The much anticipated Texas Franchise Tax (a.k.a. Margin Tax) “Technical Corrections” bill was filed on March 9, 2007. The new Margin Tax, which is effective for tax returns filed in 2008, is based on deducting the taxpayer’s choice of either cost of goods sold (COGS) or compensation from total revenue. The bill (House Bill 3928) was filed by Representative Jim Keffer, Chairman of the Ways and Means Committee, and is expected to be the starting point for discussions on clarifications and revisions to the Margin Tax.
While no official fiscal note has been done on the filed bill, the filed version of the bill is not intended to create any gains or losses in state revenue. The bill addresses most of the clarifications referenced in House Concurrent Resolution 51 passed by the Texas Legislature last spring. The bill would make several of the clarifications that were included in various draft versions of a proposed “clean-up” bill (Senate Bill 6) introduced in the Senate during the 2006 Special Session of the 79th Texas Legislative Session. The Texas Senate considered Senate Bill 6 after the passage of the Margin Tax, enabling legislation (HB 3) last spring.
The following is a summary of the more relevant “clarifications”:
- Amended the definition of “controlling interest” to clarify that controlling interest for a limited liability company (LLC) is either 80 percent or more of
- the total membership interest of the LLC, owned directly or indirectly; or
- the beneficial ownership interest in the membership interest of the LLC, owned directly or indirectly.
- Amended the definition of “lending institution” to be either
- a regulated depository institution, including a subsidiary or affiliate of the depository institution, whose deposits are insured by the FDIC; or
- an entity that makes loans and is regulated by the Commodity Futures Trading Commission.
- Added a definition of “natural person” to mean a human being or the estate of a human being.
- Amended the definition of a “taxable entity” to specifically include limited liability partnerships (LLPs) and clarify that the exclusion for a general partnership owned by natural persons does not apply to LLPs.
- Deleted the references to a family limited partnership (FLP), passive investment partnership (PIP), and trust as entities that are not included as a taxable entity. If an FLP, PIP, or trust qualifies as a passive entity, the entities would be excluded from being a taxable entity.
- Repealed the ability of a taxable entity to change its election of COGS or compensation on an amended return and requires that a taxable entity “notify the comptroller of its election not later than the due date of the annual report.”
- Clarified that the determination of total revenue is the sum of the “amount reportable as income” on the line references to the Internal Revenue Service (IRS) federal income tax returns rather than the “amount entered” on the line referenced.
- Amended the line references for the determination of total revenue for a partnership to be the “amount reportable as income” on lines 1c and 4 through 7 on the IRS Form 1065 and lines 2, 3a, and 5 through 11 on the IRS Form 1065, Schedule K. This change in line references ensures that guaranteed payments are not double counted in the determination of total revenue. (Note: This change in line references does not make the change to capture “gross rental income” rather than “net rental income” for partnerships in the determination of total revenue. The change from net to gross rental income for determination of total revenue for partnerships could increase the state’s revenue by as much as $100 million per year.)
- Amended the definition of “tangible personal property” to include “live and prerecorded television and radio programs.”
- Amended COGS to
- limit depreciation, depletion, and amortization to the amounts “reported on the federal income tax return on which the franchise tax report is based";
- delete the reference to “all research or experimental expenditures described by Section 174, Internal Revenue Code”;
- provide that a taxpayer can choose to either expense or capitalize costs; and
- prohibit used merchandise sellers, such as pawn shops, that make loans to the public from choosing interest as COGS.
- Amended the definition of “compensation” to
- include net distributive income from an LLC treated as a sole proprietorship but only if a natural person receives the distribution;
- clarify that benefits are included only to the extent deductible for federal income tax purposes; and
- clarify that the $300,000 limitation on amounts paid to one employee applies to all amounts paid to the employee by all members of a combined group.
- Clarified that the limitation that a taxable entity’s taxable margin cannot exceed 70 percent of total revenue applies to the taxable margin of a combined group.
- Clarified that a member of a combined group may claim as COGS, qualifying costs, if the goods for which the costs are incurred are owned by another member of the combined group.
- Clarified that each member of the combined group “shall be jointly and severally liable for the tax of the combined group.”
- Amended the Temporary Credit provision for net operating losses to clarify
- the credit applies to reports due after January 1, 2008;
- the credit can be taken over ten consecutive privilege periods;
- the credit is the amount of “business loss carryforwards” calculated under Section 171.110(e) as that section applied to returns due before January 1, 2008;
- the appropriate tax rate is the applicable tax rate of 1 or one-half percent; and
- unused credits can be carried forward subject to the ten-year limitation.
- Clarified the transition provisions to require the entities described below to pay an “additional tax” for the privilege of doing business in the state any time after June 30, 2007 and before January 1, 2008. The additional tax would be the appropriate Margin Tax rate applied to the entity’s taxable margin, which would be based on the period
- beginning on the later of January 1, 2007 or the date the entity began doing business in the state; and
- ending on the date the entity became no longer subject to the tax.
- is not doing business in the state on January 1, 2008;
- would be subject to the new Margin Tax but was not subject to the old Franchise Tax; and
- was doing business in the state after June 30, 2007 and before January 1, 2008.
As noted in the summary, the bill does not address all of the technical corrections identified in HCR 51, specifically the change to require partnerships to include gross rental income rather than net rental income. This change was recommended during the special session last spring to ensure that taxable entities were treated the same without regard to their legal structure. If this change is adopted, the increased revenue could provide the Legislature with the ability to adopt changes to the Margin Tax that would reduce the state’s revenue but not reduce the overall amount of revenue estimated to be generated by the new Margin Tax.
The Technical Corrections bill is only one of about 40 bills that have been filed that propose changes to the new Margin Tax. Several bills would increase the total revenue threshold for the small business exemption to an amount greater than $300,000. Several would provide Margin Tax incentives for various actions undertaken by taxpayers. Over the remaining 79 days, lawmakers will be considering the changes proposed by the filed bills and amendments to bills such as the Technical Corrections bill. Ryan & Company will be monitoring these issues on behalf of our clients who do business in Texas and would be affected by the changes.