CHECK THE MATH ON THE TEXAS MARGINS KAREY W. BARTON PRINCIPAL RYAN, INC.

Transcription

1 CHECK THE MATH ON THE TEXAS MARGINS KAREY W. BARTON PRINCIPAL RYAN, INC.

2 TEXAS MARGIN TAX A. Margin Tax Basics 1. Overview The margin tax applies to all entities that enjoy the privilege of liability protection, meaning that in addition to applying to corporations and LLCs; limited partnerships, limited liability partnerships, professional associations and business trusts are also included in the tax. General Partnerships that are solely owned by individuals and Sole Proprietorships are not subject to the new tax. Under the old Franchise Tax, taxable entities paid the taxed based on the higher of.25 percent of the entity s capital (net worth) or 4.5 percent of the entity s earned surplus (net income plus officer compensation). These tax bases are replaced in the revised franchise tax with a margin tax base and the tax rate is set at one percent except for entities that qualify as retailers or wholesalers that are subject to a half percent rate. A business tax liability under the margin tax is calculated as the lesser of 70 percent of total revenue OR total revenue minus either cost of goods sold or compensation; this is multiplied by the apportionment factor (Texas sales or receipts/sales or receipts from everywhere) and then multiplied by the appropriate tax rate. Alternatively, a business with $10 million or less in total revenue may choose to calculate its tax liability using the E-Z computation and.575 percent tax rate. The margin tax maintains the privilege period concept where the entity pays for the privilege of doing business in the state during the calendar year when the tax is paid. The tax due is based on the business activity that occurred in the entity s accounting period that ended in the preceding calendar year. For example, an entity whose accounting period (i.e. fiscal year) ended on December 31st would pay for the privilege of doing business in the state during calendar year 2007 on May 15, 2007 and the tax due would be based on its business activity done during calendar year The first time that a business would have to pay the margin tax would be May 15, 2008 and that tax would be calculated based on its business activity during Additional Tax or Exit Tax The margin tax retains the Additional Tax or as it is commonly referred to the Exit Tax. The Exit Tax was added to the old franchise tax in 1991 when the earned surplus component of the tax was added. The Exit Tax was imposed by the Texas Legislature to ensure that all of the business activity of a corporation ceasing to do business in the State of Texas was taxed.

3 When one remembers the somewhat prospective nature of the franchise tax, it becomes apparent why the Legislature may have considered the Exit Tax necessary. As previously explained, a taxpayer reports and pays its franchise tax on May 15th for the privilege of doing business in that calendar year, and the tax is based on its accounting period from the previous year. The purpose of the Exit Tax is to ensure that the business activity that occurred after the end of the taxpayer s last accounting period that was used to calculate its most recent franchise tax report to the date of its ceasing to do business in the state is taxed. The Exit Tax is imposed at the appropriate tax rate (1% or ½%) of the taxable entity s taxable margin for the period beginning on the day after the last day for which the franchise tax has already been paid and ending on the day the taxpayer exits or ceases to do business in Texas. For purposes of the Exit Tax, a taxable entity s taxable margin is determined in the same manner as taxable margin is calculated for the margin tax. The tax and final report of the taxable entity ceasing to do business in the state are due 60 days after the last day the entity did business in Texas. The Exit Tax is not imposed on a taxable entity that becomes no longer subject to the margin tax because it qualifies as a passive entity. Texas Tax Code (eff. 1/1/08). B. Taxpayers 1. Included Entities The margin tax has been characterized as a tax applying to all entities that enjoy the privilege of limited liability under state law. The statute, however, does not define taxable entities in this manner. Rule defines a taxable entity as a: Partnership, both general and limited General partnership is defined as a partnership described in Revised Partnership Act, Article 6132b-1.01 et.seq., or Business Organizations Code, Title 4, Chapter 152, or an equivalent statute in another jurisdiction. Limited partnership is defined as a partnership formed pursuant to Revised Partnership Act, Article 6132a-1 or Business Organizations Code, Title 4 Chapter 153, or an equivalent statute in another jurisdiction. Limited Liability Partnership Limited liability partnership is defined as a partnership registered pursuant to Revised Partnership Act, Article 6132b-3.08, or Business Organizations Code, Title 4, Chapters 152 and 153, Subchapter H, or an equivalent statute in another jurisdiction.

4 Corporation A corporation is defined as an entity formed pursuant to Business Corporation Act, Non-Profit Corporation Act, Professional Corporation Act, or Business Organizations Code, Title 2 or 7, or other equivalent statute of this state or of another jurisdiction. Banking Corporation Banking corporation is defined as each state, national, domestic, or foreign bank, whether organized under the laws of this state, another state, or another country, or under federal law, including a limited banking association organized under Finance Code, Title 3, Subtitle A, and each bank organized under 25(a), Federal Reserve Act (12 U.S.C ) (edge corporations), but does not include a bank holding company as that term is defined by Bank Holding Company Act of 1956, 2,(12 U.S.C. 1841). Savings and Loan Association Savings and loan association is defined as a savings and loan association or savings bank, whether organized under the laws of this state, another state, or another country, or under federal law. Limited Liability Company Limited liability company is defined as an entity formed pursuant to Limited Liability Company Act, Article 1528n, or Business Organizations Code, Title 3 or 7, or an equivalent statute in another jurisdiction. Business Trust A business trust is an entity defined by Internal Revenue code, Treasury Regulation, (b). Professional Association Professional association is defined as an entity organized under Professional Association Act, Article 1528e, or Business Organizations Code, Title 7, Chapter 302, or an equivalent statute in another jurisdiction. Business Association

