New Developments in the Texas Franchise Tax

Editor: Stephen E. Aponte, CPA

On May 18, 2006, Texas governor Rick Perry signed legislation that completely revamped the Texas franchise tax law (2006 TX H.B. 3). Under the new law, many more entity types are now required to submit a franchise tax report. Most notably, most partnerships doing business in Texas must now file the report. Previously, partnerships did not have a filing requirement.

Another major change under the new law is the requirement that entities doing business in Texas are now subject to combined reporting, as opposed to the separate reporting filing method under the old law. (For more on the Texas franchise tax, see Chisholm, “Texas Comptroller Provides Rules on the Texas Franchise Tax,” Tax Clinic, 39 The Tax Adviser 499 (August 2008).)

This item describes some of the unusual facets of the new law and some recent developments that practitioners should be aware of.

Revenue Below $434,782 Is Tax Free

There are four different situations in which taxable entities filing the Texas franchise tax report will owe no tax:

1. The entity is a passive entity as defined in Chapter 171 of the Texas Tax Code (TX Tax Code §171.0003). Note: Rental income is not passive per the Texas Tax Code.
2. The entity has zero Texas gross receipts.
3. The entity has a tax due of less than $1,000 (TX Tax Code §171.002(d)).
4. The entity has $434,782 or less in total revenue.

As originally passed in 2006, the new Texas franchise tax law actually used an amount of $300,000 for item 4 above. Texas Tax Code §171.002(d) continues to reflect the $300,000 amount. However, per a September 17, 2007, Texas state comptroller press release, this amount is actually $434,782. This unusual figure is a result of tax discounts made available by the June 17, 2007, technical corrections bill (2007 TX H.B. 3928) that amended the May 18, 2006, law.

How exactly does a total revenue amount of $434,782 result in no tax due on a Texas franchise tax report? One method by which entities calculate franchise tax due under the new Texas franchise tax law is by multiplying total revenue by a rate of .575% (.00575) (TX Tax Code §171.1016). Under this “E-Z computation” method, a total revenue amount of $434,782 will result in just under $2,500 tax due ($434,782 × .00575 = $2,499.9965). One of the provisions of the technical corrections bill was to allow entities with $900,000 or less in total revenue to experience at least some relief from the new margin tax (TX Tax Code §171.0021). Under this provision, entities with total revenue greater than or equal to $400,000 and less than $500,000 are allowed a tax discount equal to 60% of the tax otherwise due.

An entity with $434,782 in revenue can therefore further reduce its tax due by a discount of just under $1,500 ($2,499.9965 × .60 = $1,499.9979). The tax due after taking the discount is just under $1,000 ($2,499.9965 – $1,499.9979 = $999.9986). Because the tax due for this entity is now just under $1,000, its franchise tax liability is zero, per §171.002(d).

An item of note for tax preparers who use tax preparation software to generate Texas franchise tax reports: Most tax software packages use rounding when generating tax reports. When rounded, the “just under” amounts used here would result in a calculated tax amount of $1,000, as opposed to the less-than- $1,000 amounts required in §171.002(d). As a result, when an entity has $434,782 in total revenue, many software packages will generate an incorrect tax due amount of $1,000 instead of zero. In these situations, tax preparers would need to enter input overrides to provide the correct “no tax due” calculation.

Cost of Goods Sold

Under the new Texas Tax Code §171.101, entities calculate their franchise tax base in one of two ways:

1. An E-Z computation, in which the franchise tax base is equal to total revenue. The example above reflects a franchise tax base calculated under this method.
2. A franchise tax base that is equal to the taxable entity’s margin.

A taxable entity’s margin is generally the lowest of the following three calculations:

1. Total revenue minus cost of goods sold (COGS);
2. Total revenue minus compensation; or
3. Total revenue × 70%.

In using total revenue minus COGS to calculate its margin, an entity must take into account the following statement in the instructions to the new Texas franchise tax report:

In no instance will COGS for franchise tax reporting purposes equal the amount used for federal income tax reporting purposes or for financial accounting purposes. This amount can not be found on a federal income tax report or on an income statement. It is a calculated amount specific to franchise tax. [Instructions to Form 05-158, Texas Franchise Tax Report (March 2008).]

The Texas state comptroller never expressly said why it made such a definitive statement with regard to the Texas COGS number. However, a review of the short history of the Texas COGS deduction reveals some possible reasons for this comptroller declaration.

It was not determined until January 11, 2008, when the Texas state comptroller issued Policy Letter Ruling No. 200801034L, that an entity’s beginning inventory could, in fact, be used in the Texas COGS equation. Texas had originally stated that it did not want costs incurred prior to the new franchise tax law to be included in COGS in any way. As the federal COGS calculation does use a beginning inventory amount, the Texas COGS would be different based on this fact alone.

Prior to the letter ruling, Texas correctly reasoned that allowing a beginning inventory amount would allow amounts incurred but not expensed in a prior year to be part of the Texas COGS equation. The letter ruling now allows for using a beginning inventory amount. Perhaps the quotation above was made part of the Texas instructions prior to this January 11, 2008, ruling, which allows a more federal- like treatment of the COGS equation.

