Margin of Error: Fixing the Texas Franchise Tax after Allcat

by Jimmy Martens of Martens, Todd & Leonard

© 2012 Martens, Todd & Leonard



            Texas’s revised franchise tax (a/k/a the “margin tax”) has been the target of extensive criticism by many businesses since Texas adopted it in 2006.  They chide it as unfair and unnecessarily complicated.  The unfairness and complexity arose, in large part, because its drafters were compelled to navigate around a Texas constitutional provision that barred a net income tax on person’s share of partnership and unincorporated association income without voter approval.  Until recently, many Texas legislators believed this prohibition would prevent them from enacting a more equitable tax.  However, the Texas Supreme Court’s recent decision in In re  Allcat Claims Service, L.P. (“Allcat”)[1] found that the tax does not violate this prohibition because Texas imposes it on business entities instead of persons, which opens the door for much-needed legislative reform.

This article explores the margin tax’s flaws and offers suggestions for fixing them in the wake of the Allcat decision.  The first section describes the tax and its origins.  The second discusses some major complaints about the tax, with a focus on issues currently under litigation.  Lastly, we provide suggestions for reforming the tax, either by replacing it entirely or by changing its structure.

I.                   Background

a.      Margin Tax Origin

In late 2005, Texas found itself in financial peril.  In Neely v. West Orange-Cove Consol. Independent School Dist.,[2] the Texas Supreme Court declared Texas’s system for funding its public schools unconstitutional, based in part on its over-reliance on local property taxes.  It gave the Legislature a deadline of June 1, 2006 to find a solution.  Texas lawmakers scrambled to find new sources of revenue.  Ultimately, Governor Rick Perry appointed a 24-member Texas Tax Reform Commission to find an answer.[3]

Initially, the Commission considered expanding the existing Texas franchise tax to other business entity forms, including partnerships.  At that time, Texas imposed its franchise tax only on corporations and limited liability companies (“LLCs”).  The primary base for the tax was federal net taxable income adjusted for a few state law items.  But, a potential obstacle stood in the Commission’s way:  Article VIII, § 24 of the Texas Constitution prohibited a tax on “the net incomes of natural persons, including a person’s share of partnership or unincorporated association income” without voter approval.  Many believed that expanding the existing corporate franchise tax would violate this constitutional bar.[4]

Ultimately, the Commission proposed a brand new type of tax; one which was arguably not a net income tax.  It proposed imposing a new type of franchise tax on partnerships and other previously-untaxed entities -- one that included all revenues, but did not allow deductions for most business expense categories.  In doing so, it sought to create a tax more akin to a gross receipts tax rather than a net income tax. 

The Legislature hurriedly pushed the Commission’s proposed tax through the House and Senate in a two-and-a-half week special session.  The Governor signed the bill into law on May 19, 2006, shortly before the Texas Supreme Court’s deadline, and the Texas margin tax was thus born.

b.      Margin tax calculation

The tax base combines aspects of a gross receipts base and a net income base.  To compute its taxable margin, an entity calculates its “total revenue.”  To do this, the entity first adds together the revenue amounts it reported on various lines of its federal income tax return.[5]  The entity then subtracts various statutorily-defined “revenue exclusions” to determine its reportable revenue.[6] 

Next, the entity then deducts one of the following categories of deductions to determine its taxable margin:

·         Cost of goods sold (“COGS”).  Texas uses its own definition of COGS, which differs significantly from the federal income tax definition.  Under Texas law, COGS includes “all direct costs of acquiring and producing goods,” up to 4% of overhead and administrative costs, and certain other listed costs.[7] With some exceptions, only entities that sell real or tangible personal property may deduct COGS. 

·         Compensation.  Compensation is the sum of the wages and benefits paid to an entity’s officers, directors, owners, partners, and employees.[8]  It does not include amounts paid to independent contractors.

·         30 percent of total revenue.[9]

The tax rate is 1 percent for most entities, except retailers and wholesalers who pay at the rate of ½ percent.[10]  Entities with total revenue of $10 million or less may elect the “E-Z Calculation” and pay tax on .575 of their total revenue.[11] 

c.       The Allcat Decision

            In Allcat, the Texas Supreme Court held that the margin tax did not violate the Texas Constitution’s prohibition of a net income tax.  The Court grounded its holding entirely in the separate entity theory of partnership taxation. It found that a tax directly imposed on a partnership is not the same as a tax on a person’s share of partnership income because a partnership is an entity separate from its partners. As a result, the court held that the state income tax prohibition applies only to taxes directly imposed on people, not business entities.  By extension, the same result should apply to other forms of unincorporated entities.

