The Texas Franchise (Margin) Tax: Did it bite you?
Have concerns over the amount of franchise tax your business paid this year? Worried that this system is only going to get more expensive in the future? Then this article is for you. There may be ways you can reduce your franchise tax bill in future years.
Prior to 2007, the Texas Franchise Tax was practically a voluntary tax. Anyone who could figure out how to run their business as a limited partnership (and did so) was exempt from the tax. Rumors persist that this exemption was drafted into the code at the lobbying behest of the Bass family, who allegedly owned about half of downtown Fort Worth in limited partnerships. And so, over the years I helped many clients move business operations into limited partnerships to avoid this tax.
But effective in 2007, as a means to solve the unconstitutionality of the state’s method of funding public education (think Robin Hood), the Legislature radically changed the Texas Franchise Tax. They reduced the tax rates, but it now applies to virtually every entity that provides limited liability for its owners, including limited partnerships. Initial returns were due May 15, but this Spring the Comptroller announced it would practically extend the due date to June 16.
We are just beyond that date now, and the Comptroller recently announced that about 133,000 Texas businesses have paid $4.2 billion in franchise tax so far this year. Another 46,000 businesses filed for extensions and will settle up in full either August 15 or November 15. The problem is, the financial gurus projected this new tax scheme would generate $5.9 billion this year (so collections are about 2/3rds of this amount so far), and some politicians are now scared it won’t raise enough money. If Texas hits $5.9 billion, it will have collected nearly double what the old franchise tax system generated. Think about that for a minute. The Texas business income tax is expected to double its revenue in one year. Led by a Texas Aggie Republican Governor who used to be a Democrat not that long ago. Ouch! But I digress.
Others point out that the bill for property tax reduction just for 2007 is $6.75 billion, and so in their eyes the “new and improved” franchise tax must generate at least that much in 2008 just to break even. So what happens if the franchise tax formula doesn’t raise enough money to meet the budget, or what happens if the politicians decide they’ve found a new honey pot here and want to raise the rates? The tax burden increases.
To increase a business’s bottom line in this economy, it may be more important to cut costs than to try to generate more revenue. So how can one reduce franchise (margin) tax liability? By understanding how the new system works and changing to take what it gives.
The new system characterizes the type of income businesses earn. Some income is “qualified passive entity income” (QPIE). This QPIE can be exempt from franchise tax IF it is directed through a limited partnership and it makes up at least 90% of the partnership’s income in each year. All other types of income are subject to the tax. Many business owners may have entities that receive both QPIE and non-QPIE income, and so they are now volunteering to pay the tax on this QPIE. Is this you?
The new system also changes the way some businesses should operate, if possible, in order to reduce franchise taxes. These are much more difficult to identify. But take one example. A business that is a services-based business, one that doesn’t produce a “good,” can deduct from its taxable income the amounts it pays to its emploees (W-2 wages), but cannot deduct from its taxable income amounts paid to independent contractors (Form 1099). These businesses are generally hammered by the new franchise tax if they use mostly independent contractors and few employees. One way to solve this problem while still not hiring the individuals directly is to work with an outsourced human resources company. Let them hire the people and pass the deduction on to the business.
The professional community (myself included) has identified 15 specific non-operational strategies, generally available to businesses operating in Texas, to reduce or eliminate this new form of franchise tax liability. Contact us today to see if we can use any of them to help you.
For some businesses, the best that can be done is to replace a limited partnership that has an entity general partner (like an LLC or corporation), which was formerly exempt from franchise tax but provides no benefit now, with a single level entity like a limited liability company (from 2 entities to 1). At least in these instances annual maintenance expenses may be cut (bank accounts, financial statements, tax returns, annual meeting minutes, and such). There is more than one way to accomplish this (at least 3, actually), and the best method will depend on the details of the particular business operation.
Finally, I am working with a local group to collect data from Texas business taxpayers in order to identify inequities in the new franchise tax system. If you paid a significantly larger franchise tax in 2007 as compared to 2006, I would greatly appreciate hearing the details from you. Please Email me directly at mark@mctexlaw.com.
As you can see, no one has to take this new tax scheme lying down. There are options. Please give us a call (972-381-9800) if you are interested in figuring out which options are available to, and right for, you.
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McTexLaw Email Newsletters are original writings of Mark McPherson, principal attorney of the firm.
© 2008, J. Mark McPherson. All rights reserved.
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