Sweeping Texas franchise tax changes: the margin tax.

• Author: Brookner, Brad J.

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...