The Court’s opinion paves the way for the Texas Legislature to amend the margin tax to comport with a more traditional net income calculation, if it chooses to do so. The Legislature may do this because the decision implies that the franchise tax would not violate the Texas Constitution even if it were a net income tax. In the wake of the Allcat decision, Texas lawmakers, including Texas House Speaker Joe Straus, have called upon the Legislature to reform the franchise tax in the next session.[12]

II.                Margin Tax Complaints

a.      Limited Deductibility of Costs

Many businesses complain that they must pay the margin tax even when they lose money.  This is because the margin tax does not permit these businesses to deduct many of their costs of doing business. Further, the deductibility of costs is not uniform among different types of businesses.  Businesses that produce “goods” may deduct most of their costs while others, such as service providers, transportation companies, and rental businesses, often have little or no deductions.  The margin tax even treats most reimbursed costs as revenue.

To compound this disparity, the margin tax provides special deductions only to certain industries.  These include real property construction companies, same day courier and logistics companies, concert promoters, and management companies.  Some taxpayers complain that the limited nature of these deductions gives unfair tax advantages to certain businesses while not offering the same preferences to substantially similar businesses.  The Comptroller’s strict interpretation of these provisions, which sometimes appears contrary to the statutory language, increases this inequity.

The Comptroller’s interpretation of the revenue exclusion and cost of goods sold deductions for payments to real property subcontractors illustrates this well, and it is the subject of several cases pending in the Texas courts. 

Revenue Exclusion for Real Estate Contractors

The statute provides a revenue exclusion for certain “flow-through funds that are mandated by contract to be distributed to other entities,” including:

subcontracting payments handled by the taxable entity to provide services, labor, or materials in connection with the actual or proposed design, construction, remodeling, or repair of improvements on real property or the location of the boundaries of real property.[13]

 

COGS for Real Estate Contractors

The margin tax also provides a similar cost of goods sold deduction.  It states that:

a taxable entity furnishing labor or materials to a project for the construction, improvement, remodeling, repair, or industrial maintenance . . . of real property is considered to be the owner of that labor and materials and may include the costs, as allowed by this section, in the computation of cost of goods sold.

The Comptroller generally limits the revenue exclusion to payments to subcontractors performing construction work or designing improvements to real property. The Comptroller limits the cost of goods sold provision further. According the Comptroller, the provision applies only when the entity furnishing the labor or materials physically works on the property and makes a physical change to that property.[14]  The statutory language and legislative intent may not support the Comptroller’s limited interpretation of these provisions. Neither statutory provision expressly includes the limitations the Comptroller imposes. In fact, the language of both provisions appears fairly broad in scope.

Several pending cases allege that the Comptroller improperly denied real property construction businesses the revenue exclusion and the cost of goods sold deduction for payments for labor provided to construction projects.  These taxpayers include insurance claims adjusters, workers that transport waste and materials to and from oil and gas well sites, and aggregate haulers.[15]  These suits also allege that denying deductions for these costs while allowing them to other similarly-situated taxpayers violates the Texas Constitution’s equal and uniform taxation requirement.[16]

b.      No Compensation Deduction for Independent Contractors

Service industry businesses complain that the margin tax’s compensation deduction does not include independent contractor costs.[17]  This means that businesses in the same industry may have widely divergent tax bills simply because they choose to use contract labor instead of hiring employees.  This may also violate the Texas Constitution’s equal and uniform taxation requirement.[18] This aspect of the margin tax places a particular burden on industries such as transportation which have historically relied on contract labor. 

