Sweeping Texas franchise tax changes: the margin tax.

A recent trend in state taxation is for state officials to modify pure net income taxes and replace them with taxes imposed on gross receipts or modified gross receipts. For example, in 2002, New Jersey adopted sweeping changes to its corporate and partnership tax structure, enacting the alternative minimum assessment, based on either New Jersey gross receipts or gross profits. Kentucky and Ohio followed this lead in 2005; Kentucky imposed an alternative minimum calculation based on gross sales or gross profits, and Ohio added a new commercial activity tax (CAT) based on gross receipts (for a discussion of the latter, see Tapia, Tax Clinic, "Beware Ohio's CAT," TTA, August 2006, p. 460).

Joining this trend, Texas enacted H.B. 3 (1) on May 18, 2006, modifying the franchise tax (previously based on capital or earned surplus). Under the new law, tax is calculated on a "margin" base determined by total revenue, less either cost of goods sold (COGS) or compensation and benefits, as elected by the taxpayer on an annual basis. The margin, as calculated, cannot exceed 70% of total revenue.

The modified franchise tax--generally referred to as the new "margin tax"--applies to reports originally due after 2007. (2) The tax is imposed on a taxable entity that does business in Texas or that is chartered or organized there. (3) The rate is 1% of the taxpayer's taxable margin per period year, reduced to 0.5% for entities primarily engaged in retail or wholesale trade. (4) While H.B. 3 states that the modified tax is "not an income tax," (5) the current view of the authors' firm is that the margin tax is a tax on income to be accounted for under the Financial Accounting Standards Board's Statement of Financial Accounting Standards (SFAS) No. 109, Accounting for Income Taxes, due to the magnitude of the deductions applied in determining the tax base. (6)

Businesses Subject to Tax

Texas has significantly expanded the definition of taxable entity as compared to the previous franchise tax. A taxable entity subject to the margin tax is defined as a partnership, corporation, banking corporation, savings and loan association, limited liability company (LLC), business trust, professional association, business association, joint venture, joint stock company, holding company or other legal entity. (7) Among the entities excluded from the definition are: passive entities, (8) certain real estate investment trusts and real estate mortgage investment conduits, sole proprietorships, certain grantor trusts and estates, and general partnerships with direct ownership entirely composed of natural persons. (9) A passive entity is defined as a general or limited partnership or a trust, other than a business trust. In addition, the entity's Federal gross income must comprise at least 90% of certain types of income, including dividends, interest, distributive shares of partnership income, and gains from the sale of real property, commodities and securities, among others. (10) Rental income is not qualifying passive income. (11)

An otherwise taxable entity is not required to pay the tax if its computed liability is less than $1,000 or if its total revenue from its entire business is no more than $300,000. (12)

Tax Computation

In general, the tax is computed as discussed below; see the exhibit above.

Total revenue from entire business: The starting point for a corporation's "total revenue from entire business" is its total income from IRS Form 1120, lines 1c and 4-10. (13) Subtractions from this amount include bad debts; foreign royalties; foreign dividends; net distributive income from partnerships, trusts and LLCs treated as partnerships; and certain IRS Form 1120 Schedule C deductions. (14) A number of other modifications to total revenue exist for specific industries, such as law firms, real estate brokers, contractors, lending institutions, staff leasing services and healthcare providers. (15) A similar definition of total revenue exists for partnerships; the major difference is the absence of a dividends-received deduction. (16)

COGS: This includes certain identified direct costs of acquiring or producing real or tangible personal property sold in a taxable entity's ordinary course of business, and certain other related costs. (17) A very detailed list of expenses is specifically excluded. (18)

Lending institutions that offer loans to the public may subtract interest expense in determining COGS. (19) Taxable entities in the business of (1) motor vehicle rental or leasing that remit tax on gross receipts imposed under Section 152.026, (2) heavy construction equipment rental or leasing and (3) railcar rolling stock rental or leasing may include as COGS the cost otherwise allowed in relation to the property that the entity rents or leases. (20)

Compensation: While special rules exist for certain businesses, (21) compensation is generally defined as:

1. All wages and cash compensation paid by the taxable entity to its officers, directors, owners, partners and employees, up to $300,000 per person. "Wages and cash compensation" is the amount entered in the Medicare wages and tips box on IRS Form W-2.

