HOUSTON BUSINESS REVIEW

Franchise Tax Letter Part Two
By Gary Cooper

GARY N. COOPER, C.P.A., C.V.A., is managing partner of Cooper, Bergman & Company, L.L.P., certified public accountants which was formed in 1991, assisting small businesses and individuals with accounting, consulting and income tax planning and compliance. Services provided include medical practice consulting, business valuation, assistance with buy/sell transactions, development and implementation of policies and procedures, accounting services and tax compliance and planning. The Company has offices in Plano and Houston, Texas.

In part one of this article I reviewed how the franchise tax is determined and did an overview of the new law’s major factors.  In this article I will continue that review by examining those points in detail.  We will review the entity structure, the determination of taxable revenues, the determination of deductions, the apportionment of revenue, and the reporting requirements.  We will also look at the possible future of the tax.

Entity Structure
Prior to the implementation of the new margin tax, there were several entities not subject to State franchise tax.  Now, generally all entities doing business in Texas that enjoy some type of protection from liability are subject to the margin tax.  This includes limited partnerships, corporations, limited liability companies (LLCs), and professional associations. 

Determination of Taxable Revenues
Revenues used for determining margin tax are determined using particular line item amounts from an entity’s Federal tax return.  Gross revenues may be reduced by bad debts, foreign royalties and dividends, partnership distributions, deductible corporate dividends, stripper well income, and Federal obligations dividends and interest.  Doctors and attorney also may receive a deduction from pro-bono services and Medicaid and Medicare receipts.

Determination of Deductions
There are three possible combinations of expenses to be applied in reducing taxable revenues – (1) cost of goods sold (COGS), (2) compensation, or (3) 30% of total revenue.  Each year the business may select the greater of one of the aforementioned amounts in the calculation, and the choice may vary from one year to the next.  Unfortunately, the allowable costs are not as clear-cut as their names might suggest.  The COGS amount is limited to certain direct and indirect costs that are detailed in the statute, such as labor, materials, depreciation/amortization, utilities, and licensing and franchising costs.  Certain administrative, or overhead, costs may also be included, limited to a maximum of 4% of revenues.  The COGS figure may also include payments to independent contractors, but those payments are not allowed when using the compensation deduction combination. 

If the compensation deduction is selected, the amount is limited to $300,000 of annual compensation per worker.  Compensation includes Medicare wages and tips and Federal partnership distributions to individuals, deductible stock and option awards, and deductible employee benefits.  

Finally, the 30% revenue deduction amount is simply 30% of the total taxable revenues as calculated in the above section id the compensation or COGS methods are not elected.

Apportionment of Revenue
The apportionment formula is relatively unchanged from its prior composition in State franchise tax calculations.  It compares Texas receipts versus receipts from the entire business to produce a percentage which is multiplied by adjusted net revenues to determine the taxable margin.

Combined Reporting Requirements
The concept of combined reporting is new for Texas tax law.  There are combined (not consolidated) reporting requirements for the margin tax based on 80% or more common ownership between entities, and qualification as a unitary business enterprise.  This means that entities are “sufficiently interdependent so as to provide synergy and natural benefit that produces a sharing or flow of value among them and a significant flow of value to the separate parts.”  Basically if the businesses have activities that are in the same general line (such as manufacturing) or are vertically structured, they will be required to calculate and report the margin tax on a combined basis. 

Another aspect of the new margin tax is that there is no provision for business loss carryovers on a go-forward basis.  There is an allowance for a credit calculation in the statute which is meant to give companies with unutilized business losses (NOL’s) some relief in beginning to calculate the new tax.. 

Looking Ahead
Overall there have been many significant changes in the way businesses will calculate and report the new margin tax in Texas.  It would be a wise choice to contact a representative at Cooper, Bergman & Company LLP or your tax advisor before 2007 to understand further how these changes will affect your business, and what can be done in the meantime to position your reporting for maximum liability reduction.  The State Comptroller’s website is also a good place to start at www.window.state.tx.us.  They provide a Margin Tax calculator and additional information for how businesses may be affected.

Gary N. Cooper CPA, CVA