Proponents of the margin tax say that disallowing deductions for independent contractors is a policy choice designed to encourage businesses to directly hire employees and provide them health insurance and other benefits.[19]  However, the cost of goods sold deduction includes the cost of all labor, whether performed by employees or independent contractors.[20]  Thus, it is unclear why the margin tax would contain no parallel employee-hiring incentive in the COGS calculation. 

c.       Cost of Goods Sold Issues

The margin tax’s unusual definition of cost of goods sold creates confusion and disparity among industries.  Much of the confusion results from the margin tax’s redefinition of the familiar federal income tax term “cost of goods sold.” This difference increases compliance costs by forcing taxpayers to keep two sets of books using different definitions of the identical term “cost of goods sold.”  Further, taxpayers complain that Texas’s definition is vague and little guidance exists interpreting it.[21] The Comptroller’s narrow interpretation of the statutory definition further complicates the issue. 

The Comptroller’s Business Tax Advisory Committee, a committee appointed by the Comptroller to analyze the effect of the margin tax, suggests that additional clarification on this and other issues will come to taxpayers through “audits, hearings, and court cases,” and that Texas will have a suitably developed body of case law “within two decades.”[22]  On the other hand, a large body of case law and administrative guidance already exists that defines “cost of goods sold” for federal income tax purposes. 

Proponents of the margin tax argue that Texas’s definition of cost of goods sold benefits many taxpayers by allowing more costs than those allowed for federal purposes.[23]  This may be true for some industries, such as oil and gas, but Texas’s definition limits taxpayers in other industries, such as telecommunications and transportation, to substantially fewer deductions.[24]

d.      Election Issues

Once a taxpayer files a margin tax report under one of the four tax bases, the Comptroller says it may not later amend to choose a different tax base.[25]  This may conflict with the underlying statute, which requires taxpayers who choose the COGS or compensation method to notify the Comptroller of their election by the due date of their annual report, but places no express restriction on a taxpayer’s ability to change their election by filing an amended report.

The Comptroller’s election change policy penalizes taxpayers for the margin tax’s confusing nature.  A recent Comptroller hearing decision illustrates this.[26]  An oilfield service company believed, based on guidance from Thomson Reuters’ Texas Franchise Tax Deskbook, that it was not eligible to deduct COGS.  After the company filed its annual report, the Comptroller posted an FAQ on her web site stating that oilfield service companies could deduct COGS.  Deducting COGS would have resulted in a substantially lower tax liability for the company.  Despite this, the Comptroller refused to allow the company to amend its report.  The Comptroller has treated other taxpayers similarly in other hearing decisions.[27]

Texas courts may be more willing to allow taxpayers to switch computation methods by filing amended reports.  In the first margin tax case tried in Texas courts, the taxpayer prevailed in proving that it qualified as a temporary employment service, rather than as a professional engineering firm as alleged by the Comptroller.  In her order, the trial judge ruled that the taxpayer could claim the compensation deduction for the wages and benefits of the unassigned workers.  The taxpayer previously claimed the COGS deduction.[28] Another pending case concerns whether a taxpayer who initially files using the E-Z Calculation may elect the cost of goods sold deduction.[29]

e.       Tax Rate Issues

Some businesses take issue with the margin tax’s differing rates for different industries.  Most businesses pay at the rate of 1 percent, but retailers and wholesalers pay at the rate of ½ percent.[30] The stated reason for the lower rate is that retailers and wholesalers already operate on low margins.[31] But does this justification really make sense?  These taxpayers typically have a higher cost of goods sold than others, which already minimizes the amount of tax they owe relative to other industries.  Therefore, it is unclear why retailers and wholesalers receive a lower tax rate while businesses with higher margins due to limited or no statutory deductions would pay tax at the full rate.  Pending cases allege that imposing disparate rates among industries may also violate the Texas Constitution’s equal and uniform taxation requirement.[32]

Generally, the margin tax allows a business to use the ½ percent rate if “the total revenue from its activities in retail or wholesale trade is greater than the total revenue from its activities in trades other than the retail or wholesale trades.”[33]  It defines these as activities described in Division F and Division G or the 1987 Standard Industrial Classification Manual (“SIC”).[34]  However, instead of considering all of a business’s different revenue producing activities, the Comptroller typically looks for an SIC code description of a business in order to disqualify the business from the lower rate.  As a result, the Comptroller has prevented businesses that provide services but also sell significant amounts of items at retail, such as nurseries and auto parts/repair shops, from taking the reduced rate.[35]   A pending case challenges the Comptroller’s denial of the reduced rate to an auto body shop.[36]

III.             Fixing the Margin Tax

a.       Replacing It Altogether

The Allcat decision opens the door for the Legislature to replace the margin tax with a net income tax on business entities.  It could greatly simplify the tax base by “piggybacking” off of the IRS form that calculates federal net income.   Doing so would largely eliminate the problems and inequities discussed above.  Most unprofitable businesses would not then have to pay the tax, and the availability of deductions would be fairly uniform among different industries.  The tax would treat employee and independent contractor labor equally.    Moreover, incorporating the federal income tax laws would also reduce compliance costs and provide a body of authoritative guidance to resolve substantive tax issues. 