The term also includes:

* Net distributive income from partnerships, and from trusts and LLCs treated as partnerships for Federal income tax purposes, and from LLCs and corporations treated as S corporations for Federal income tax purposes, but only if the person receiving such distributions is a natural person; and

* Stock awards and stock options

* deducted for Federal income tax purposes.

2. The cost of all benefits the taxable entity provides to its officers, directors, owners, partners and employees, including workers' compensation benefits, healthcare, employer contributions made to employees' health savings accounts, and retirement to the extent deductible for Federal income tax purposes. (22)

Margin: As discussed above, a taxable entity's margin is computed by subtracting from total revenue either COGS or compensation, at the taxpayer's election. The resulting margin cannot be greater than 70% of total revenue. (23) The election to use either COGS or compensation is valid only for the applicable year and can be changed by filing an amended report. (24)

Apportioned margin: An entity's margin is apportioned to Texas using a single gross receipts factor. (25) The apportionment factor is virtually identical to the method used for the replaced earned surplus tax; the major difference is in the elimination of the throwback provision. (26) In addition, the servicing of loans secured by real property is sourced to the property's location. (27)

Tax rate: As noted, the franchise tax rate is 1% of a taxable entity's taxable margin (28) (0.5% of the taxable margin for those taxable entities primarily engaged in retail or wholesale trade). (29) A taxable entity is primarily engaged in retail or wholesale trade only if:

* The total revenue from its activities in retail or wholesale trade is greater than the total revenue from its activities in trades other than retail and wholesale;

* Less than 50% of the total revenue from activities in retail or wholesale trade comes from the sale of products it or an affiliate produces; and

* The entity does not provide retail or wholesale utilities, including telecommunications services and electricity or gas. (30)

Retail establishments selling prepared foods and drinks for consumption on the premises and other businesses described under U.S. Department of Labor, Occupational Safety & Health Administration Standard Industrial Classification Manual, Major Group 58, qualify for the 0.5% rate. (31)

Combined Reporting

Taxable entities that are part of an affiliated group (32) engaged in a unitary business (33) file a combined group report. (34) A combined group is a single taxable entity for franchise tax purposes, eliminating any intercompany transactions. (35) Certain entities operating outside of the U.S. are excluded. (36)

The election to subtract COGS or compensation is made by the combined group and applies to its members. (37) For apportionment purposes, gross receipts sourced to Texas include only the gross receipts of combined group members having nexus with Texas. (38)

Effective Date/Transition

The margin tax is effective Jan. 1, 2008 and applies to reports originally due after 2007. (39) For taxpayers currently subject to the franchise tax, their 2007 report would continue to be computed on the capital and earned surplus tax base from the calendar or fiscal year ending in 2006. The 2008 report would be computed on the new margin tax base, reflecting activity from the calendar or fiscal year ending in 2007.

Credit Carryovers

With limited exception, credits currently available against the franchise tax are repealed. (40) However, taxable entities with certain unused credits accrued prior to the margin tax's effective date can use those credits against their margin tax liability. (41)

Temporary Credit

A taxable entity can claim a temporary credit on the margin tax by notifying the Comptroller in writing no later than March 1, 2007. (42) According to the statute, the credit claimed can be used against the margin tax for 20 consecutive privilege periods. The credit is generally determined by computing the difference between (1) deductible temporary differences and net operating loss carryforwards (after any related valuation allowances) and (2) taxable temporary differences. (43) The total difference is then apportioned using the factor from the taxpayer's 2007 privilege period (based on the entity's first report due after 2006), multiplying by 10% and finally multiplying by the applicable tax rate. (44)

