Note: The following is an excerpt from the introduction to the article as published in The Tax Lawyer. Author citations have been omitted for brevity. Tax Section members may read the article in its entirety in Adobe Acrobat format.
The New Texas Margin Tax: More Than a Marginal Change to
Cynthia M. Ohlenforst*
* Partner, K. & L. Gates, Dallas, Texas; Southern Methodist University School of Law, J.D., 1980; University of Dallas, M.A., 1974; Loyola University, B.A., 1970. The author gratefully acknowledges the assistance of Sam Megally, associate, K. & L. Gates, Dallas, Texas; University of Texas, J.D., 2005; Southern Methodist University, B.B.A., 1999.
The Texas franchise tax differs in multiple respects from other states’ franchise and income taxes, in part because of the bifurcated formula that has been in place for several years for calculating the amount due. Although once imposed solely on taxable capital, the tax has included an alternate “earned-surplus” calculation, based loosely on federal taxable income, since a 1991 legislative expansion of the tax. Both the pre- and post-1991 tax applied to corporations, limited liability companies, and banking corporations but, until the 2006 amendments, not to partnerships or to limited partners whose only connection with Texas is a limited partnership interest.
Although the 1991 shift to a bifurcated tax brought a temporary respite from legislative expansion of the tax, 2006 brought new pressure for legislators to expand the tax again—not only to reach previously nontaxable entities (including partnerships) but also to fund property tax relief. The Texas Supreme Court accelerated the push for tax reform by holding, in Neeley v. West Orange-Cove Consolidated Independent School District, that Texas’s method of funding public education violates the Texas constitution. The court’s mandate that the legislature find a solution by its June 2006 deadline, coupled with legislative frustration at the large number of entities that successfully planned around the tax by operating through partnerships, set the stage for sweeping changes to the long-standing Texas franchise tax.
The Governor appointed a special commission which held hearings across the state and ultimately presented legislators with recommendations to change fundamentally the calculation of the franchise tax. The commission’s recommendations formed the basis for what became House Bill No. 3, and included an entirely new tax that combines elements of a gross receipts tax with elements of a net income tax. In part because of the Texas Supreme Court’s deadline and in part because of the political environment, the House quickly passed House Bill No. 3 with very few amendments. Although many House members undoubtedly expected to see the bill again in conference committee, the Senate passed the House version without making any amendments, another effect of the court’s deadline and the political pressures. An advantage of the legislature’s prompt action is the timely enactment of a reformed tax; a disadvantage is the confusion that arises from the enacted language, including from some ambiguities and drafting errors that legislators did not have the opportunity to fix before the session ended.
The new law, effective for reports filed on or after January 1, 2008, imposes an entirely new “margin tax” on taxpayers, subjects additional businesses to this franchise tax, and fundamentally changes the way the tax is calculated. Like other taxes based on activity during a period prior to the report year, the tax reaches back to 2007—and even earlier for some taxpayers.
As this article went to press, the legislature had recently adopted technical changes to the law; both the State Bar of Texas Tax Section and the Texas Society of CPAs had released written comments on the tax; and the recently elected Texas Comptroller of Public Accounts was working to develop further guidance, including new regulations to be issued and applicable to 2008 returns. Draft “Instructions for Completing Texas Franchise Tax Information Report due February 15, 2007” together with several draft forms and additional instructions (collectively, the Guidelines) offered some early guidance. While these drafts do not extend substantially beyond the statutory language, they address some of the outstanding issues, particularly those faced by taxpayers required to file pro forma (practice) returns in February 2007. In this article, the substance of key Technical Corrections provisions appears in footnotes to the relevant discussions.
As noted above, the franchise tax as in effect prior to the new margin tax is imposed only on corporations (as defined in the Texas Tax Code) and limited liability companies and is imposed on a separate-entity basis. As a practical matter, that tax is the greater of 0.25% of an entity’s adjusted (as required by the Texas Tax Code generally) taxable capital or 4.5% of its adjusted (again, as required by the Texas Tax Code) federal taxable income plus officer and director compensation, in both cases as apportioned to Texas.
While the new tax incorporates many provisions from prior law, the margin franchise tax differs from the “old” franchise tax in several material respects:
(1) it applies to additional businesses or entities;
(2) it has a different starting point (revenue);
(3) it requires combined reporting for many entities;
(4) it has different rates for different taxpayers (one percent for most taxpayers and 0.5% for wholesale and retail sellers); and
(5) it allows deductions from revenue for either (a) cost of goods sold or (b) compensation, in both cases as defined by the Texas Tax Code and as apportioned to Texas.
The following paragraph provides a very brief overview of the calculation required by the new tax, and the article then addresses the most significant components of the tax, together with several outstanding issues.Generally, the starting point for computing the margin tax is a taxable entity’s total revenues. A taxable entity subtracts from this “revenue” number its choice of either cost of goods sold (COGS) or compensation; this election may be changed on an annual basis and applies to all members of a combined reporting group, each of which computes its revenue and deductions separately. The resulting amount is the entity’s margin. The margin is multiplied by the entity’s Texas apportionment factor, which is the entity’s Texas gross receipts divided by its total gross receipts. Thus, the single-factor formula used for the old franchise tax is retained, but without the throwback rule. The resulting amount is the entity’s taxable margin. The taxable margin is then multiplied by the one-percent tax rate (or the 0.5% tax rate for retailers and wholesalers), to arrive at the entity’s tax. Taxpayers with total revenue of less than or equal to $300,000 (with CPI adjustments for later years) or total tax liability of less than $1,000 are not required to pay the tax. Additionally, the tax may be reduced by certain already-accrued but unused credits and by a credit for certain losses.