Texas Margin Tax FAQ

Important Notice

We are not attorneys and the advice in this FAQ (and elsewhere on this web site) is not intended to be legal advice.  There are numerous legal issues associated with the Margin Tax.  If you have questions you should contact your attorney and ask their advice.

There are still many aspects of the Margin Tax that are yet to be determined by the Comptroller's office.  This FAQ contains answers based on the situation as of November, 15 2007.

1.  Why is there a new business tax in Texas?

2.  When does the new tax go into effect?

3.  Which companies must pay taxes under the Margin Tax law?

4.  If my entity is not taxed under federal income tax laws is it exempt from paying Margin Tax in Texas?

5.  How is the Margin Tax calculated?

6.  What is the Margin Tax rate?

7.  How is revenue defined?

8.  How is the cost of goods deduction defined?

9.  How are employee compensation and benefits defined?

10.  The rate is different for wholesales and retailers.  How are wholesaler and retailer defined?

11.  If I have multiple entities do they file separately or together?

12.  Who are projected to be the "winners" and "losers" under the new law?

13.  I have a Franchise Tax net operating loss carryover.  Does this apply to the new Margin Tax?

14.  I have heard that this new law is unconstitutional?  What is that about?

15.  Can I expect this to have an impact on my accounting fees?

If you have any other questions, please contact us.

1.  Why is there a new business tax in Texas?

Finally, the franchise tax sorely needed to be reworked anyway.   It was ineffective and filled with loopholes. The result was that many businesses paid no taxes at all under the franchise tax provisions.  The Margin Tax addresses this by eliminating some of the loopholes.

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2.  When does the new tax go into effect?

Governor Perry signed the law on May 18, 2006.  The first taxable period begins on January 1, 2007 with the first returns due in May of 2008.  However, there are ways within the new law to minimize your taxes.  This may require you to take steps in advance so you need to consider the changes in the law early rather than later. 

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3.  Which companies must pay taxes under the Margin Tax law?

As a general statement any legal entity that does business in Texas and is organized to have some form of limited liability protection must pay the margin tax.  This includes corporations, limited partnerships (LPs), limited liability companies (LLCs), limited liability partnerships (LLPs), banking corporations, savings and loan associations, business associations, professional associations, and some joint ventures.  This also means that, in general,  sole proprietorships and general partnerships that only have natural persons as its partners are not taxed under the Margin Tax law. 

The following list provides a general summary of entities that are exempt from the Margin Tax.

• Entitles with gross receipts of $300,000 or less (inflation adjusted every two years) 

• Entitles that owe less than $1,000 in franchise tax

• General partnerships owned by natural persons

• Tax-exempt entities

• Grantor Trusts where all parties are natural persons

• Estates

• Escrows

• Family limited partnerships that are passive entities and do not operate a business

• Insurance companies

• Non-Profits

• Real Estate Investment Trusts (REITs)

• Real Estate Mortgage Investment Conduits (REMICs)

• Passive entities that meet the following three requirements.

• Must be a general or limited partnership, or a trust other than a business trust.

• At least 90% of federal gross income must arise from a specific list of sources. The list includes interest, dividends, capital gains, distributive partnership income, and income from non-operating mineral interests.

• No more than 10% of the entity’s federal gross income can be received from conducting an active trade or business.

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4.  If my entity is not taxed under federal income tax laws is it exempt from paying Margin Tax in Texas?

Not necessarily.  You may still have a Texas Margin Tax obligation.

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5.  How is the Margin Tax calculated?

The Margin Tax is based on a percentage of "taxable margin". 

The taxable margin is the lower of 

       a.  Total revenue minus cost of goods sold, or

       b. Total revenue minus employee compensation and benefits (not including payroll taxes)

       c.  70% of total revenue

The taxable margin is then apportioned by the percentage of the entity's business done in Texas.  This percentage is calculated by dividing gross receipts from business done in Texas by gross receipts from business done everywhere.

(Note:  Service businesses are not eligible to use the cost of goods sold method.)

The Margin Tax rate is then applied to the apportioned taxable margin.

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6.  What is the Margin Tax rate?

It is one-half percent for taxable entities primarily engaged in retail or wholesale trade, and one percent for all other taxable entities.   However, if the entity has less than $10 million in revenue the tax may be calculated, under the EZ method, at .575% of revenue (no deductions are allowed).

There is a discount based on the size of the business.  It is based on the following table. 

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7.  How is revenue defined?

Total revenue is determined based on federal income tax reporting.  Different types of entities will calculate revenue in different ways. 

• Corporations - For a corporation you start by adding lines 1c and lines 4 - 10 on federal From 1120.  This will include gross receipts (less returns and allowances,) dividends, interest, gross rents and royalties, capital gains, and other income.  A corporation is allowed to subtract bad debt expense, foreign royalties and dividends, partnership distributable income, and dividends that qualify for the federal deduction for dividends received.

• Partnerships - Partnership tax is calculated like that of corporations with the difference that the data comes from Form 1065.

Exemptions to the revenue recognition calculation include the following.

• Dividends and interest received from federal obligations are exempt for everyone.