5 Joint Venture Joint venture is defined as a partnership engaged in the joint prosecution of a particular transaction for mutual profit. A joint venture does not include a joint operating or co-ownership arrangement meeting the requirements of Treasury Regulation (a)(3) that elects out of partnership treatment for federal income tax purposes under Section 761(a), Internal Revenue Code. Joint Stock Company A joint stock company is defined as a common-law unincorporated business enterprise of natural persons possessing common capital with ownerships interests represented by shares of stock. Holding Company A holding company is defined as an entity that confines its activities to owning stock in, and supervising management of, other companies. Other Legal Entity 34 TAC Margin: Taxable and Taxable Entities The statute also specifically states that a combined group (combined group is explained later in the materials) is considered a taxable entity. The statute further clarifies that a joint venture does not include a joint operating or co-ownership arrangement meeting the requirements of Treasury Regulation (a)(3) that elects out of partnership treatment for federal income tax purposes under Section 761(a), Internal Revenue code. Texas Tax Code (a) (eff. 1/1/08). A taxable entity is also defined to include an entity that can file as a sole proprietorship for federal income tax (i.e. limited liability company) if that entity is not a sole proprietorship and the entity is formed in a manner under state law that limits the liability of the entity. Texas Tax Code (d) (eff. 1/1/08). 2. Excluded Entities The following entities are either eligible to pay no tax or reduced tax or specifically defined as not taxable entities or exempt from the margin tax: a. Sole Proprietorships Observation: Rule 3.581, concerning Margin: Taxable and Nontaxable Entities, a sole proprietorship is defined as a natural

6 person carrying on business, if the business is not formed in a manner that limits the liability of the owner. It does not include single member limited liability companies or other entities treated a sole proprietorships for federal income tax purposes. 34 TAC 3.581(b)(23) and (d)(1) and Texas Tax Code (b)(1) (eff. 1/1/08). b. General Partnerships owned directly and entirely by natural persons and the liability of which is not limited by Texas or another state s law, including by registration as a limited liability partnership Observation: The partnership is either in or out as a taxable entity. If the partnership is directly and solely owned by individuals, it is not considered a taxable entity. However, if just one of the partners is not an individual or natural person the partnership is a taxable entity. In this instance, the partnership s tax liability is calculated based on the entire business activity of the partnership not just on the share of the partnership owned by the non-natural person. In Rule 3.581, a natural person is defined as a human being or the estate of a human being. The term does not include a purely legal entity given recognition as the possessor of rights, privileges and responsibilities, such as a corporation, limited liability company, partnership or trust. 34 TAC 3.581(b)(5), (6), & (23) and (d)(2) and Texas Tax Code (b)( 2) (eff. 1/1/08). c. Small Business Exemptions/Tax Discounts (1) Entities with $300,000 or less in total revenue The current franchise tax contains a small business exemption for taxpayers whose gross receipts are less than $150,000. Under the margin tax, the exemption is changed to exempt a taxable entity with $300,000 or less in total revenue from its entire business. Observation: The $300,000 cap is not based on the total revenue for each of the individual members of the combined group rather on the sum of the total revenue for all of the members of the combined group. Therefore, to qualify for this exemption, a combined group s total revenue would have to be $300,000 or less.

7 Observation: The $300,000 cap is indexed to inflation and beginning in 2010 will be adjusted biennially and rounded to the nearest $10,000. (2) Tax Liability Discounts for Small Businesses The Legislature during the 2007 Regular Session added several provisions to ease the impact of the margin tax on small businesses. One of the provisions was a scaled tax discount schedule ranging from an 80 percent to 20 percent discount. The appropriate discount is determined by the taxable entity s level of total revenue and applied against its calculated tax liability. The discount schedule is: 80% discount for taxable entities with more than $300,000 but less than $400,000 in total revenue 60% discount for taxable entities with $400,000 or more but less than $500,000 in total revenue 40% discount for taxable entities with $500,000 or more but less than $700,000 in total revenue 20% discount for taxable entities with $700,000 or more but less than $900,000 in total revenue. (3) Taxable entities that owe less than $1,000 in tax Under the current law if a taxpayer owes less than $100, the taxpayer is not considered to owe any tax. Under the margin tax this threshold is increased to $1,000. Therefore, a taxpayer that determines that its margin tax liability is less than $1,000 will not have to pay any tax. Observation: A taxable entity must file an information report even if no tax is due. 34 TAC 3.584(d)(3) & (4) and Texas Tax Code (d), and (eff. 1/1/08). d. Passive Entities, as determined on an annual basis To qualify as a passive entity, an entity must meet the following criteria: The entity must be a general or limited partnership or a non-business trust;

