Legal Advice: "Margins" Tax

House Bill 3: Revised Franchise Tax At-a-Glance

Recently, the Texas legislature, in a Special Legislative Session that concluded in May 2006, passed a school finance and tax reform bill (known as House Bill 3) that will affect many TSSA members and other businesses. The new “margins” tax applies to all entities receiving liability protection from the state (in a nutshell, it applies to everything except general partnerships and sole proprietors—it applies to limited partnerships, corporations (including subchapter S corporations), limited liability corporations, and other such entities).

To calculate the “margins” tax that a business will owe, start with the company’s gross revenue, and deduct the greater of the following: cost of goods sold; total compensation (including health care and retirement benefits); or 30 percent of total revenue. There is a tax on the resulting margin (the portion apportioned/attributable to your Texas business(es) as opposed to out of state businesses) at a rate of 1 percent. Most all TSSA members subject to the tax will likely use the “30% of gross revenue” deduction. There is an exception for taxable entities with yearly revenues of $300,000 or less. They will owe no tax, but must still file a return.

Revisions to the margins tax, also known as the reformed franchise tax, passed by House Bill (HB) 3 are expected when the Legislature convenes in regular session in January, 2007. As passed by HB 3, total revenue for partnerships is calculated by pulling certain information from Internal Revenue Service (IRS) forms by referencing line numbers on these forms. The bill (new law) contains an error and currently enables rental partnerships to calculate total revenue based on net rents rather than gross rents. Gross rents are the basis for all other taxable entities (but this oversight will be fixed most likely in 2007, so there will be no loophole/windfall).

The reformed franchise tax contained in HB 3 becomes effective on January 1, 2007, but payments based on these changes are not due until May 15, 2008. The tax will be paid based on business activity taking place from January 1 through December 31, 2007. It is recommended that you confirm with your facility’s accountant that he or she is up to speed on the new law, and ask your accountant what if anything your company will need to do (any procedures or bookkeeping procedures that will need to be changed, etc.) in order to make sure you are in compliance with the new law. For more information, you can go to the State Comptroller’s website at www.window.state.tx.us. This site contains a “franchise tax calculator” program, and also an overview on the revised franchise tax.

Entities Subject to Tax
The tax applies to partnerships (general limited and limited liability) companies, business trusts, professional associations, business associations, joint ventures and other legal entities with statutory liability protection, except for:

Sole proprietorships
• General partnerships directly owned by natural persons
• Entities exempt under Subchapter B of Chapter 171
• Certain unincorporated passive entities
• Grantor trusts, estates of natural persons and escrows
• A passive investment partnerships
• Certain family limited partnerships

House Bill 3: Revised Franchise Tax At-a-Glance

Margin
The revised tax base is the taxable entity’s margin.
Margin equals the lesser of three calculations: total revenue minus cost of goods sold; total revenue minus compensation; or total revenue times 70 percent.
Total revenue is determined based on federal income tax reporting.

Exclusions from revenue include:
• Schedule C dividends, foreign royalties and dividends under Section 78 and Sections 951 964;
• Certain flow-through funds
• Attorney’s cost of providing pro bono legal services, limited to $500 per case.
• Cost of goods sold is traditionally defined, but excludes officer compensation and includes some specific items for certain industries and up to 4 percent of overhead costs.

Taxable entities only selling services are not eligible for the cost of goods sold deduction. However, motor vehicle and heavy construction equipment rental or leasing may use cost of goods sold.

Payments for undocumented workers are not deductible.
Compensation and benefits include:
• W-2 wages and cash compensation paid to officers,
directors, owners, partners and employees (including owner or partner distributions to natural persons), limited to $300,000 per person; and
• benefits provided to all personnel, including workers’ compensation, health care and retirement benefits to the extent deductible for federal income tax purposes. Payments for undocumented workers are not deductible.

No Tax Due
Taxable entities with revenues of $300,000 or less will owe no tax. Taxable entities with tax due of less than $1,000 will owe no tax. However, all taxable entities, including those that will owe no tax, must file a return.

Combined Reporting
Taxable entities that are part of an affiliated group engaged in a unitary business must file a combined group report without regard to the $300,000 limitation on revenue. Members of a combined group must use the same method to compute margin.