The relative fairness of net income taxes and ease of compliance compared with other types of business taxes makes them by far the most popular type of business tax in the United States.  Of the 47 states that tax businesses, 42 have net income taxes, while 5 have gross receipts taxes or modified gross receipts taxes similar to the margin tax.[37]  Since 2006, three states -- Michigan, Kentucky, and New Jersey -- have repealed gross receipts or modified gross receipts taxes and replaced them with income taxes.[38]   

The simplest way for Texas to adopt a business net income tax would be to reinstate the prior earned surplus tax and expand it to entities other than corporations and LLCs.  This would allow Texas to rely on a previously-established body of law and administrative policy.  This may also allow Texas to avoid the political baggage associated with imposing a brand new “income tax.”

Critics of business income taxes complain that revenue from these taxes varies greatly depending on economic conditions.  The Texas Tax Reform Commission provided this justification for choosing the margin tax over a net income tax.[39]  When businesses are less profitable, states inevitably receive less revenue from business income taxes.  The margin tax makes many unprofitable businesses pay the tax even when they suffer losses.  We question whether the inequities created by the margin tax’s structure are overcome by the need for steady revenues, especially as Texas businesses fail in the current economic depression.

b.      Reforming It Instead             

Replacing the margin tax entirely is likely the most complete and efficient way to remedy its issues.  However, if the Texas Legislature chooses to keep the existing tax structure, the following reforms may increase fairness and reduce confusion and compliance costs:

1.      Exemption for Unprofitable Businesses

The Legislature may choose to exempt unprofitable businesses from the margin tax.  The simplest way to do this would be to exempt businesses that report a loss for federal income tax purposes from paying the tax.  Such an exemption would eliminate the burden on unprofitable businesses, but would not address the structural problems and inequities in the tax.

The Texas House Ways & Means Committee considered this option in its Interim Report to the 82nd Legislature.  However, it expressed concern that adding this exemption would transform the tax into a net income tax, which would violate the Bullock Amendment.  The Allcat decision minimizes this concern.

2.      Include Independent Contractor Costs in the Compensation Deduction

Allowing businesses to include independent contractor costs in the Compensation deduction would minimize the disparate treatment among industries.  The policy justification for treating employees and independent contractors differently appears flimsy at best.

3.      Redefine Cost of Goods Sold

The Legislature may incorporate the federal definition of “cost of goods sold” into the margin tax.  This would allow taxpayers to deduct all costs deductible as cost of goods sold for federal purposes.  If the Legislature wishes to add additional deductable costs unavailable under federal law, it should do so explicitly.  Using the federal definition as a baseline would decrease confusion and decrease compliance costs.

At minimum, the Legislature should remove the 4 percent limitation on overhead costs and eliminate the requirement that entities own the goods they sell to deduct cost of goods sold.  The 4 percent limitation prohibits the deduction of many significant business costs.  It also creates reporting issues because taxpayers must make illusory distinctions between direct and overhead costs.  The Comptroller’s strict interpretation of the provision complicates matters further.  For example, the Comptroller’s position is that supervisory construction labor is an indirect cost.[40] Moreover, removing the requirement that entities own the goods they sell would eliminate disparities between the rental industry and other industries.    

4.      Tax Rate Changes

The Legislature may eliminate the special reduced tax rate for retailers and wholesalers.  This reduction is not justified considering the high amount of deductions already available to retailers and wholesalers.  Instead, the Legislature may consider a reduced tax rate for businesses with high taxable margin as compared to total revenue.  For example, taxpayers who must take the 30% deduction could receive a reduced rate.  The Legislature may also consider imposing a graduated rate system, with higher rates for taxpayers with higher taxable margin.  A graduated rate system imposes tax based upon the ability to pay, which is one hallmark of a fair tax base.