8 At least 90 percent of the entity s gross federal income during the period on which its margin is based must be passive income as described below; and The entity can not receive more than 10 percent of its gross federal income from conducting an active trade or business. Rule concerning margin: passive entities identifies the following categories of income as the only income that qualifies as passive income : Dividends, interest, foreign currency exchange gain, notional contract payments, option premiums, cash settlement or termination payments for a financial instrument, and income from a limited liability company; Distributive shares of partnership income if the share is greater than zero; Net capital gains from the sale of real property, net gains from the sales of commodities traded on a commodities exchange, and net gains from the sale of securities; and Royalties from mineral properties, bonuses from mineral properties, delay rental income from mineral properties and income from other nonoperating mineral interests. Rule defines security to include: An instrument defined by Internal Revenue Code, 475(c)(2), where the holder of the instrument has a noncontrolling interest in the issuer/investee; An instrument described by Internal Revenue Code, 475(e)(2)(B), (C), (D); An interest in a partnership where the investor has a noncontrolling interest in the investee; And interest in a limited liability company where the investor has a non-controlling interest in the investee; or A beneficial interest in a trust where the investor has a noncontrolling interest in the investee. Observation: Non-controlling interest, for purposes of passive entity determination only, as a less than 50 percent interest that is

9 held by an investor, either directly or indirectly, in an investee. [Rule (b)(8)] Observation: Rental income is not considered passive income for purposes of the margin tax. Rule defines an active trade or business for purposes of the passive entity exemption only as follows: an entity conducts an active trade or business if the activities include active operations that form a part of the process of earning income or profit, and the entity performs active management and operational functions; Activities performed by the entity include activities performed by persons outside the entity, including independent contractors, to the extent that the persons perform services on behalf of the entity and those services constitute all or part of the entity s trade or business; or An entity conducts and active trade or business if assets, including royalties, patents, trademarks, and other intangible assets, held by the entity are used in the active trade or business of one or more related entities. 34 TAC and Texas Tax Code and (eff. 1/1/08). e. Grantor Trusts To qualify, the grantor trust must meet the requirements set out in Sections 671 and 7701(a)(30)(E) of the Internal Revenue Code and all the grantors and beneficiaries must be natural persons or charitable organizations that qualify as 501(c)(3), IRC organizations. Observation: A trust that is taxable as a business entity based on Treasury Regulation Section (b) does not qualify for this exclusion from the margin tax. 34 TAC 3.581(b)(7) and (d)(5) and Texas Tax Code (c)(1) (eff. 1/1/08). f. Estates To qualify, the estate must be an estate of a natural person and meet the requirements of Section 7701(a)(30)(D) of the Internal Revenue Code.

10 Observation: An estate taxable as a business trust based on Treasury Regulation Section (b) does not qualify for this exclusion from the margin tax. 34 TAC 3.581(b)(5) and Texas Tax Code (c)(2) (eff. 1/1/08). g. Escrows Escrows are defined as legal arrangements whereby an asset is delivered to a third party to be held in trust or otherwise pending a contingency or the fulfillment of a condition or conditions in a contract. 34 TAC 3.581(b)(4) and (d)(7) and Texas Tax Code (c)(3) (eff. 1/1/08). h. Trusts qualified under Internal Revenue Code 401(a) 34 TAC 3.581(b)(11) and Texas Tax Code (c)(7) (eff. 1/1/08). i. Trusts or other entities that are exempt under Internal Revenue Code, 501(c)(9) 34 TAC 3.581(b)(12) and Texas Tax Code (c)(8) (eff. 1/1/08). j. Real Estate Investment Trusts (REITs) REITs and their qualified REIT subsidiaries, as defined by Section 856 of the Internal Revenue Code, are excluded from the tax as long as the REIT holds interests in limited partnerships or other entities that are taxable entities and directly hold real estate and the REIT does not directly hold real estate, other than real estate it occupies for business purposes. Observation: This exclusion for REITs does not extend to an exclusion for the limited partnerships or other entities through which a REIT might hold its real estate investments. 34 TAC 3.581(b)(18) & (19) and (d)(8) and Texas Tax Code (c)(4) (eff. 1/1/08). k. Real Estate Mortgage Investment Conduits (REMICs) REMICs are entities defined by Internal Revenue Code, 860D. 34 TAC 3.581(b)(20) and (d)(9) and Texas Tax Code (c)(5) (eff. 1/1/08).

