July 2007

Texas Franchise Tax Update

Texas Governor Rick Perry earlier this year created a “Tax Reform Commission” to recommend reforms to the current Texas tax structure, which is used to finance public education. The Texas Supreme Court ruled late last year that the state’s current school financing structure was inequitable. The court set a June 1, 2006 deadline for the state to propose changes to the state’s current tax structure.

On March 29, 2006, the Tax Reform Commission released its report to Governor Perry, and a special legislative session was convened to consider the commission’s recommendations. On April 24th, the Texas House approved HB-3, which is summarized below and includes many of the commission’s recommendations. The tax overhaul is intended to reduce property taxes used to finance schools. The property tax reductions would be replaced by the new Texas Margin Tax and an increase in cigarette taxes. The bill passed by the House and Senate, and was recently signed into law by Governor Perry.

The new tax would be based on total revenue, and businesses would pay on the lesser of two calculations: deducting either the costs of goods sold (similar to federal income tax) or employee compensation (including health insurance and other benefits) from their total revenue. The proposed rate would be reduced from 4.5% to .5% for retail and wholesale businesses and 1% for all other business. The cigarette tax would also be increase by $1 per pack, and taxes on other tobacco products would be increased by 13.6%.

If your company is doing business in Texas or if your company set-up Texas partnerships to minimize the Texas franchise tax, then you should determine how this new Margin Tax may impact your company’s Texas taxes. Cherry, Bekaert & Holland can assist you in performing this analysis.

HB-3 is the franchise tax component of the Tax Reform Commission’s recommendations. The new franchise tax applies to partnerships, corporations, limited liability companies, business trusts, professional associations, business associations, joint ventures and other legal entities with statutory liability protection, except for:

• Entities with gross receipts of $300,000 or less (inflation-adjusted every two years)
• Entities who owe less than $100 in franchise tax
• Sole proprietorships
• General partnerships owned by natural persons
• Passive entities
• Tax-exempt entities – same ones that are tax-exempt under current law
  Grantor trusts where all parties are natural persons
• Estates
• Escrows
• Family-limited partnerships that do not operate a trade or business
  

The tax base or “taxable margin” is the lower of Texas total revenue less either cost of goods sold or employee compensation and benefits, but not more than 70% of total revenue. The following would also apply:

• Total revenue is determined based on federal income tax reporting
• Cost of goods sold, as traditionally defined, but excluding officer compensation and includes some specific items, such as:
  • Research, experimental and design activities
  • Geological and geophysical costs incurred to identify and locate property that has the potential to produce minerals
  • Cost of electricity sold
  • Interest expense for lending institutions
• Companies selling services are not eligible for the cost of goods sold deduction
• Employee compensation and benefits includes:
  • Wages and cash compensation paid to officers, directors, owners, partners and employees (includes owner or partner distributions), limited to $300,000 per person (the $300,000 is inflation-adjusted every two years)
  • All benefits provided to all personnel including workers’ compensation, health care and retirement benefits to the extent deductible for federal income tax purposes

The tax rate is .5% for retail and wholesale businesses and 1% for all other taxable entities. But the rules for apportioning receipts would not change. The first tax payment will be due in May 2008, based on 2007 financial results, and will result in the repeal of most franchise tax credits. Any constitutional challenge of the law would be heard in a Travis County District Court, and would be appealed directly to the Supreme Court on an expedited basis.
For a copy of the “Tax Commission Report” and the proposed form to be used to file the new margin tax and a draft of House Bill 3 please visit our web site at www.cbh.com.
For additional information or questions please contact.

PLEASE NOTE: This summary was prepared based on information available as of the date of this bulletin. The proposed margin tax is subject to change until appropriate rules are issued by the Texas Comptroller of Public Accounts. Any such changes could affect the validity of the final implementation of this new tax. In addition, the Comptroller of Public Accounts has requested an Attorney General Opinion to determine if the margin tax could be considered an income tax. If the margin tax can be considered an income tax, then the tax would have to be approved by Texas voters.

For more information, please contact:
John Corn
State and Local Tax
jcorn@cbh.com
866.859.9792

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