In addition to the inventory discussion above, the Texas COGS amount also allows for a maximum of 4% of general and administrative overhead costs to be included in the COGS deduction. There is, of course, no similar federal law regarding this 4% item. This difference could also lead to a difference between federal and Texas COGS. However, a close review of the Texas law reveals that not all entities will be able to take advantage of this 4% addition.

Texas relaxes its position: In the July 2008 issue of Texas Tax Policy News, a state comptroller newsletter, the state of Texas now says that it is only “very unlikely” that the Texas COGS number will equal some other COGS amount. The “no instance” language has been removed. Perhaps some of the analysis above was the reason for this latest policy change.

Service industry companies: Generally, a taxable entity in the service industry will not have COGS (TX Tax Code §171.1012). However, a rule issued by the state comptroller notes that service companies can deduct cost of goods sold for “costs otherwise allowed by this section in relation to the tangible personal property sold” (34 TX Admin. Code §3.588(c)(6)).

The frequently asked questions portion of the comptroller’s website gives an example of an oil change service business that is allowed to generate a COGS number by computing the cost of oil filters and oil that is included in the performance of the oil change. A crop duster business and a veterinarian’s practice are also listed as examples of businesses that perform “mixed transactions” that may qualify for a COGS deduction. It appears that a taxpayer will indeed be able to count as COGS certain items consumed or transferred in connection with providing its services.

Observation: Even though the comptroller is apparently allowing the calculation and deduction of a COGS amount for entities that are generally thought to be service entities, it is still entirely possible, if not probable, that service entities will benefit more by electing the compensation deduction.

Newly Taxable Entities Should Formally Dissolve

One of the more notable changes brought about by the new Texas franchise tax is that many additional entity types are required to file a franchise tax report. Reports originally due on or after January 1, 2008, are required to be filed by these entities. The Texas state comptroller’s website provides a summary of those entities that were required to file under the old law and those required to file under the new law, as shown in the exhibit.

Current procedures in Texas require those Texas corporations and limited liability companies (LLCs) that are intending to close their businesses to formally dissolve with the Texas secretary of state in order to avoid being subject to the following year’s franchise tax filing requirements (see Texas Comptroller Publication 98-336D, Requirements to Dissolve/Terminate, Merge or Convert a Texas Entity (March 2007).

Recent discussions with the state comptroller’s office reveal that the same type of procedures will be required of the newly taxable entities. That is, newly taxable entities will also be required to formally dissolve their businesses in order to prevent them from being subject to the following year’s franchise tax requirements. Dissolving an entity that does business in Texas requires:

1. Filing a final franchise tax report with the Texas state comptroller;
2. Filing dissolution forms with the Texas secretary of state; and
3. Sending a dissolution fee to the Texas secretary of state.

The dissolution procedures above can be reviewed at the websites of both the Texas secretary of state and the Texas state comptroller.

Combined Reporting

For many years, Texas had made it very clear that separate entity reporting was the required reporting method for Texas franchise tax purposes. That is, each separate legal entity chartered or authorized to do business in the state of Texas was required to file its own Texas franchise tax report. With the change in the Texas franchise tax law, the state has implemented mandatory combined reporting (TX Tax Code §§171.0001 and 171.1014).

Combined reporting requires that under certain circumstances more than one entity should be included on a combined Texas franchise tax report. To determine if entities should be included on a combined report, a return preparer must determine if two or more entities are affiliated with regard to some common ownership. The franchise tax statute defines an affiliated group as a group of one or more entities in which a controlling interest is owned by a common owner or owners, either corporate or noncorporate, or by one or more of the member entities (TX Tax Code §171.0001(1)). In addition, for entities to be included on a combined report, the tax return preparer must determine if the entities are operating in a way that makes the entities interdependent on each other’s activities.

What if entities that have filed separate reports later determine that they should have filed a combined report? On June 24, 2008, the state comptroller’s office added this question to its list of frequently asked questions, and then amended it on August 11, 2008. In answer to this question, the comptroller noted, “The entity that filed incorrectly should submit a letter with their [sic] name and taxpayer number stating that the report was filed in error and the entity will report with a combined group. The letter must also include . . . authorization to transfer any tax payment from the member’s account to the reporting entity’s account.” 

The comptroller’s office did not address the situation in which entities file extensions and then prior to filing their original returns discover that only one combined entity extension should have been filed. Presumably, the entity that filed incorrectly should submit a letter with its name and taxpayer number stating that the extension was filed in error and the entity will report with a combined group. It would seem that this letter should also include the name and taxpayer number of the combined group’s reporting entity along with a request for refund or authorization to transfer any tax payment from the member’s account to the reporting entity’s account.

EditorNotes

Stephen E. Aponte is senior manager at Holtz Rubenstein Reminick LLP, DFK International/USA, in New York, NY.

Unless otherwise noted, contributors are members of or associated with DFK International/USA.

For additional information about these items, contact Mr. Aponte at (212) 792-4813 or saponte@hrrllp.com.