11 l. Nonprofit Self-insurance trusts A self-insurance trust is defined as a trust created and operated according to the provisions of Insurance Code, Chapter 2212, or a predecessor statute. 34 TAC 3.581(b)(22) and (d)(11) and Texas Tax Code (c)(6) (eff. 1/1/08). m. Current Exempt Entities The margin tax exempts those entities for which the current tax provides a specific exemption. The following is a list and brief explanation of the franchise tax exemptions for certain types of corporations and nonprofit corporations. Observation: Rule requires an entity to apply for exemption from the margin tax. Observation: The margin tax provides that an entity that is not a corporation but because of its activities would qualify for a specific exemption in the following list would qualify for the exemption and be exempt in the same manner and under the same conditions that a corporation is exempt. Texas Tax Code (eff. 1/1/08). C. Tax Rates 1. Wholesalers / Retailers To qualify for the one-half of one percent rate, a business must be primarily engaged in wholesale or retail trade. Wholesale and retail trades are defined as the activities described in Divisions F and G of the 1987 Standard Industrial Classification Manual published by the Office of Management and Budget. In general, wholesale trade is described as businesses primarily engaged in selling merchandise to retailers or other businesses to be resold or used. Retail trade is described as businesses primarily engaged in selling merchandise for personal or household consumption. A business is considered primarily engaged in retail or wholesale trade if it satisfies three conditions set out in the statute. The three conditions are: 1. revenue from the business s retail or wholesale trade activities is greater than its revenue from its other trade activities (nonretail & nonwholesale activities);

12 2. less than half of the revenue from its retail or wholesale trade activities results from the sale of products it produces or products produced by an affiliate; and 3. the business does not sell, at retail or wholesale, utilities such as telecommunications, electricity or gas. Observation: Restaurants and Bars are considered retailers for purposes of the margin tax and the provision excluding entities from qualifying for the halfpercent rate because the entity produces more than 50 percent of the product it sells does not apply to restaurants and bars. 2. All Others The rate is one percent for all entities that cannot qualify for the one-half of one percent rate. 34 TAC 3.584(d)(2) and Texas Tax Code and (eff. 1/1/08). D. Computation Of Taxable Margin 1. Overview A business s tax liability under the margin tax is calculated as the lesser of: 70 percent of Total Revenue or Total Revenue less either: Times Times Times Cost of Goods Sold or Compensation Apportionment Factor (Texas Sales or Receipts/Sales or Receipts from everywhere) Applicable tax rate Applicable tax liability discount if total revenue is greater than $300,000 but less than $900,000. Observation: In addition to the cost of goods sold deduction and compensation deduction from total revenue, taxpayers can deduct compensation paid to

13 employees during the time period that the employees are on active duty in the military if the employees are residents of Texas at the time they are called to active duty. The training costs for these employees replacements can also be deducted. Texas Tax Code (a)(1)(B)(iii) (eff. 1/1/08). Observation: The election may be changed annually. The election may not be changed retroactively by filing an amended return. Texas Tax Code (d) (eff. 1/1/08). A staff leasing service company is required to choose compensation as its deduction from total revenue. A staff leasing services company is defined as a business entity that offers staff leasing services as that term is defined by Labor Code, , or a temporary employment service, as that term is defined by Labor Code, Texas law defines Staff Leasing Services as an arrangement by which employees of a license holder are assigned to work at a client company and in which employment responsibilities are in fact shared by the license holder and the client company, the employee s assignment is intended to be of a long-term or continuing nature, rather than temporary or seasonal in nature, and a majority of the work force at a client company worksite or a specialized group within that work force consists of assigned employees of the license holder. The term includes professional employer organizations services. The term does not include temporary help; an independent contractor; the provision of services that otherwise meet the definitions of staff leasing services by one person solely to other persons who are related to the service provider by common ownership (greater than 331/3%); or temporary common worker employer as defined by Labor Code, Chapter 92. Texas Labor Code Texas law defines a temporary employment service as a person who employs individuals for the purpose of assigning those individuals to the clients of the service to support or supplement the client's workforce in a special work situation, including: (A) an employee absence; (B) a temporary skill shortage; (C) a seasonal workload; or

14 (D) a special assignment or project. Texas Labor Code (2) 2. E-Z Computation The Legislature in 2007 provided for an alternative calculation method for businesses with $10 million or less in total revenue. A qualifying business tax liability is determined under the E-Z Computation by multiplying its total revenue times its apportionment factor times.575 percent tax rate. Additionally, if applicable, the small business discount can be applied. No other credits or adjustments are allowed to be made by a business choosing the E-Z Computation. 34 TAC 3.584(d)(5) and Texas Tax Code (eff. 1/1/08). 3. Total Revenue Total revenue is the starting point for determining a business franchise tax liability. Total revenue is determined based upon the amounts reportable on specific lines on a taxable entity s federal income tax returns with adjustments. a. Additions Although the line references are different for the various types of federal income tax returns that might be filed by a taxable entity, the intent of the Legislature was total revenue for all taxable entities be the sum of the following types of revenues: Gross sales or receipts from business operations less returns and allowances Dividends received Interest income earned from bonds, deposits and notes to name a few Gross income received from the rental of real property Royalty income Net Capital gains both short and long term Net gain or loss from the sale of business property Other income not reported in above lines such as ordinary income from business activities of a partnership