As a result of numerous ambiguities in the statute's wording, questions have arisen over the computation of the temporary margin tax credit. In June 2006, the Texas Comptroller's Office released guidance to assist taxpayers in estimating their liability under the new statute: see www.cpa.state.tx.us/ taxinfo/franchise/calculator. In describing the credit computation, the Comptroller explains that an entity may take a credit based on the unexpired business losses accrued under the previous franchise tax structure. The annual credit is then computed at 10% of those business losses multiplied by the appropriate margin tax rate, with the credit expiring on Sept. 1, 2016. While the Comptroller's guidance provides some clarification, statutory inconsistencies remain that may require the 2007 Texas legislature to address the credit computation.

Conclusion

The Texas margin tax reflects a state trend toward gross receipts Or modified gross receipts taxes. Only time will tell whether it will be effective and equitable. If there is a certainty, however, both Texas tax authorities and taxpayers will likely face challenges in the coming months in interpreting and applying the new provisions.

Editor's note: Mr. Salmon is the chair of the AICPA Tax Division's State & Local Taxation Technical Resource Panel. For more information about this column, contact Mr. Brookner at [e-mail] or Mr. Brown at [e-mail].

(1) Along with H.B. 3, the Texas Legislature passed four other bills: H.B. 1 (property tax relief), H.B. 2 (appropriations), H.B. 4 (used motor vehicle reform) and H.B. 5 (cigarette tax increase).These bills have been enacted but are not addressed herein, except to note that the property tax bill (H.B. 1) reduces property tax rates in 2006 and 2007. H.B. 1 attempts to correct a constitutional violation identified by the Texas Supreme Court; see Shirley Neely v. West Orange-Cove Consolidated Independent School District, 176 SW3d 746 (2005) (holding that the state's method of funding public schools violated the constitutional prohibition against state property tax under Article VIII, Section 1-e of the Texas Constitution).

(2) 2006 TX H.B. 3, Sections 22 and 26. Special rules appear in 2006 TX H.B. 3, Section 22.

(3) TX Tax Code Section 171.001(a).All citations to the TX Tax Code are as amended by 2006 TX H.B. 3.

(4) TX Tax Code Section 171.002(a) and (b).

(5) 2006 TX H.B. 3, Section 21. H.B. 3, Section 21 also provides that the protection granted under P.L. 86-272 does not apply. Interestingly, in an April 21, 2006 letter to the Texas Attorney General, the Texas Comptroller questioned whether H.B. 3 may operate to impose a net income tax on natural persons, thus requiring voter approval to be constitutionally permissible under Article VIII, Section 24(a) of the Texas Constitution.

(6) Note that the view that the margin tax is a tax on income for SFAS No. 109 purposes does not extend to whether or not P.L. 86-272 applies to the tax margin.

(7) TX Tax Code Section 171.0002(a).

(8) A passive entity is generally defined as an entity that (1) is a general or limited partnership or a trust, other than a business trust; (2) derives at least 90% of its Federal gross income from passive income (i.e., dividends, interest, royalties, real property gains, etc.); and (3) does not receive more than 10% of its Federal gross income from conducting an active trade or business; see TX Tax Code Section 171.0003. Certain "passive" family limited partnerships, general and limited investment partnerships, and certain trusts are identified as not being "taxable entities" under specified circumstances; see TX Tax Code Section 171.0002 (c)(4)-(7).

(9) TX Tax Code Section 171.0002(b) and (c).

(10) TX Tax Code Section 171.0003(a).

(11) TX Tax Code Section 171.0003(b).

(12) TX Tax Code Section 171.002(d). Beginning in 2009, these amounts will be adjusted by a formula measured by the Consumer Price Index; see TX Tax Code Section 171.006.

(13) TX Tax Code Section 171.1011(c)(1)(A). Additional subsections of Section 171.1011(c) define "total revenue from entire business" for taxable entities other than corporations. Also, the reference to IRS Form 1120 includes variants of the form (e.g., IRS Forms 1120-A and 1120-S).

