The “Revised” Texas Franchise Tax

The Basics Broader Base and Lower Rate Applies to a broader range of business types The Capital and Earned Surplus Tax Bases are replaced with a Margin Tax Base The Tax Rates are reduced to 1% and .5% for retailers and wholesalers Timing – Reports due on or after January 1, 2008

Who’s in? Entities with Liability Protection Applies to entities with liability protection Includes: Limited Liability Partnerships Limited Partnerships Business Trusts Corporations Limited Liability Companies Professional Associations Professional Corporations Commission – Privilege Tax for the right to do business as a liability protected entity

Who’s out? Sole proprietorships and general partnerships owned by natural persons Partnerships that qualify as passive entities Grantor trusts Entities currently exempt from franchise tax Taxable entities that owe less than $1,000 in tax Taxable entities with $300,000 or less in total revenue Estates of natural persons Escrows REIT REMIC

What is a passive entity? A Passive Entity is: A General or Limited Partnership or non-Business Trust Meets 90% Passive Income Test 90% of income must be Passive Income Examples: Dividends, Mineral Royalties, LLC Income, Interest, Distributive Shares of Partnership Income, Gains from Sales of Real Property and Securities No more than 10% of gross income from conducting active trade or business Rental income is not considered passive income

How is the tax calculated? An Entity’s Taxable Margin is calculated as: The Lesser of: 70% of Total Revenue; or Total Revenue less either Cost of Goods Sold, or Compensation Times Apportionment Factor Tax Rate The election to deduct either Cost of Goods Sold or Compensation is done on an annual basis No Taxpayer’s taxable margin would be greater than 70% of Total Revenue – Every taxpayer gets at least a standard deduction equal to 30% of Total Revenue

Total Revenue Gross Receipts/Sales less returns & allowances Dividends Interest Gross Rents Gross Royalties Net Capital Gains Other Income Refunds of taxes deducted in prior years Ordinary income from trade or business activities of a partnership, LLC, or S-Corp What is included in Total Revenue How do you arrive at Total Revenue Pulls revenue amounts from IRS forms Correct line references are Form 1065 Lines 1(c), and 4-7 Schedule K, Lines 3(a), 5-11 Form 8825, Line 17

Total Revenue Specific provisions for Health Care, Legal, and Staff Leasing industries Specific provisions to reduce gross revenues to net revenues Specific allowable subtractions from Total Revenue to limit: Total Revenue to Water’s edge revenue Double Taxation of receipts How do you arrive at Total Revenue Pulls revenue amounts from IRS forms Correct line references are Form 1065 Lines 1(c), and 4-7 Schedule K, Lines 3(a), 5-11 Form 8825, Line 17

Cost of Goods Sold Statutorily defined - similar to Federal definition COGS deduction generally can only be taken by entities selling goods (TPP or real property) Expenses that can be included in COGS: Raw materials Labor directly related production Depreciation related to production Indirect and administrative overhead costs that are allocable to the acquisition or production of goods limited to 4% of total indirect and administrative overhead costs

Cost of Goods Sold Enumeration of Items in COGS Allowances: Certain expenses for mining industry, such as depletion or geological costs Interest expenses for Lending Institutions Cost of Goods Sold expenses for several specific rental businesses Prohibitions: Selling expenses Officer compensation Advertising Outbound transportation

Compensation Compensation is defined as wages and salaries and employee benefits Wages - Medicare wages and tips box on W-2, plus: Distributions to natural person from entities treated as partnerships and S-Corporations Federal tax deductible Stock Awards and Options Limited to $300,000 per employee Benefits - federal tax deductible benefits (not subject to $300,000 cap) Health care Retirement Worker’s compensation

Apportionment Changes? Limited changes – Current apportionment rules and policies are meant to apply to Margin Tax Single Gross Receipts Factor remains the standard Mortgage Loan Services – Receipts from the servicing of loans secured by real property are sourced based on the location of the real property No Throwback Rule Generally, sales of TPP sourced to Texas if delivered in the state and receipts from services performed in the state are sourced to Texas.

Tax Rates General Rule: 1% tax rate for all entities Exception: ½% tax rate for entities primarily engaged in retail and wholesale trade (includes restaurants) Primarily engaged in retail and wholesale trade if: Total Revenue from retail and wholesale trade is greater than Total Revenue from non-retail and wholesale trade activities, Less than 50% of the Total Revenue from retail and wholesale trade activities comes from the sale of products produced by the entity or an affiliated entity, AND The entity does not provide retail or wholesale utilities such as telecommunications, electric, or gas

Unitary Combined Reporting Water’s edge unitary combined reporting is required Taxable Entities in a unitary affiliated group must file a combined report An affiliated group is a group of one or more entities owned by common owner(s) Controlling interest is 80% or more ownership Unitary definition is adapted from MTC model language for unitary reporting Same general line of business Vertically or horizontally integrated Strong centralized management Same election of COGS or Compensation for all members Can include partnerships

Filing Periods & Accounting Periods The traditional “privilege period” concept in the Tax Code is preserved The new “margins” tax base replaces the traditional tax bases of Taxable Capital and Earned Surplus for reports due on or after January 1, 2008 and would be based on Federal income tax accounting periods ending in 2007

Franchise Tax Credits in the Future Investment, Jobs, & R&D Credits Established credits can be taken against margin tax liability No new credits can be established. Toyota Provision – State makes good on all contracts signed with the State before June 1, 2006 Business Loss Carryforwards March 1, 2007 notification required Current language requires technical corrections

Information Report Requirement Information reports must be filed by certain entities by February 15, 2007 What must be filed? An information report that would be completed as if the “margins tax” were already in effect for reports that would have been due on May 15, 2006 Who must file? The largest 1,000 franchise tax taxpayers The largest 1,000 entities in the State based on gross receipts The largest 1,000 entities in the State based on employment The largest 1,000 entities in the State based on the amounts of school maintenance property taxes paid

What does the future hold? Technical Corrections – HCR 51 & Senate Bill 6 HCR 51 Partnership clarification Corrections of line references for determining total revenue for partnerships SB 6 Clarification of Unitary Business Clarification of tier partnership language Clarification of “business loss carryforward” language Clarification of transition language related to partnerships ceasing to do business

Future Issues? Other proposed changes for 2007 Legislative session based on SB 6 Apportionment – Which standard will be used for unitary combined reports? Joyce or Finnegan 50% vs. 80% control for affiliated groups Cost of Goods Sold – Should it be extended to service industry? Tax Credits – Re-establish investment, jobs, and R&D credits

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