15 The statute specifies the specific line numbers for the amounts reportable as income for corporations and partnerships. For a taxable entity treated as a: corporation for federal income tax purposes, total revenue is the sum of the amounts reportable as income on the following lines of IRS Form 1120: Line 1c; Lines 4 through 10; plus any total revenue reported by a lower tier entity as includable in the taxable entity s total revenue under Tax Code (b). partnership for federal income tax purposes, total revenue is the sum of the amounts reportable as income on the following: Lines 1c, 4, 6 and 7 Internal Revenue Service Form 1065; Lines 3a and 5 through 11 Internal Revenue Service Form 1065, Schedule K; Line 17, Internal Revenue Service Form 8825; and Line 11, plus line 2 or line 45, Internal Revenue Service Form 1040, Schedule F; plus any total revenue reported by a lower tier entity as includable in the taxable entity s total revenue under Tax Code (b).. The terminology amounts reportable as income was added as a clarification. The statutory change states that a reference to an amount reportable as income on a line number on an IRS form is the amount entered on the line to the extent the amount entered complies with federal income tax law. The specified line references for corporations and partnerships are meant to serve as guidelines for the Comptroller s office to identify and to specify by rule the line references for other taxable entities filing different federal income tax returns. Observation: In Rule 3.587, the Comptroller s office has specified the amounts reportable of income on the following line references for taxable entities treated as S-corporations, sole proprietorships or trusts for federal income tax purposes.

16 For a S-corporation, total revenue is the sum of the amounts reportable as income on the following lines: Lines 1c, 4, and 5 on IRS Form 1120S; Lines 3a and 4 through 10 from IRS Form 1120S, Schedule K; Line 17 from IRS Form 8825; plus any total revenue reported by a lower tier entity as includable in the taxable entity s total revenue under Tax Code (b). For a single member LLC filing as a sole proprietorship, total revenue is the sum of the amounts reportable as income on the following lines: Line 3 on IRS Form 1040, Schedule C; Line 17 on IRS Form 4797 to the extent that it relates to the LLC; ordinary income or loss from partnerships, S- corporations, estates and trusts, to the extent that it relates to the LLC on IRS Form 1040, Schedule E; Line 16 on IRS Form 1040, Schedule D, to the extent it relates to the LLC; Lines 3 and 4 on IRS Form 1040, Schedule E, to the extent that it relates to the LLC; Line 11, plus line 2 or line 45, on IRS Form 1040 Schedule F, to the extent that it relates to the LLC; Line 6 on IRS Form 1040, Schedule C, to the extent not already included; plus any total revenue reported by a lower tier entity as includable in the taxable entity s total revenue under Tax Code (b). For a trust, total revenue is the sum of the amounts reportable as income on the following lines: Lines 1, 2a, 3, 4, 7, and 8 from IRS Form 1041; Lines 3, 4, 32, and 37 from IRS Form 1040, Schedule E; Line 11, plus line 2 or line 45, from IRS Form 1040, Schedule F; plus any total revenue reported by a lower tier entity as includable in the taxable entity s total revenue under Tax Code (b). 34 TAC Rule 3.587(d)

17 Observation: A corporation that is part of a group filing for federal income tax purposes as a consolidated group must determine its total revenue as if it had filed a separate federal income tax return. Likewise, a taxable entity that is treated as a disregarded entity for federal income tax purposes must determine its total revenue as if it had filed a separate federal income tax return. Texas Tax Code (d) (eff. 1/1/08). A taxable entity that is not exempt and the state is not prohibited from taxing because of treaty, federal law or the United States Constitution, must calculate its tax liability based on a proforma federal return, if the taxable entity does not file a federal return. 34 TAC Rule 3.587(c)(10) Observation: For taxable entities other than a taxable entity treated for federal income tax purposes as a corporation, S-corporation, partnership, trust, or single member limited liability company filing as a sole proprietorship, total revenue should be an amount determined in a manner substantially equivalent to the amount calculated for the previous specified entities. 34 TAC Rule 3.587(d)(6) b. Subtractions The following items may be subtracted from total revenue by all taxable entities to which the corresponding items apply. (1) Bad debt Bad debts that have been expensed for federal income tax purposes that represent gross receipts included in the determination of total revenue for current or past reporting periods may be subtracted from total revenue. (2) Foreign royalties and foreign dividends Foreign royalties and dividends from an affiliated taxable entity that does not transact a substantial portion of its business or regularly maintain a substantial portion of its assets in the United States, to the extent that these sources of revenue are included in total revenue may be subtracted. The amounts deducted can include the revenue amounts determined under Section 78 and Sections of the Internal Revenue Code.

