For two and half years in IAEI News, Jesse Abercrombie has been addressing financial issues of concern to those in the electrical industry. For this issue, he has submitted a guest article by Attorney Jay Crutcher, who will discuss a new tax in Texas. It is not yet known whether other states are implementing similar taxes. —The Editor
There’s a new tariff in town called the Texas Margin Tax. The margin tax replaces the old franchise tax and affects virtually every business entity in Texas (including out-of-state companies “doing business” in Texas). Vast numbers of limited partnerships, previously exempt from the old franchise tax, will now pay margin tax and it could be a sizeable amount. Corporations and limited liability companies that paid the old franchise tax will calculate margin tax using methods significantly different from the old franchise tax. Businesses now face new reporting rules for combined groups and tiered-partnership arrangements. In short, the margin tax affects business owners in fundamental ways — how they structure (or restructure) their businesses, how they account for their business operations, how they file their margin tax returns, and bottom-line, how much tax they pay. As a business owner, you need to know exactly how the margin tax affects your business so that you can take proactive measures to minimize your tax liability. Otherwise, you could face a surprising tax bill or overlook tax planning opportunities. This article describes who pays the margin tax and how much they pay.
The margin tax applies to a taxable entity. Most business entities, including limited partnerships, are considered to be a taxable entity. Limited partnerships were exempt from the old franchise tax. Prior to the margin tax, many businesses operated as a limited partnership to avoid franchise tax liability. One of the primary legislative purposes behind the margin tax was to eliminate the old franchise tax exemption for the vast majority of limited partnerships.
The margin tax does not apply to a passive entity. To qualify as a passive entity, the business must be organized as a general partnership, limited partnership or non-business trust. A limited liability company does not qualify as a passive entity. Also, the business must satisfy specific passive income tests prescribed by the margin tax statute. Oddly enough, the margin tax statute expressly provides that rent is not passive income.
Margin Math: Taxable Margin
The margin tax rate is 1% for most businesses. Some businesses qualify for a lower rate of 0.5%. A business pays margin tax based upon its taxable margin. The business calculates taxable margin using one of three methods: (1) the cost of goods sold method, (2) the compensation method, or (3) the 70% percent method. The business uses the method that results in the lowest taxable margin. The business can elect to use a different method from year to year and is not required to use the same method each year. The old franchise tax was based on a net income concept. By changing the tax base to a gross margin concept, the margin tax potentially disregards many deductions.
Taxable Margin: The Texas Six-Step
A business calculates its taxable margin in basically six steps:
- First, the business determines its total revenue. Revenue exclusions apply for certain types of revenue. Special rules apply to specific types of businesses, including construction companies and contractors;
- Second, the business determines its cost of goods sold. The margin tax statute enumerates eligible costs and excluded costs. Special rules apply to construction companies, projects involving real property, and companies that lease heavy construction equipment;
- Third, the business determines its compensation. Compensation includes W-2 wages and, in certain cases, distributive shares of income from partnerships, limited liability companies and “S” corporations. However, the compensation deduction is limited to $300,000 per person. Compensation does not include amounts paid to undocumented workers or 1099 payments. Special rules apply to specific types of businesses, including management companies and managed entities;
- Fourth, the business determines the lower of three separate calculations; (1) total revenue minus cost of goods sold (i.e., the cost of goods sold method), (2) total revenue minus compensation (i.e., the compensation method), or (3) total revenue multiplied times 70% (i.e., the 70% method). The business elects each year to use the method that results in the lowest margin;
- Fifth, the business apportions its margin as between Texas and other states in which it conducts business; and
- Sixth, the business subtracts other allowable deductions specifically granted by the margin tax statute.
Combined Groups and Tiered-Partnership Arrangements
The margin tax statute requires combined groups to file on a combined group basis. This reporting rule represents a significant change from the old franchise tax law that prohibited consolidated reporting. Combined groups are affiliated entities, whether corporate or non-corporate, that have 80% common control and are engaged in a so-called unitary business. A unitary business generally includes separate parts of a single entity or a controlled group of entities that, in either case, constitute a single economic enterprise by reason of interdependent and integrated business activities.
The margin tax statute permits a form of combined reporting for tiered partnership arrangements. A tiered partnership arrangement includes partnerships that are 100% owned by one or more other taxable entities and may consist of one or more tiers. In this case, the other taxable entities may pay and report the margin tax attributable to their respective ownership interests in the partnership.
Tangling with the Texas Margin Tax
Businesses must assess the business, legal and tax implications resulting from the Texas Margin Tax. Business structures need to be viewed (and perhaps revisited) in light of the fact that most limited partnerships are now taxable. Tax planning needs to be revamped to carefully consider the different methods used to calculate the margin tax, how to maximize the benefits of each method and how to minimize margin tax liability. Tax reporting will need to be revised to include combined groups and, as appropriate, tiered partnerships.
This article is for general information purposes only and is not intended to constitute legal or tax advice and should not be viewed as such. Readers are encouraged to consult with their attorney or tax advisor to consider the matters discussed in this article in light of their unique tax circumstances. ©2007