provision is not available if the lower-tier entity is included in a combined group. Second, the no-tax-due thresholds, discounts, and the E-Z computation method do not apply to an upper-tier entity if, before the attribution of any total revenue by a lower-tier entity to an upper-tier entity, the lower-tier entity does not meet the criteria.
Practice tip: The tiered partnership election should be used when the taxable entity is using the compensation deduction. Because some of the owners are other taxable entities, the lower-tier entity is not able to use the full compensation deduction through net distributive income. By making the election, the total tax paid by the lower- and upper-tier entities decreases. In addition, the upper-tier entities may elect to use either the deduction method or the E-Z method, even if the lower-tier entity does not use the same method, which could increase the tax savings even more. This is premised on the notion that the election need be available only at the lower level and not necessarily elected by the lower-level entity.
In determining taxable margin, a Texas taxable entity applies a single gross receipts factor to apportion the tax base (TX Tax Code §§171.101(a)(2) and 171.106(a)). The gross receipts factor does not include any receipts that are excluded from total revenue. In addition, the new tax law has done away with the throwback rule (TX Tax Code §171.103(1)).
For unitary combined returns, only Texas receipts from members that have nexus with Texas on their own are included in the numerator of the gross receipts factor. The denominator includes receipts from everyone in the group, regardless of whether or not they have nexus with Texas. The legislature considered changing from the Joyce rule, under which entities are evaluated on a stand-alone basis instead of as a unitary business group (Appeal of Joyce, Inc., No. 066-SBE-069 (CA SBE 11/23/66)), but decided against the change, at least for this legislative session.
Tax Rate and E-Z Computation Method
The tax rate under the deduction method is 0.5% for taxable entities engaged primarily in retail or wholesale trade and 1% for all other taxpayers, and is effective for reports due after 2007 (TX Tax Code §171.002). Wholesalers and retailers are described in Divisions F and G of the 1987 Standard Industrial Classification Manual, published by the federal Office of Management and Budget (34 TX Admin. Code §3.584(d)(2)). Additional rules for qualification as a wholesaler or retailer include: (1) total revenue from activities in retail or wholesale trade must be greater than total revenue from activities in trades other than retail and wholesale trades; (2) less than 50% of the total revenue from activities in retail or wholesale trade comes from the sale of products it produces or products produced by an entity that is part of an affiliated group to which the taxable entity also belongs; and (3) the taxable entity does not provide retail or wholesale utilities, including telecommunications services and electricity or gas (TX Tax Code §171.002(c)).
The tax rate under the E-Z computation is 0.575% (TX Tax Code §171.1016). To use the E-Z method a taxable entity must have no more than $10 million of total revenue (after revenue exclusions) from its entire business. No deduction or credit is allowed under the E-Z method, and the apportionment is the same single receipts factor. Like the deduction method, the E-Z method also utilizes the applicable small business discount. In addition, a unitary group may elect to use the E-Z method (34 TX Admin. Code §3.584(d)(2)).
After computing the tax due on its taxable margin, a taxable entity will employ a discount of the tax imposed if it is a small business (TX Tax Code §171.0021). A small business is a taxable entity with total annualized revenue less than $900,000. The tiered discount is based on the total revenue of the entity before apportionment.
If the tax due after the discount is less than $1,000 then no tax is due (TX Tax Code §171.002(d)). By using the E-Z method and the discounts, a taxable entity will owe zero tax if revenue is no greater than $434,782.
The revised franchise tax has come a long way in the two years since H.B. 3 was passed. It seems, however, that the developments so far are just the tip of the iceberg. The immediate future should see more comptroller’s decisions and policy rulings. There may also be a constitutional challenge to the validity of the tax because the Texas constitution (Art. VIII, §24(a)) does not allow for an income tax, which the margin tax arguably is. Texas taxable entities should expect more tax changes in the coming years.