18 (3) Net distributive income from certain entities Net distributive income from entities treated as partnerships for federal income tax purposes, such as partnerships, LLCs, and trusts, may be deducted from total revenue to the extent the amounts were included in determining total revenue. Likewise, net distributive income from entities treated as S- corporations for federal income tax purposes, such as LLCs and corporations, may be deducted from total revenue. Rule Margin: Total Revenue defines net distributive income as the net amount of income, gain, deduction, or loss relating to a pass-through entity or disregarded entity reportable to the owners for the tax year of the entity. Observation: The net distributive income from a passive entity must be included in the determination of total revenue. The inclusion of this passive entity income in the determination of total revenue is limited to the extent that the net income was not generated and taxed in the margin of another taxable entity. (4) Dividends Received Deduction Taxable entities may subtract from total revenue the allowable dividend deductions that are determined on IRS Form 1120, Schedule C to the extent the corresponding dividend income is included in total revenue. (5) Income attributable to federally disregarded entities Taxable entities may subtract from total revenue items of income that are included in total revenue and can be attributed to entities that are treated as disregarded entities for federal income tax purposes. (6) Other authorized amounts This deduction seems to be a catch-all to cover the other items that can be deducted from total revenue. The next section discusses the various other deductions that can be made from total revenue. c. Other Authorized amounts that can be excluded or deducted from total revenue to the extent the amounts are included in total revenue

19 (1) Allocated Revenue Allocated revenue is revenue that Texas cannot tax because the activities generating the item of revenue do not have sufficient unitary connection with the entity s other activities conducted in Texas under the U. S. Constitution. Allocated revenue is not included in total revenue. (2) Dividends and interest from federal obligations All taxable entities shall deduct from total revenue dividends and interest received from federal obligations. This deduction from total revenue is similar to the current deduction from Earned Surplus for dividends and interest received from federal obligations. Texas Tax Code (m) & (p)(1), (4), (5), (6) & (7) (eff. 1/1/08). A federal obligation is defined to include stocks and other direct obligations of, and obligations unconditionally guaranteed by, the United States government and its governmental agencies. The term also includes the direct obligations of a US government-sponsored agency. United States government is defined to be any department or ministry of the federal government, including the Federal Reserve Bank. The term does not include a state or local government, a commercial enterprise owned wholly or partly by the US government or a local governmental entity or commercial enterprise whose obligations are guaranteed by the US government. A United States government agency is defined to mean an instrumentality of the US government whose obligations are fully and explicitly guaranteed as to the timely payment of principal and interest by the full faith and credit of the US government. The term includes the Government National Mortgage Association, the Department of Veteran Affairs, the Federal Housing Administration, the Farmers Home Administration, the Export-Import Bank, the Overseas Private Investment Corporation, the Commodity Credit Corporation, the Small Business Administration and any successor agency. A United States government-sponsored agency is defined to mean an agency originally established or chartered by the US government to serve public purposes specified by the US Congress but whose obligations are not explicitly

20 guaranteed by the full faith and credit of the US government. The term includes the Federal Home Loan Mortgage Corporation, the Federal National Mortgage Association, the Farm Credit System, the Federal Home Loan Bank System, the Student Loan Marketing Association and any successor agency. A federal obligation includes any bond, debenture, security, mortgage-backed security, pass-through certificate, or other evidence of indebtedness of the issuing entity. The term does not include a deposit, a repurchase agreement, a loan, a lease, a participation in a loan or pool of loans, a loan collateralized by an obligation of a US government agency, or a loan guaranteed by a US government agency. (3) Principal repayment proceeds A taxable entity must exclude the principal repayment of loans. Observation: The statute, limits this exclusion to lending institutions. The Comptroller s Rule 3.587(e)(3) states that a taxable entity must exclude principal repayment of loans. 34 TAC 3.587(e)(3) and Texas Tax Code (g-1) (eff. 1/1/08). Observation: These amounts may not be excluded if the taxable entity belongs to an affiliated group and these amounts are paid to entities that are members of the affiliated group. Texas Tax Code (h) (eff. 1/1/08). (4) Tax basis of securities and loans sold All taxable entities may deduct from total revenue the tax basis, as determined under the Internal Revenue Code, of securities and loans sold. Texas Tax Code (g-2) (eff. 1/1/08). Observation: Security for purposes of total revenue and apportionment is defined by the meaning assigned by Internal Revenue Code, 475(c)(2) and includes instruments described by Internal Revenue Code, 475(e)(2)(B), (C), and (D). Observation: These amounts may not be excluded if the taxable entity belongs to an affiliated group and these amounts are paid to entities that are members of the affiliated group. Texas Tax Code (h) (eff. 1/1/08).

21 (5) Flow-through Funds The statute contains several provisions to address receipts that were commonly referred to as flow-through funds when the Commission and the Legislature were developing the margin tax. The flow-through funds that can be deducted from total revenue are generally limited to those discussed in this section. Observation: To the extent that flow-through funds are not included in revenue from the start, no deduction is necessary. In other words, if these flow-through funds are not include in the amounts picked-up from a taxable entity s federal income tax return then the flow-through funds will not be included in the margin tax base. (a) Funds that are mandated by law or fiduciary duty to be distributed to other entities A taxable entity may deduct from total revenue flowthrough funds that are mandated by law or fiduciary duty to be distributed to other entities. An example of this type of funds would be taxes collected from a third party by the taxable entity and remitted by the taxable entity to a taxing authority. Texas Tax Code (f) (eff. 1/1/08). Observation: These amounts may not be excluded if the taxable entity belongs to an affiliated group and these amounts are paid to entities that are members of the affiliated group. Texas Tax Code (h) (eff. 1/1/08). (b) Certain funds that are mandated by contract to be distributed to other entities A taxable entity may deduct from total revenue only the following flow-through funds that are mandated by contract to be distributed to other entities: Sales commissions to nonemployees, including split-fee real estate commissions For purposes of this provision, sales commissions are defined to mean any form of compensation paid to a person for engaging in an act for which a license is required by Chapter 1011, Texas Occupations Code (real estate commissions) or compensation paid to a sales representative by a