(14) TX Tax Code Section 171.1011(c)(1)(B).

(15) TX Tax Code Section 171.1011(g),(g-1), (g-2), (g-3), (k), (m),(m-1),(n) and (o).

(16) TX Tax Code Section 171.1011(c)(2).

(17) TX Tax Code Section 171.1012(a), (c) and (d).

(18) TX Tax Code Section 171.1012(e).

(19) TX Tax Code Section 171.1012(k).

(20) TX Tax Code Section 171.1012(k-1).

(21) See, e.g., the rules that apply to staff leasing companies and management companies, under TX Tax Code Section 171.1013(d)-(g).

(22) TX Tax Code Section 171.1013(a)-(c).Amounts paid to "undocumented workers" are excluded; see TX Tax Code Section 171.1013(c-1).

(23) TX Tax Code Section 171.101(a)(1).

(24) TX Tax Code Section 171.101(d).

(25) TX Tax Code Sections 171.101(a)(2) and 171.106(a).

(26) See the repealed portion of TX Tax Code Section 171.103(a) (2006 TX H.B. 3, Section 5).

(27) TX Tax Code Section 171.1032(a)(2).

(28) TX Tax Code Section 171.002(a).

(29) TX Tax Code Section 171.002(b).

(30) TX Tax Code Section 171.002(c).

(31) TX Tax Code Section 171.002(c-1).

(32) Art "affiliated group" means a group of one or more entities in which a controlling interest is owned by a common owner or owners (either corporate or non-corporate), or by one or more of the member entities; see TX Tax Code Section 171.0001(1). A "controlling interest," for a corporation, means 80% or more of the total combined voting power of all classes of stock or 80% or more of the beneficial ownership interest in the voting stock; see TX Tax Code Section 171.0001(8).

(33) A "unitary business" means a single economic enterprise 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; see TX Tax Code Section 171.0001(17).

(34) TX Tax Code Section 171.1014(a).

(35) TX Tax Code Section 171.1014(b) and (c).

(36) TX Tax Code Section 171.1014(a).

(37) TX Tax Code Section 171.1014(d).

(38) TX Tax Code Section 171.1032(b).

(39) 2006 TX H.B. 3, Sections 22 and 26; see 2006 TX H.B. 3, Section 22 for special compliance considerations.

(40) 2006 TX H.B. 3, Sections 18 and 19.

(41) 2006 TX H.B. 3, Section 18.

(42) TX Tax Code Section 171.111(a).

(43) TX Tax Code Section 171.111(b)(1). These amounts are calculated as they are shown on the taxable entity's books and records on the last day of its tax year ending in 2006; see id.

(44) TX Tax Code Section 171.111(b)(2)-(4 ).

Editor:

Scott Salmon, CPA, M.Acc.

Partner

KMPG LLP

Washington, DC

Brad J. Brookner, CPA, MPA

Director

Deloitte Tax LLP

Houston, TX

Russell D. Brown, CPA

Partner

Deloitte Tax LLP

Dallas, TX

Exhibit: Texas margin tax calculation

Begin with:      Total revenue from entire business

Less:            The greater of:
                 1. COGS or
                 2. Compensation and benefits (with certain limits)

Equals:          Margin (not to exceed 70% of total revenue)

Multiplied by:   Texas apportionment percentage (calculated under TX
                 Tax Code Section 171.106)

Equals:          Apportioned margin

less:            Other allowable deductions; see TX Tax Code Section
                 171.101(a)(3) (a)

Equals:          Taxable margin

Multiplied by:   Tax rate, generally 1% (0.5% for wholesalers and
                 retailers)

Equals:          Total tax liability

Less:            Allowable credits

Equals:          Tax due

(a) For "other allowable deductions," see, e.g., the
industry-specific deductions set forth in TX Tax Code
Sections 171.107 and 171.108.