5.      Clarify that Taxpayers May File Amended Reports to Switch Calculation Methods

Clarifying that taxpayers may file amended reports to switch calculation methods would ease the burden on taxpayers as case law and policy develop to interpret the margin tax laws.  This would ensure that all taxpayers are allowed the full benefit of any deductions legally available to them.  The Comptroller’s current prohibition on switching calculation methods places the burden of the tax’s vagueness and uncertainty on taxpayers.  It also penalizes taxpayers in the event of an adverse IRS audit.  For example, if the IRS, after an audit, disallows a taxpayer’s claimed compensation as excessive, this will in turn reduce the taxpayer’s compensation deduction for the margin tax.  In that instance, it would be appropriate for the taxpayer to switch to COGS.

IV.             Conclusion

Taxpayers have long complained about the margin tax’s confusing nature and general unfairness.  The Allcat decision gives the Texas Legislature the freedom and certainty it needs to fairly reform the margin tax.  While replacing the margin tax with a net income tax would be the best solution, any reforms to make the margin tax base closer to a net income base would benefit taxpayers.  The Texas Legislature should act in the next session to remove inequalities from the margin tax. 



[1] No. 11-0589, 2011 WL 6091134 (Tex. Nov. 28, 2011).  The authors of this article represented Allcat Claims Service, L.P. before the Texas Supreme Court.

[2] 176 S.W.3d 746 (Tex. 2005).

[3] For a list of committee members, see Press Release, Office of the Governor, “Gov. Perry names 24-Member Texas Tax Reform Commission” (Nov. 4, 2005), available at http://governor.state.tx.us/news/appointment/5077.  22 of the members represented the business community.  Over half of the members represented capital-intensive industries.  Only one member, a partner in a “Big Four” accounting firm, represented the service industry.

[4] For example, in 2006, John Sharp, head of the Texas Tax Reform Commission, testified before the Texas House Ways & Means Committee that “We looked at taking the current franchise tax [i.e. the earned surplus method] and extending it to partnerships.  We came to the conclusion that it wouldn’t work because it would be a violation of the Bullock Amendment and because when you extend a net income tax which is pretty much what the current franchise tax is, to partnerships, it would wind up being in violation of the Bullock Amendment and most likely a personal income tax.”  Hearing on Tex. H.B. 3 Before the House Ways & Means Comm., 79th Leg., 3rd Sp. Sess. (Apr. 10, 2006).

[5] These amounts include gross receipts from a trade or business, dividends, interest, rents and royalties, capital gains, and other income.  Texas Tax Code § 171.1011(c)(2)(A). 

[6] These include, among others, bad debts, sales commissions, the cost of securities sold, amounts paid to real property subcontractors, the cost of providing indigent care, and co-counsel payments to other attorneys.  Texas Tax Code § 171.1011(c)(2)(B) & (e)-(r).

[7] Texas Tax Code § 171.1012.

[8] Texas Tax Code § 171.1013.

[9] Texas Tax Code § 171.101(a)(1)(A).

[10] Texas Tax Code § 171.002.

[11] Texas Tax Code § 171.1016.

[12] See, e.g., Zahira Torres, Texas House Speaker Joe Straus: We Have To Correct the Deficit, El Paso Times, October 28, 2011; Laylan Copelin, Margins Tax, Economic Development at Top of List for Legislature's Business-Focused Agenda, Austin American-Statesman, November 5, 2011; April Castro, Texas Lawmakers Push for Tax Reform in 2013, The Associated Press, November 8, 2011.

[13] Texas Tax Code § 171.1011(g)(3).  The Comptroller interprets this section to require that the general contractor’s agreement with the owner state that the general contractor will subcontract out a specific portion of the work.  The Comptroller states that a general statement that some of the work may be subcontracted out is insufficient.  Comptroller Letter No. 201008001L, “Franchise Tax and the Construction Industry.”  It is unclear whether the statutory language and legislative intent support such a limited scope.

[14] Comptroller Letter No. 201008001L, “Franchise Tax and the Construction Industry.”

