In May 2008, most taxpayers doing business in Texas will face the reality of a new franchise tax regime—the margin tax (2006 TX H.B. 3). The new law requires that taxpayers doing business in Texas must pay a franchise tax based on their taxable margin. Naturally, when the legislation was first passed, CPAs, lawyers, and business owners examined this new law to understand it and to anticipate problems they and their clients might encounter. As with any new legislation, the community was quick to point out technical errors. In addition, the Texas constitution does not allow for a tax on net income; therefore, questions were raised about the constitutionality of the law itself.
The old law imposed a franchise tax only on corporations and limited liability companies (LLCs) conducting business in Texas. To dramatically reduce the tax, many companies restructured to a limited or general partnership. The intent of the new law is to impose a franchise tax on any entity conducting business in Texas that is afforded any type of limited liability, including limited partnerships (LPs) and limited liability partnerships (LLPs).
The new law is effective for reports due on or after January 1, 2008. This item briefly explores which types of entities are taxable and which are nontaxable, illustrates the basic calculation of the tax, and explains new concepts introduced by the new tax law, such as taxable margin, combined reporting, and passive entities.
Entities Subject to the Tax
Corporations and LLCs are still subject to the franchise tax; however, the new law specifically expanded the scope to include:
- Professional associations;
- Banking corporations;
- Savings and loan associations;
- Business trusts;
- Joint ventures;
- Holding companies;
- Joint stock companies;
- Combined entities; and
- Other legal entities (TX Tax Code §171.0002(a)).
On the other hand, entities not subject to the tax include:
- Sole proprietorships;
- General partnerships (100% owned by natural persons);
- Grantor trusts;
- Passive entities;
- Exempt entities specifically listed under Chapter 171, Subchapter B, of the Texas Tax Code;
- Estates of natural persons;
- Real estate investment trusts or real estate mortgage conduits;
- Nonprofit self-insurance trusts; and
- Trusts qualified under Sec. 401(a) (TX Tax Code §§171.0002(b) and (c)).
These lists contain many new terms not previously used in the Texas Tax Code, such as natural persons, passive entities, and combined entities. Most of the entities listed above are already familiar in tax practice, but in some instances the entity’s ownership and activities determine its taxability. For example, a general partnership with a corporation or LP as an owner could be a taxable entity. A general partnership is a nontaxable entity only if 100% of its ownership is natural persons (defined as human beings or estates of human beings; TX Tax Code §171.0001 (11-a)) or if it meets the definition of a passive entity.
A passive entity is defined under TX Tax Code §171.0003 as a general or limited partnership or a trust that derived at least 90% of its federal gross income from specified sources, including:
- Dividends, interest, foreign currency exchange gains, periodic and nonperiodic payments with respect to notional principal contracts, option premiums, cash settlement, or termination payments with respect to financial instruments;
- Distributive shares of partnership income to the extent the amount is greater than zero;
- Capital gains from the sale of real property, gains from the sale of commodities, and gains from the sale of securities; and
- Royalties, delay rentals and bonuses from mineral properties, and income from nonoperating mineral interests.
Conversely, a passive entity cannot receive more than 10% of its gross revenue from an active trade or business, including rental income and income from a working interest in an oil and/or gas well. As such, the passive-entity rule does not consider rental income to be passive income (as is the case under federal tax law). In addition, the law specifically states that “capital gain” from the sale of real property is passive income. It does not elaborate on whether taxation as capital gain for federal purposes is the deciding factor. For instance, a gain is taxed at ordinary rates due to Secs. 1245 or 1250 recapture; does this mean it is not capital gain for margin tax purposes as well?
Note: LLCs are not eligible for passive-entity treatment; therefore, entities with real property as the majority of assets should be formed as an LLP or a general partnership. This rule gives taxpayers the opportunity to escape the franchise tax on the sale of real property if that income is greater than 90% of all federal gross income.
Calculating the Tax
The new tax is progressive and is based on the entity’s taxable margin. Taxable margin includes revenue less the greater of (1) cost of goods sold, (2) compensation, or (3) 30% of revenue (TX Tax Code §171.101(a)). Most taxable entities pay tax of 1% of taxable margin; however, entities engaged primarily in wholesale and retail activities are subject to a rate of 0.5% (TX Tax Code §171.002). No tax is due if total revenues are less than $300,000 or tax due is less than $1,000 (TX Tax Code §171.002(d)). A second method, the “EZ computation,” is available to entities with less than $10 million in total revenue; these entities may calculate tax due based on 0.575% of total revenues (TX Tax Code §171.1016). In addition, for entities with less than $900,000 of total revenue, the tax due is discounted 20%, to 80%. The discount percentage depends on the amount of the entity’s total revenue (TX Tax Code §171.0021).
The following examples help to illustrate the basic calculations:
Example 1: ABC partnership (not primarily engaged in wholesale or retail activities) has $15 million in total revenue and $13.8 million in taxable margin. The tax due is $138,000 ($13.8 million × 1%).
Example 2: DEF partnership (not primarily engaged in wholesale or retail activities) has $8 million in total revenue and $7.2 million in taxable margin. Because DEF’s revenue is less than $10 million, the tax due is either $72,000 ($7.2 million × 1%) or $46,000 ($8 million × .575%) if the entity elects the EZ computation.
Combined Reports for Unitary Businesses
Taxable entities that are part of an affiliated group engaged in a unitary business are required to file on a combined basis (TX Tax Code §171.1014(a)). This is a dramatic change from the previous law in which each taxable entity filed separately. The new law requires a two-part test to determine an affiliated group and unitary business status. The first part of the test is fairly straightforward. An affiliated group is a group of one or more entities in which a controlling interest is owned by a common owner or owners. A controlling interest is defined as more than 50% of the voting stock or interest owned directly or indirectly (TX Tax Code §171.0001(8)).
The second part of the test is more complex. The term “unitary business” recognizes that two entities work more efficiently together than separately. To date, there is no universally accepted definition (only court decisions) to help determine unitary business status. It is clear that the rule is too new to have definite guidance, and there is no clear-cut answer. However, the Texas Tax Code (§171.0001(17)) does provide some guidelines, including: (1) Are the entities in the same line of business? (2) Are the entities steps in a vertically structured enterprise or process, such as the steps involved in the manufacturing process? (3) Are the entities functionally integrated through strong centralized management?
The calculation of a combined group’s taxable margin presents a planning opportunity for practitioners and business owners. The law specifically states that the election to deduct cost of goods sold or compensation must be made for the entire combined group. In other words, all of the entities in the combined group must use either cost of goods or compensation. Making the election therefore requires careful consideration.
Many issues in the new law remain unclear. Many of the questions may be answered when the Texas comptroller issues guidance later this year. For now, taxpayers and preparers can only wait and hope that the final impact of this new tax law will not be detrimental to their businesses.