BUSINESSES IN TEXAS FACE A NEW TAX – the “Margin Tax” - which becomes effective on January 1, 2008. Because the first Margin Tax reports and payments will be based on business activities during a taxpayer’s fiscal year ending in 2007, it is important to focus on the Margin Tax now to understand how it will affect your business. Further, you should consider whether planning opportunities are available to you to avoid the Margin Tax, or at least to minimize its impact on your business.
Margin Tax Overview
The Margin Tax was signed into law in 2006. The tax revises and expands the existing Texas franchise tax by changing the tax base, lowering the rate, and extending coverage to businesses which are not subject to the franchise tax. Essentially all active businesses will be subject to the Margin Tax, with the exception of: (1) sole proprietorships and general partnerships directly owned by natural persons; (2) businesses meeting the definition of a “passive entity;” and (3) certain nonprofits and other tax-exempt entities. Taxable entities with total gross receipts of $300,000 or less, or a tax liability of less than $1,000, will not pay any Margin Tax.
The Margin Tax assesses a tax on an entity’s “taxable margin,”which is the amount that equals the lesser of (A) 70% of the taxpayer’s total revenue or (B) the taxpayer’s total revenue minus either Cost of Goods Sold (COGS) or employee compensation and benefits paid. Several exemptions and limitations apply. Hotels and similar establishments will likely use their compensation and benefits calculation to determine their taxable margin. Bars, restaurants and similar retailers are expected to use COGS.
The Margin Tax rate equals 0.5 percent for taxable entities primarily engaged in wholesale or retail trade and 1.0 percent for all others. Bars and restaurants should qualify for the 0.5 percent tax rate; however, hotels and similar establishments will likely be taxed at the higher rate.
The Margin Tax does not offer many planning opportunities to minimize tax liability. However, all businesses should consider the following:
Converting out of a Limited Partnership
Limited partnerships were not subject to tax under the franchise tax. However, they are taxable under the Margin Tax. A business organized as a limited partnership to avoid the franchise tax should consider converting into a limited liability company or other corporate form to avoid the unnecessary complexity and costs of maintaining a partnership structure.
As a general rule, the legal instruments necessary to effect a conversion are not complex. However, because a conversion is viewed as a liquidation of the existing business entity and the creation of a successor entity, the business owner should evaluate and address several business issues before conversion. These include, but are not limited to, (1) the effect of the conversion on licenses and permits, (2) the impact on change of control restrictions in contracts and restrictive covenants in loan agreements, and (3) issues relating to insurance and property transfers.
A business owner also should evaluate the anticipated Federal income tax consequences resulting from the conversion. While most conversions can be accomplished without triggering Federal tax, the unique characteristics of a business may cause an otherwise tax-free conversion to be viewed by the IRS as a taxable transaction.
Become a General Partnership
General partnerships owned directly by individuals are not subject to the Margin Tax. As such, closely-held businesses should consider the possibility of converting to a general partnership. In addition to the same business considerations with respect to converting out of a limited partnership (discussed above), a conversion into a general partnership results in a business foregoing its state law liability protection. The business should evaluate the availability of liability insurance to protect its owners from third-party claims.
Determine the Method Expected to be used to Calculate the Margin Tax
Every business should examine its cost of goods sold (COGS), the amount of compensation and benefits it pays to employees, and its total gross revenues to determine which alternative the business will be using to compute its tax liability under the Margin Tax. This determination is made annually. In other words, the business is not locked into one method because it used that method in a previous tax year.
Depending on the method chosen, planning opportunities may be available. For example, a hotel owner that leases out restaurant space to a third party may be able to pass utility and other costs on to the lessee through a “triple net” lease in exchange for lower gross rents. By reducing its rent receipts, the hotel owner reduces its total revenue amount calculated for purposes of the Margin Tax and ultimately, its tax liability.
The Margin Tax is a new and important law. The Texas legislature is considering technical corrections and other changes to the Margin Tax which may become law in the current legislative session. Further, the Comptroller’s office is in the process of drafting administrative guidance interpreting the Margin Tax for the benefit of both taxpayers and the State’s tax collectors. These government activities may help identify new opportunities for businesses to minimize their Margin Tax liability.