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The New Texas Margins Tax

by Tony Goodall

The game appears to be over, namely the Texas State tax dodge that so many have used over the last two decades to avoid the effects of the Texas franchise tax. In answer to the many business entities that have converted to limited partnerships (exempt from the state franchise tax) the Texas legislature enacted a new reformed tax system that would apply to a broader base of business entities—including limited partnerships.

Whereas the prior franchise tax was based on the higher of earned surplus or taxable capital, the new margins tax is based on taxable margin. Under the prior law, the franchise tax was imposed only on corporations (including S corporations), limited liability companies, savings and loan associations and banking corporations. As of January 1, 2007, the new tax will apply to virtually all filing companies, namely those that file their organizations with the Texas Secretary of State.

Sole proprietorships, general partnerships directly owned by natural persons and entities currently exempt under the current Texas franchise tax code will be exempt from the new tax.

As stated above, the new tax goes into effect as of January 1, 2007 for filings due in the spring of 2008.

The Basic Calculations of the Tax. There are various rules, exceptions and qualifications to the way the margin tax is determined, but the basic rules include the following: Step 1--the determination of the taxable margin. Taxable margin is the lower of 1) 70% of the total revenue of the business; 2) total revenue of the business minus the cost of goods sold (if applicable) or; 3) total revenue of the business less compensation and benefits.

Step 2—application of the rate. The tax rate on the taxable margin, as determined above is 1% for most entities. Those entities primarily engaged in wholesale or retail trade will apply a tax rate of .5%. These enterprises will pay the lower tax rate, providing more than 50% of their gross revenues are derived from wholesale or retail trade.

Any entities with total gross revenues less than $300,000 or an annual tax liability of less than $1,000, will not be taxed.

These are just a few of the points involved in the calculation of the margin tax. There are exclusions for Medicare/Medicaid revenues, passive revenues, rules for affiliated group organizations, apportionment rules for in-state and out-of-state revenues and several other rules for determining the exact tax. These rules must be explored with your tax compliance professionals.

Some are saying that it may be wise to organize business enterprises in Texas as general partnerships or sole proprietorships to avoid the Texas State Margins Tax. Certainly there will be instances where general partnerships and sole proprietorships will be the better choices, but since the tax rate is relatively small, businesses would be well-advised to not disregard other important factors, such as limited liability and entity governance when deciding on the choice of entity. In other words, although most entities may now pay more state franchise tax (through the Margin Tax system) than before, business leaders should be careful to not unduly focus on the Margin Tax for deciding which form of entity to use for their enterprise.

Barring any court decisions affecting its implementation date, the Texas margin tax is coming in 2007. The margin tax was enacted rather quickly, and many details, including promulgation and release of regulations to the statutory framework, are forthcoming. Some of these details may still be coming during the 2007 tax year.

Tony Goodall
512.327.3400 Ext 26