[15] These cases are all currently pending in the district court of Travis County, Texas.  They are Allcat Claims Service, L.P. v. Combs, No. D-1-GN-11-002294 (insurance claims adjusters); Newpark Resources, Inc. v. Combs, No. D-1-GN-11-002866 (transportation of waste and materials to and from oil and gas well sites, set for trial May 21, 2012); P.E.K., Inc. d/b/a Serviceline Transport v. Combs,  No.  D-1-GN-11-003539 (aggregate retailer/hauler, set for trial April 9, 2012); and  Titan Transportation, L.P. v. Combs, No. D-1-GN-11-002866 (aggregate haulers, set for trial July 16, 2012).  Martens, Todd & Leonard, the law firm of the authors of this article, represents the plaintiffs in these cases.

[16] The Texas Supreme Court recently dismissed for lack of jurisdiction a suit that alleged that other disparities in available deductions among different industries violate the Texas Constitution’s equal and uniform taxation requirements.  In re Nestle USA, Inc., et al., No. 11-0855 (Tex. Feb. 10, 2012) (“Nestle”).  The Texas Supreme Court found that it lacked jurisdiction over the suit because the taxpayers failed to pay the tax under protest or request a refund from the Texas Comptroller before filing suit, as the Texas statutes governing taxpayer suits require.

[17] See Texas Tax Code § 171.1013.

[18] The Nestle case alleged this, among other claims.  See note 16, supra.

[19] Texas Tax Reform Commission, Tax Fairness: Property Tax Relief for All Texans, at 19; Texas Taxpayers and Research Association, Understanding the Texas Franchise – or “Margin” – Tax, at 7.

[20] Texas Tax Code § 171.1012.

[21] Texas Taxpayers and Research Association, Understanding the Texas Franchise – or “Margin” – Tax, at 4.

[22] Texas Comptroller of Public Accounts, Business Tax Advisory Committee, Report to the 82nd Texas Legislature, at 18.

[23] Texas Comptroller of Public Accounts, Business Tax Advisory Committee, Report to the 82nd Texas Legislature, at 16.

[24] Texas House Ways and Means Committee, Interim Report to the 82nd Legislature, at 6.

[25] The Comptroller’s rules allow taxpayers to file amended reports to switch to the 30% deduction or to the E-Z Calculation from any other method.  However, the Comptroller’s rules do not allow taxpayers to file amended reports to switch to COGS or compensation from any other method.  34 Tex. Admin. Code § 3.584(f)(1).

[26] Comptroller Hearing No. 103,167 (2011).

[27] See, e.g., Comptroller Hearing No. 103,450 (2010); Comptroller Hearing No. 103,083 (2010); Comptroller Hearing No. 104,076 (2011).

[28] Taylor & Hill, Inc. v. Combs, No. D-1-GN-10-004429, 53rd District Court, Travis County, Texas (July 7, 2011).  Jimmy Martens and Lacy Leonard with Martens, Todd & Leonard represented the plaintiff.

[29] Bigham Bros., Inc. v. Combs, No. D-1-GN-11-002206, Travis County District Court (set for jury trial August 20, 2012).  Martens, Todd & Leonard represents the plaintiff.

[30] Texas Tax Code § 171.002.

[31] Texas Tax Reform Commission, Tax Fairness: Property Tax Relief for All Texans, at 19.

[32] These cases include Rent-A-Center, Inc. v. Combs, No. D-1-GN-11-001059 (Travis County District Court), and Service King Paint & Body, LLC successor to Alamo Body & Paint, Inc. v. Combs, No. D-1-GN-11-003039 (Travis County District Court) (Martens, Todd & Leonard represents the plaintiff).  The Nestle case also alleged this. See note 16, supra.

[33] Texas Tax Code § 171.002(c).

[34] Texas Tax Code § 171.0001(12) and (18).  Effective January 1, 2012, the definition also includes certain apparel rental activities.

[35] See, e.g., Comptroller Hearing No. 103,786 (2011); Comptroller Hearing No. 104,092 (2011).

[36] Service King Paint & Body, LLC successor to Alamo Body & Paint, Inc. v. Combs, No. D-1-GN-11-003039 (Travis County District Court).  Martens, Todd & Leonard represents the plaintiff.

[37] Mark Robyn, “2012 State Business Tax Climate Index” Tax Foundation Background Paper (January 2012).

[38] Id.

[39] Texas Tax Reform Commission, Tax Fairness: Property Tax Relief for All Texans, at 19.

[40] Comptroller Letter No. 201108182L (Aug. 30, 2011).