• Certain flow-through funds mandated by law, fiduciary duty, or contract are excluded for all taxable entities.

• Attorneys may exclude from total revenue the cost of pro bono services, limited to $500 per case.

• Physicians' revenue from Medicaid, Medicare, CHIP, workers’ compensation claims and TRICARE are excluded from taxable margin as are the costs for uncompensated care.

• Income received from certain low-volume oil and gas wells is exempt.

• Guaranteed payments are exempt.

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8.  How is the cost of goods deduction defined?

Cost of goods sold is as traditionally defined by Texas law, but excludes officer compensation.

Note: Services companies are not allowed to use the cost of goods sold method of calculating the margin tax.

It is defined as the costs required to produce or acquire a "good".  The goods that can be used in the the Cost of Goods calculation are defined as follows.

• Real or tangible personal property  (Note that the definition of tangible personal property is complicated.  For example  cost of goods can include cost of developing films, sound recordings, or books if the tangible medium in which the property is embodied will be mass distributed.  Similarly, it also includes computer programs.)

• Must have been owned by the entity

• The Cost of Goods includes all direct costs associated with acquiring or producing the goods.  For example, it includes inbound freight, storage, research and development, and depreciation of equipment used to produce the goods.  There are other direct costs specifically listed in the law.

• Cost of Goods can also include costs for goods that were not sold if they are obsolete products or products that could not be sold due to spoilage or other deterioration. 

• Up to 4% of indirect administrative costs can be included in the cost of goods calculations if it can be shown that the costs are associated with the acquisition or production of goods.

• Lending institutions that offer loans to the public may include interest expense in cost of goods sold

 Cost of Goods cannot include the costs of the following.

• Intangible property (For example, accounts receivable is an intangible property.)

• Services  (For example, legal services or tax return preparation.)

• Bidding costs

• Selling costs

• Outbound freight

• Interest costs  (See the exception above for lending institutions)

• Idle facility costs

• Officer's compensation

• Compensation paid to undocumented workers

• Income taxes

There are a number of outstanding questions regarding the calculations for the cost of goods deduction.  The Comptroller is addressing some of these in her rules.  These are currently "proposed" and questions remain.

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9.  How are employee compensation and benefits defined?

The calculations for compensation and benefits include the following.

• Start with "Medicare wages and tips" box on Federal Form W-2.  (It is unclear how fiscal year taxpayers comply with this.)

• Partnerships, LLPs, LLCs, S corporations, or other entities treated as a partnership for federal tax purposes can also include the net distributive income allocable to to natural persons.  (Note estates are defined as "natural persons".)

• The cost of stock awards and options that were deducted for federal tax purposes can be included.

• Benefits include workers’ compensation insurance premiums, healthcare, and retirement benefits to the extent they are deductible for federal income tax purposes.

The following restrictions apply.

• The maximum wages and compensation that can be included for any individual is $300,000.  Benefits are not subject to this cap.

• Wages for undocumented workers can not be deducted.

• Payroll taxes cannot be included.

• All wages and cash compensation and benefits can be included only if they are paid to employees, officers, directors, owners, or partners.

• Staff leasing companies, management companies, and the customers of these companies have specific rules that apply only to them.

A consideration that falls out of this method of calculating the taxes is whether to hire contract and temporary workers or full-time employees.  If you are expecting to use the compensation deduction method, it may be better to hire workers as employees since their wages and benefits will be deductible and payments to independent contractors and temporary staffing companies will not be.

Just like with the cost of goods method, there are outstanding questions regarding the calculations for the compensation deduction.   Some examples include the following.

• There is no definition of benefits and sometimes there appears to be overlaps in the lap between wages and benefits.

• The deductions do not clearly address wages and benefits in a logical manner.  For example, wages are limited to the $300,000 ceiling, but there is no ceiling for benefits.  Also undocumented worker wages cannot be  used in the compensation deduction, but undocumented worker benefits apparently can be used.

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10.  The rate is different for wholesales and retailers.  How are wholesaler and retailer defined?

Wholesale and retail trade are defined in the Margin Tax law by referring to definitions in the 1987 Standard Industrial Classification (SIC) Manual published by the federal Office of Management and Budget. 

The SIC classification system divides industry into 10 divisions.  Entities in Division F are considered wholesalers.  Entities in Division G are considered retailers.  Due to the way the classification system works, an entity with a SIC code in the 5000's is a wholesale or retail entity.  Note that while this includes the businesses that yo traditionally think of as service business like law firms and accountants, it also includes businesses such as bars and restaurants, car dealerships, gasoline service stations, mail-order houses, and vending machine operators.

(The SIC code was replaced as the U.S. standard by the North American Industrial Classification System (NAICS)  in 1997.  However, the Margin Tax law refers to the older SIC system, not NAICS.)

The law says the entity must be "primarily engaged in retail or wholesale trade".  There are three characteristics the entity must have to meet this requirement. 

• The total revenue from activities classified as retail or wholesale trade is greater than from its activities in trades other than retail or wholesale.

• At least half of the revenue from the entity's wholesale or retail activities must not be derived from the sale of goods produced by the entity.  This simply means that the entity must sell more of some other company's product than it does of its own internally produced products.  This does not apply to SIC code group 58 entities which are restaurants and bars. 

