The New Texas Margin Tax— What Will They Think of Next?
After several failed attempts, numerous special legislative sessions, and a Texas Supreme Court-mandated deadline, Texas overhauled its corporate tax system by replacing the franchise tax with a new “margin” tax. The 79th Legislature passed House Bill 3 during its 3rd Called Session in June, 2006 and the 80th Legislature passed HB 3928 to provide technical corrections and much needed small business relief in June, 2007. The Margin tax is effective as of January 1, 2007 with the first margin tax report due May 15, 2008 based upon the results of the year ending in 2007. The following is a summary of these new laws, and is not meant to be all-inclusive.
Previous to the margin tax, many businesses operated as limited partnerships, which by statute were exempt from the franchise tax. This new law completely eliminates that exemption.
The tax appears on the surface to be fairly simple. It is a 1% tax on the lesser of: 70% of a taxable entity's total revenue, or total revenue less either cost of goods sold for manufacturers and wholesalers/retailers, or employee compensation for all other industries. The resulting margin tax base is apportioned based upon Texas sourcing rules—basically gross Texas revenues divided by total entity revenues. The rate is ½% for entities primarily engaged in retail or wholesale businesses.
The intent of the law is to tax all entity types that offer liability protection to their owners. Sole proprietorships, general partnerships with only individuals as partners, passive income entities, certain grantor trusts and estates, family limited partnerships meeting specified criteria, real estate investment trusts with restricted holdings, qualified charities, and real estate mortgage investment conduits are not taxable entities and are not subject to the tax; almost all other business entities are subject to it.
Although the tax appears to be fairly simple, the calculation may not be so. The starting point in the calculation is gross revenue on the taxpayer's federal tax return. Then the following are excluded: Sales commissions to non-employees; the tax basis of underwritten securities; net distributable income from partnerships, S corporations and LLC's; and, for lenders, principal repayments on loans.
Manufacturers and retailers/wholesalers then deduct cost of goods sold. The cost of goods sold deduction, however, is different than the deduction used in calculating cost of goods sold for either federal tax purposes or generally accepted accounting principles (GAAP). The primary differences relate to the amounts which must be capitalized for tax or GAAP, the details of which are beyond the scope of this article. For entities using the cost of goods sold deduction, the cost of preparing the Texas margin tax return could exceed the cost of the preparation of the federal return.
All other entities can deduct compensation and employee benefits, up to $300,000 per employee. Limited partnerships and limited liability companies can deduct compensation plus net distributable income, up to the $300,000 limit. LPs, LLCs and LLPs cannot only deduct net distributable income allocated to natural persons.
There is a maximum taxable amount of 70% of an entity's gross receipts; in other words, there is a floor on the tax of either ½% or 1% of 70% of an entity's gross receipts. For many businesses, this may be the simplest and easiest way to calculate the margin tax.
There is some relief available via an alternative tax for entities with less than $10 million in gross receipts, which can pay a tax of .575% on total receipts. Additionally, small businesses with less than $300,000 in gross receipts are exempt from the tax, with a phase-in of the tax rate up to $900,000 in gross receipts.
For multi-state entities, the tax is apportioned based on gross receipts in Texas versus total gross receipts. Most states use a formula based on three criteria—relative gross receipts, relative payroll and relative assets, so, there may be some planning opportunities based on apportionment. There is also no 'throw-back' rule, that is, receipts in states that aren't taxed are not ‘thrown-back’ to Texas.
For entities which have common ownership (defined as 50% or more), and are considered in a common business, there is a requirement for unitary reporting. This could be detrimental to many businesses, since all entities in a unitary group must use only one type of deduction, either COGS or compensation.
Certain industries fared well under the law: Oil and gas working interest owners who are not operators can deduct intangible drilling costs and lease operating expenses; contractors can deduct costs of subcontractors as well as materials; health care providers can deduct amounts paid under Medicaid, Medicare, and the Children’s Health Insurance Program as well as the cost of uncompensated care.
Other businesses did not come out so well: Professional partnerships with professional corporations as partners cannot deduct the payments to those partners; real estate operators and developers cannot deduct interest or depreciation, and, they must also pay tax on gains from sale of property.
This new law leaves many questions unanswered—and the Comptrollers office and the courts will be answering those questions over the next few years. As tax professionals, we are intellectually interested in these issues; our clients will be financially interested.
The above is merely a general summary of the new laws and is not meant to be all inclusive. All business owners should consult their own tax consultants/preparers to determine the effect of the new law on their businesses.
DONNA RUTTER is a Tax Partner with Hartman Leito and Bolt, LLP in Forth Worth and specializes in State and Local Tax matters. She is the Chairperson of the State Tax Committee for the Texas Society of CPAs for 2007-2008. DAVID DONNELLY is a Partner with Gainer, Donnelly & Desroches LLP in Houston and specializes in Real Estate taxation.