22 principal in an amount that is based on the amount or level of certain orders for or sales of the principal s product and that the principal is required to report to the IRS on 1099s. For purposes of the sales commission provision, a principal means a person who manufactures, produces, imports, distributes, or acts as an independent agent for the distribution of a product for sale, uses sales representative to solicit orders for the product, and compensates the sales representative wholly or partly by sales commission. Texas Tax Code (l) (eff. 1/1/08). The tax basis as determined under the Internal Revenue Code of securities underwritten; and 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. Texas Tax Code (g) (eff. 1/1/08). Observation: These amounts may not be excluded if the taxable entity belongs to an affiliated group and these amounts are paid to entities that are members of the affiliated group. Texas Tax Code (h) (eff. 1/1/08). (6) Specific Industry exclusions or deductions from Total Revenue (a) Legal Industry A taxable entity that provides legal services may deduct from total revenue the following amounts: i) The following flow-through funds that are mandated by law, contract, or fiduciary duty to be distributed to the claimant by the claimant s attorney or to other entities on behalf of a claimant by the claimant s attorney:

23 ii) iii) damages due the claimant funds subject to a lien or other contractual obligation arising out of the representation, other than fees owed to the attorney funds subject to subrogation interest or other third-party contractual claim fees paid an attorney in the matter who is not a member, partner, shareholder, or employee of the taxable entity Reimbursement of the taxable entity s expenses incurred in prosecuting a claimant s matter that are specific to the matter and that are not general operating expenses; and $500 per bono services case handled by the attorney, regardless of whether it was included in the determination of total revenue. Observation: An attorney must maintain records of the pro bono services for auditing purposes in accordance with the manner in which those services are reported to the State Bar of Texas. Pro bono services are defined as the direct provision of legal services to the poor, without an expectation of compensation. Texas Tax Code (g-3) (eff. 1/1/08). Observation: These amounts may not be excluded if the taxable entity belongs to an affiliated group and these amounts are paid to entities that are members of the affiliated group. Texas Tax Code (h) (eff. 1/1/08). (b) Pharmacy Cooperative A pharmacy cooperative must exclude flow-through funds from rebates from pharmacy wholesalers that are distributed to the pharmacy cooperative s shareholders. (c) Staff leasing Services Companies Staff leasing service companies shall exclude from its total revenue payments received from a client company for wages, payroll taxes on those wages, employee benefits,

24 and workers compensation benefits for the assigned employees of the client company. Client Company means: a person that contracts with a license holder under Chapter 91, Labor Code and is assigned employees by the license holder under that contract; and a client of a temporary employment service, as that term is defined by Section (2), Labor Code, to whom individuals are assigned for a purpose described by that subdivision. Assigned Employee means an employee under a staff leasing services arrangement whose work is performed in this state. The term does not include an employee hired to support or supplement a client company s work force in a special work situation, including an employee absence, temporary skill shortage, seasonal workload, or a special assignment or project. Texas Labor Code (d) Management company A management company shall exclude reimbursements of specified costs incurred in its conduct of the active trade or business of a managed entity, including wages and compensation as determined in Section (a) and (b). Texas Tax Code (m-1) (eff. 1/1/08). A management company is defined as a corporation, LLC, or other limited liability entity that conducts all or part of the active trade or business of another entity (the managed entity ) in exchange for a management fee and reimbursement of specified costs incurred in the conduct of the active trade or business of the managed entity, including wages and cash compensation. Texas Tax Code (12) (eff. 1/1/08). (e) Health Care Industry For purposes of the margin tax, a health care provider is defined as a taxable entity that participates in the Medicaid program, Medicare program, Children s Health Insurance Program (CHIP), state workers compensation program or TRICARE military health system as a provider of health care services. Texas Tax Code (p) (3) (eff. 1/1/08).

25 For purposes of the margin tax, a health care institution includes the following: An ambulatory surgical center An assisted living facility licensed under Chapter 247, Health and Safety Code An emergency medical services provider A home and community support services agency A hospice A hospital A hospital system An intermediate care facility for the mentally retarded or a home and community-based service waiver program for persons with mental retardation adopted in accordance with Section 1915(c) of the federal Social Security ACT (42 U.S.C. Section 1396n) A birthing center A nursing home An end stage renal disease facility licensed under Section , Health and Safety Code or A pharmacy. Texas Tax Code (p)(2) (eff. 1/1/08). A Health Care Provider that is not a health care institution shall exclude the payments received under the Medicaid program, Medicare program, Indigent Health Care and Treatment Act and the Children s Health Insurance Program for professional services provided in relation to a workers compensation claim under Title 5, Labor Code; for professional services provided to a beneficiary rendered under the TRICARE military health system