• The entity cannot provide retail or wholesale utilities, including electrical, or gas or telecommunication services.  Note that this requirement means that even if the utilities sold are a small  amount of an entity's business it could still not be classified as a wholesaler or retailer.

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11.  If I have multiple entities do they file separately or together?

The law defines how multiple affiliated entities are handled.  It defines a "combined group" and requires that such a group of entities be treated as one taxable entity instead of treating each member of the group as a separate entity for tax purposes.   

To be a combined group the following conditions must be met.

• The entities within the combined group must be an "affiliated group".  An affiliated group is one or more entities in which a controlling interest is owned by a common owner or owners (corporate or non-corporate), or by one or more of the member entities.  Controlling interest generally means at least 50% ownership.

• The entities must be in a "unitary business".  The definition of unitary business will be up to interpretation by the Comptroller.  The law states that unitary businesses consist of a collection "of entities that 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".

• There is also a "water's edge" requirement in determining if an entity belongs in a combined group.  In general, if 80% or more of the entity’s property or payroll are located outside of the United States, the entity is considered past the "water’s edge," and must be excluded from the combined group

The tax for the combined group is determined as follows.

• Each individual entity within the group calculates its own revenue and deductions for compensation or cost of goods separately.

•  The amounts are added together to get numbers for the combined entity.

• All intercompany transactions are removed.

• The combined entity must make the election as to which deduction to take (30% of revenue, cost of goods sold calculation, or compensation calculation).

• The determination of the portion of the combined group’s gross receipts performed in Texas is for the group as a whole after eliminating intercompany receipts.

Entities with a combined group that do not have a physical presence in Texas are not required to include their Texas gross receipts in the allocation formula, but they are permitted to include their gross receipts from total sales.  In this case, reporting as a combined group may be beneficial for certain entities, since group members without presence in Texas may reduce the margin apportioned to Texas more than they contribute in margin.

The taxpayer has an option regarding whether to include exempt entities that otherwise meet the combined group requirements.  If the taxpayer includes the exempt entity, it’s treated as if it was taxable for purposes of determining the combined group’s tax. For instance, if the same owner that owns the entities in a combined group also owns a passive entity, and both the combined-group entities and the passive entity are in the same unitary business, the owner doesn’t have to include the passive entity in the combined group. However, the owner can elect to include the passive entity in the group if its inclusion would be beneficial.

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12.  Who are projected to be the "winners" and "losers" under the new law?

Winners might include the following.

• Capital intensive businesses - oil and gas for example - could profit from the property tax reduction enough to see a net decrease in Texas taxes.

• Businesses that can take advantage of the passive entity definition under combined entities could also be winners.  Oil and gas also could do well in this category since royalty interests and non-operating working interests in mineral rights are not treated as active.

• Manufacturers may be better off than service companies because of the cost of goods deduction method.

• Wholesales and retailers have the advantage of the lower tax rate.

Losers could include the following.

• Service companies are the biggest losers.  (Especially since some of them were exempt under the franchise tax.)  Lawyers, CPAs, and architects will pay more taxes.  Doctors will also pay, but there are a number of large exemptions that will help them.

• Companies with significant non-deductible costs will also suffer.  Transportation and rental companies are examples. 

An area in which there could be winners or losers based on circumstances is the area of lease agreements for commercial space.  These agreements often require the leasee to pay a pro-rata portion of the property tax.  Since property taxes are going down, this implies that this share will go down.  However, most of the lessor's major expenses are not deductible under the new law so their costs will go up.  So a leasee with a long term lease might be in good shape, but the lessor could be in bad shape.  Of course new lease agreements will quickly be re-written to compensate for this.

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13.  I have a Franchise Tax net operating loss.  Does this carryover to the new Margin Tax?

No, the Franchise Tax net operating loss can not be carried over to the Margin Tax.  However, there is a credit against the margin tax going forward.

• 2.25% of the loss carry forward is allowed as a credit on reports due between January 1, 2008 and December 31, 2017.

• 7.75% of the loss is allowed as a credit on reports due between January 1, 2018 and September 1, 2027.

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14.  I have heard that this new law is unconstitutional?  What is that about?

Texas has a provision in the state Constitution that requires voter approval of a personal "income tax".  The issue has been raised regarding whether or not the margin tax is actually just an income tax.  The Texas Comptroller has asked for a ruling from the Texas Attorney General regarding this question.  This is a question that will likely be answered by the courts.

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15.  Can I expect this to have an impact on my accounting fees?

Every client's situation is different.  However, we expect many of our clients will see fees for margin tax return preparation that are higher than previous fees for franchise tax returns.  This is partially due to the amount of information that must be collected and evaluated and partially due to the fact that some of the calculations involved cannot be performed by existing tax preparation software and will therefore require manual decisions and calculations.

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Important Notice

We are not attorneys and the advice in this FAQ (and elsewhere on this web site) is not intended to be legal advice.  There are numerous legal issues associated with the Margin Tax.  If you have questions you should contact your attorney and ask their advice.