On May 2, 2006, the Texas Legislature passed House Bill 3, which - although it is contained in the same chapter of the Texas Tax Code - essentially replaces the current Texas franchise tax and its alternative bases of "capital and earned surplus" with a "Margin Tax," based upon gross receipts less (taxpayer's choice of) compensation or the cost of goods sold. This legislation has not yet been signed by the Governor and may still be subject to change.

Entities Subject to the Margin Tax

Most forms of doing business, including partnerships directly engaged in real estate or professional services business, would be subject to the tax. Any partnership, corporation, banking corporation, savings and loan association, limited liability company, business trust, professional association, business association, joint venture, joint stock company, holding company, or other legal entity is subject to the tax.

Some specific forms of business are exempt from the margin tax: sole proprietorships, general partnerships owned solely by natural persons, certain passive income entities, entities specifically exempted under current franchise tax provisions, grantor trusts, escrows, REITs that do not directly hold real estate, and REMICs. A partnership that earns over 90% of its income from investments is exempt as a passive income entity. Rent is not considered passive income, so entities with direct real estate holdings are subject to the tax.

Taxpayers that owe less than $1000 in margin tax and those with total revenues of $300,000 or less are exempt from tax. The $300,000 minimum will be indexed to inflation beginning in 2009.

Calculating the Margin Tax

The tax is based on a taxpayer's tax margin, which is calculated as follows:

Tax Margin = Total Revenue (minus) the greater of: (A) Cost of Goods Sold; or (B) Compensation

The tax margin may not exceed 70% of the taxpayer's total revenue. The tax margin is then apportioned to Texas using the standard franchise tax apportionment method to obtain the taxable margin. The tax rate is 1% per year of the taxable margin. Certain entities primarily engaged in retail or wholesale trades are subject to a lower, alternative rate of 0.5%.

Total Revenue

 

A taxpayer's total revenue represents its total income as reported on IRS Form 1120 (for corporations) or IRS Form 1065 (for partnerships and other pass-through entities), plus dividends, interest, gross rents and royalties, capital gain net income minus bad debt, foreign royalties and foreign dividends, and income from a related entity, to the extent already included. Certain items are specifically excluded from total revenue, such as payments made to other entities within an affiliated group, and certain oil and gas revenue from stripper wells.

    

Compensation

 

The deduction for compensation includes wages and cash compensation paid to officers, directors, owners, partners, employees, and the cost of all benefits provided. Compensation does not include social security or Medicare contributions. No more than $300,000 of compensation may be deducted for a single individual. The $300,000 maximum will be indexed to inflation beginning in 2009. Compensation paid to undocumented workers may not be deducted.

 

Cost of Goods Sold

 

The deduction for cost of goods sold covers the direct costs of acquiring or producing goods, including labor, materials expenses, handling costs, storage costs, depreciation, cost of renting or leasing equipment, facilities or real property, repairs, and research and development costs. Certain costs are excluded, such as selling costs, distribution costs, advertising costs, idle facility expenses, rehandling costs, bidding costs, interest, income taxes, and officer compensation. For purposes of deducting the cost of goods sold, goods are defined as real or tangible personal property sold in the ordinary course of business. Services are not included.

 

Up to 4% of a taxpayer's indirect or administrative overhead costs may be deducted if the taxpayer can demonstrate such costs are allocable to the acquisition or production of goods. Cost of goods sold must be capitalized in the same manner they are capitalized for federal purposes.

Credits/NOLs

Net operating losses based upon business activity and computed under the franchise tax laws prior to the effective date may be claimed in 10% installments until they are exhausted or until 2026. Unused franchise tax credits may be claimed, but no new credits may be accumulated.

Combined Groups

Taxpayers that are part of an affiliated group, a group of entities in which a controlling interest of 80% or more is owned by a common owner, that are engaged in a unitary business must file a combined group report, rather than an individual report. A unitary business is a single economic enterprise in which the entities are sufficiently interdependent, integrated, and interrelated through their activities so as to provide a synergy and mutual benefit that produces a sharing or exchange of value among them and a significant flow of value to the separate parts.

When calculating the gross receipts apportionment formula, a combined group only includes the Texas gross receipts of each member entity that has nexus with Texas. Gross receipts from all entities in the controlled group are included in the total gross receipts portion of the apportionment formula, regardless of whether the entities have nexus.

Filing Requirements and Effective Date

The first margin tax returns will be due May 15, 2008 and will be based on business done in 2007 for calendar year taxpayers. In 2007, certain large taxpayers identified by the Comptroller will be required to file an information report containing the information that would have been included if a margin tax report had been required.

If you would like to discuss matters regarding these developments please contact Renn Neilson or Matt Larsen.