26 A Health Care Provider that is not a health care institution can deduct from total revenue the actual cost to the health care provider for any uncompensated care, regardless of whether it was included in the determination of total revenue, provided A Health Care Provider maintains records of uncompensated care for auditing purposes. If the provider later receives payment for all or part of that care, the provider adjusts the amounts deducted for the tax year in which the payment is received. The comptroller is required to adopt rules governing the computation and audit requirements of the actual costs to a health care provider for uncompensated care costs deducted. Actual costs of uncompensated care is determined by dividing uncompensated care by total charges multiplied by the result of total operating expenses less compensation. Uncompensated care is defined as standard charges for the health care services provided by a health care provider, where the provider has not received any payment for the health care provided to the patient. Total charges is defined as all amounts for the health care services, including uncompensated care. Compensation means amounts determined under Tax Code TAC and Texas Tax Code (n) & (n- 1) (eff. 1/1/08). A Health Care Provider that is a Health Care Institution can deduct from total revenue 50 percent of amounts that can be deducted by a Health Care Provider that is not a Health Care Institution. Texas Tax Code (o) (eff. 1/1/08). (f) Armed Forces Housing A taxable entity shall exclude from its total revenue, all revenue received that is directly derived from the operation of a facility that is:

27 Located on property owned or leased by the federal government and Managed or operated primarily to house members of the armed forces of the US. Texas Tax Code (q) (eff. 1/1/08). (g) Stripper Wells A taxable entity shall exclude from total revenue amounts received from: oil produced during the dates certified by the Comptroller from an oil well designated by the Texas Railroad Commission or a similar authority in another state whose production averages less than 10 barrels a day over a 90-day period and gas produced during the dates certified by the Comptroller from a gas well designated by the Texas Railroad Commission or similar authority in another state whose production averages less than 250 mcf a day over a 90-day period. The Comptroller is required to certify the dates when the monthly average closing price of West Texas Intermediate crude oil is below $40 per barrel and the average closing price of gas is below $5 per MMBtu, as recorded on the New York Mercantile Exchange. Texas Tax Code (r) & (s) (eff. 1/1/08). (7) Except as specifically authorized, payments made under an ordinary contract for the provision of services in the regular course of business may not be excluded from total revenue Specifically authorized payments are limited to Sales commissions Underwritten securities Subcontracting payments handled by a 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

28 or the location of the boundaries of real property. Texas Tax Code (i) (eff. 1/1/08). (8) Any amounts excluded from total revenue cannot be included in the determination of cost of goods sold or the determination of compensation. Texas Tax Code (j) (eff. 1/1/08). 4. Elective COGS / Compensation Deduction a. COGS For purposes of determining cost of goods sold, goods is defined as real or tangible personal property sold in the ordinary course of business. Tangible personal property includes personal property that can be seen, weighed and measured as well as films, sound recordings, videotapes, live and prerecorded television and radio programs, books and other similar property and computer programs. Tangible personal property does not include intangible property or services. Where not otherwise provided, an entity shall determine cost of goods sold pursuant to the federal statutes and regulations. (1) Specifically Included Costs Cost of goods sold, for purposes of computing the new Texas margin tax, includes all direct costs of acquiring or producing the goods, generally including: (1) costs for labor; Observation: Rule clarifies that labor costs include w-2 wages, IRS Form 1099 wages, temporary labor, payroll taxes and benefits. Observation: Allowing direct labor costs to be deducted as part of cost of goods sold means that sellers of goods are allowed to deduct a portion of their compensation expenses (plus the other components of costs of goods sold) whereas companies electing to deduct compensation are limited solely to compensation. (2) costs of materials that are an integral part of specific property produced or are consumed in the ordinary course of performing production activities;

29 (3) handling costs, including costs attributable to processing, assembling, repackaging, and inbound transportation; (4) storage costs; (5) depreciation, depletion, and amortization to the extent associated with and necessary for the production of goods; Observation: Rule 3.588(d)(6) requires that the depreciation, depletion and amortization amounts used in the determination of COGS be based on the amounts reported on the federal income tax return on which the franchise tax report is based. Depreciation includes recovery described by Internal Revenue Code, 197 and property described by Internal Revenue Code, 179. (6) the costs of renting or leasing equipment, facilities, or real property; (7) repair and maintenance of equipment facilities or real property directly used for the production of goods, including pollution control equipment; (8) costs attributable to research, experimental engineering, and design directly related to the production of goods; (9) geological and geophysical costs incurred to identify and locate potential mineral producing property; (10) taxes paid in relation to acquiring or producing any material or in relation to services that are a direct cost of production; (11) costs of producing or acquiring electricity sold; and (12) a contribution to a partnership in which the taxable entity owns an interest that is used to fund activities, the costs of which would otherwise be treated as cost of goods sold of the partnership, to the extent those costs are related to goods distributed to the taxable entity as goods-in-kind in the ordinary course of production rather than being sold.