The Texas Legislature has reformed its tax structure to supplement property taxes with business taxes to fund its education system. One component is a new business tax called the taxable margin tax. Consequently, businesses operating in Texas may be liable for substantially different tax bills when they make payments in May 2008.
Before the margin tax was introduced, Texas business owners were liable for a franchise tax, which was relatively easy to avoid by using loopholes. Some Texas businesses did not pay any taxes at all under its provisions. The legislature eliminated some of these loopholes with the margin tax.
Smart Business spoke with Patrick O’Shea of Grant Thornton LLP to learn about the Texas margin tax, how it will affect business owners and how they can comply with it.
What is the gist of the margin tax?
The margin tax essentially replaces the franchise tax. It is a tax on taxable margin, which is generally gross revenue less the greater of cost of goods, compensation or 30 percent of gross revenue. Being a tax on margin, even companies with net operating losses will likely be liable for some amount of margin tax.
How is the margin tax calculated?
The margin tax is based on a percentage of ‘taxable margin.’ It is the lower of total revenue minus cost of goods, total revenue minus employee compensation and benefits, or 70 percent of total revenue. The taxable margin is then apportioned by the percentage of the entity’s business done in Texas. This percentage is calculated by dividing gross receipts from business done in Texas by gross receipts from business done everywhere. The margin tax rate of 0.5 percent for taxable entities engaged primarily in retail or wholesale trade, or 1 percent for all other taxable entities, is then applied to the apportioned taxable margin.
Service businesses are not eligible to use the cost of goods sold method. In fact, service providers that were generally exempt under the franchise tax because of the way they were organized are expected to be impacted detrimentally by the new tax.
Does the margin tax apply to all Texas business entities?
Even if they are not taxed under federal income tax laws, they may not be exempt from paying the margin tax. In addition, the tax is computed and reported on a combined group basis, which is a significant change. Entities with gross receipts of $300,000 or less (inflation adjusted every two years), estates, escrows, nonprofits, insurance companies and passive entities are exempt. Sole proprietorships and general partnerships that only have human beings or the estates of human beings as their partners are not taxed under the margin tax law, either.
What does the combined reporting requirement mean to business owners?
First, this is an entirely new concept in Texas. Related entities that are unitary businesses with greater than 80 percent direct or indirect ownership (legislation passed to change to 50 percent, but not yet law) must compute and report the margin tax as if it were one taxpayer. This will now include unitary companies that did not file Texas franchise tax returns due to a lack of nexus in the state. Essentially, combined reports are very similar to the consolidated returns filed for federal income tax purposes. Even if affiliated companies do not experience increases in their tax liabilities to the state, they will certainly have greater compliance complexity.
When should companies start taking steps to deal with this new tax?
Hopefully they already have. Although the tax is effective Jan. 1, 2008, it is based on the activity of companies as early as June 1, 2006. That means all taxpayers are already in the years on which the tax will be based, and there is not one specific solution to minimize their margin taxes. There is a transition provision regarding the effective date that was passed in the current legislative session (currently under consideration by the governor) that may allow entities not previously subject to the old franchise tax to terminate prior to July 1, 2007 and, at least, avoid the margin tax through that date.
Can financial services advisers help businesses deal with the margin tax?
They can help business owners understand the margin tax impact to them and comply with its changes and clarifications, such as the combined changes. They can also assist with the proposed transition rule currently being contemplated and the wind up of structures that are no longer necessary to minimize the old franchise tax. And, they can start helping them prepare for and minimize the future ramifications, such as the audits on the tax, which will start four years down the road and will likely be messy.
PATRICK O’SHEA is tax partner State and Local Tax Practice, with Grant Thornton LLP. Reach him at (214) 561-2356 or email@example.com.