- International Practice
- Securities Regulation
- Climate Change
- Financial Institutions
- Labor and Employment
- Strategic Communications
- Corporate and Securities
- Financial Restructuring
- Educational Institutions
- Private Funds
- Intellectual Property
- Public Finance
- White Collar Defense
- Environmental Strategies
- Internal Investigations
- Real Estate and Projects
Texas Legislature Passes New Tax Legislation
May 5, 2006
The Texas Senate late on May 2, 2006 gave final approval without amendment to legislation ("House Bill No. 3") that will replace the existing Texas franchise tax with a new "margin" tax on gross receipts. Under House Bill No. 3, the current franchise tax on the greater of .25% of taxable capital or 4.5% of taxable earned surplus will be replaced with a new margin tax. This margin tax applies a tax rate of 1%, to the lower of (i) 70% of total revenue, (ii) total revenue minus cost of goods sold, or (iii) total revenue minus total compensation and benefits. It is expected that House Bill No. 3 will move straight to the Governor for his signature. Note, however, that the State Comptroller has challenged House Bill No. 3 as an unconstitutional income tax and has asked the Texas Attorney General for a formal letter ruling.
Taxpayers Subject to the Tax
The universe of taxpayers subject to the new margin tax is broader than the old Texas franchise tax. Corporations, limited partnerships, certain general partnerships, limited liability companies, business trusts, professional associations and any other legal entities that enjoy state tax liability protection are subject to the new margin tax. There are exceptions for sole proprietorships, general partnerships that are 100% owned by natural persons (which then brings into question whether general partnerships for which an LLP registration has been made are taxable or exempt), and certain passive income entities, which includes family limited partnerships (see below). Also exempt are entities that have a specific exemption under the current Texas franchise tax (for example, tax-exempt charities), grantor trusts, estates of a natural person, escrow arrangements and a real estate mortgage investment conduit. Small taxpayers are also exempt. A small taxpayer is any otherwise taxable entity that has $300,000 or less in gross receipts in a year.
Family Limited Partnerships with Passive Income
Generally, family limited partnerships are not subject to the new margin tax. In particular, a family limited partnership will not be subject to the tax if it is a passive entity in which 80 percent of the interests are held, directly or indirectly, by members of the same family, and the entity is a limited partnership formed pursuant to state law or treated as a partnership for federal income tax purposes. To qualify as a passive entity, at least 90% of the partnership's income must be produced through investment, with dividends, interest, distributive shares of partnership income and gains from the sale of real property all qualifying as passive income. Interestingly, rent does not qualify as passive income under this provision.
Calculation of the Tax
The calculation of the new margin tax is based on a taxable entity's (or unitary group's) gross receipts after deductions for either (i) compensation, or (ii) cost of goods sold. An affiliated group may choose one type of deduction to apply to the entire group. There is a floor established on the maximum amount of total revenues that may be subject to the tax so that the margin tax base may not exceed 70% of the business' total revenues. Gross receipts are apportioned based on a single factor using Texas receipts (see discussion below). The tax rate applied to the Texas portion of the net gross receipts (gross receipts after deductions) is 1% for all taxpayers with the exception of a certain groups of narrowly defined retail and wholesale businesses. These businesses pay at a rate of 0.5% of net receipts.
Items included in Gross Revenue
A taxable entity's total revenue is generally total income as reported either on IRS Form 1120 (for corporations) or IRS Form 1065 (for partnerships and other pass-through entities) plus dividends, interest, gross rents and royalties and net capital gain income. Deductions include deductions for bad debts, certain foreign items and income from related entities to the extent already included.
Other items excluded from gross receipts are funds received in trust, such as sales tax as well as real estate sales commissions. Other exclusions include flow-through payments to subcontractors and loan proceeds received by lending institutions.
There are specific exclusions provided to health care providers. Under these provisions, health care providers may generally exclude payments received from government payers, including: Medicare, Medicaid, workers' compensation, and the Children's Health Insurance Program. Doctors may also exclude the cost of uncompensated care provided to patients.
The "Cost of Goods Sold" and "Compensation" Deductions
For purposes of computing taxable margin, the taxpayer must determine total revenue from the entire business and subtract, at the election of the entity, either: cost of goods sold or compensation. The cost of goods sold generally includes all direct costs of acquiring or producing goods and indirect or administrative overhead costs. Compensation generally includes wages and cash compensation entered in the Medicare wages and tips box of Internal Revenue Service Form W-2, including net distributive income from entities treated as partnerships for federal income tax purposes and stock and option awards deducted for federal tax purposes. Compensation also includes the cost of all benefits provided to officers, directors, owners, partners and employees, but in all cases the compensation deduction is limited to $300,000 for any particular person.
Combined Reporting by Affiliated Groups
For the first time an affiliated group of entities in a unitary business will file a consolidated return that includes all taxable entities within the group. This group will include all affiliates with a common owner, as well as entities that have no nexus with Texas. Entities with 80% or more of their property and payroll outside the United States are not included. Also, exempt entities are not part of the group. The combined Texas margin tax return that is to be filed by the affiliated group is the only return required for each member of the affiliated group.
Like the old Texas franchise tax, the new margin tax is apportioned using a single factor gross receipts formula based on Texas gross receipts divided by total gross receipts. Receipts that are generally excluded must also be excluded from gross receipts for purposes of determining apportionment.
Texas gross receipts include receipts from the sale of tangible personal property delivered or shipped to a buyer in the State of Texas, services performed in Texas, the use of a patent, copyright, trademark, franchise, or license in the State of Texas, the sale of real property in the State of Texas (including royalties from minerals) and other business done in the State of Texas.
Effective Date and Filing Requirements
The first margin tax returns are due on May 15, 2008 and are to be based on financial data beginning January 1, 2007. Regular annual margin tax returns will be due on May 15 of each year, and will be based on financial data from the previous calendar year. Businesses that currently pay the Texas franchise tax will file an information return with their next franchise tax filing that must indicate that what the taxpayer's "margin tax" liability would have been under the new system. The information from these filings will then be used for revenue estimation purposes.
If you have questions, please contact Joe Hull at firstname.lastname@example.org or (713) 221-1589.