House Ways & Means Appears Willing to Make the Texas Franchise Tax “More Fair” by Making it Even More Complicated

On June 5, the Texas House Ways & Means Committee held a hearing on potential Texas franchise tax changes. The Austin American Statesman has published an article about the hearing, and the TSCPA has also covered it in its blog. A four and a half hour long recording of the hearing is available here.

After watching the hearing, it appears that the Committee is prepared to propose some fairly substantial fixes to the franchise tax. But the Committee doesn’t appear ready to repeal the tax altogether, and replace it with a simpler method. (Several witnesses and Committee member Mike Villarreal, D-San Antonio, recommended reverting back to a modified version of the old earned surplus method, now applied to partnerships as well as other entities, but most of the others on the Committee didn’t appear to be too excited about this plan.)

Members of the committee appeared most receptive to the comments and suggestions made by Dale Craymer of the Texas Taxpayers and Research Association.  TTARA has always generally supported the margin tax. TTARA testified in favor of the tax back in 2006, before it was passed, and members of the Legislature often look to TTARA for tax-policy advice. For this reason, Mr. Craymer’s testimony may turn out to be the most important part of the hearing. (It begins around the 57-minute mark and runs for around 40 minutes.)

Mr. Craymer testified that overall, the Texas franchise tax has been positive for the state. The inclusion of partnerships as taxable entities has broadened the tax’s base. Now many service companies (accounting and law firms) pay the franchise tax when they once paid nothing. At the same time, the total number of businesses that pay Texas franchise tax has decreased because of the generous small-business exemption. Mr. Craymer stated that it’s good tax policy to provide exemptions based on a taxpayer’s size instead of its choice of entity.

Nevertheless, Mr. Craymer acknowledged that the Texas franchise tax still has problems. TTARA admits that one of the goals of the 2006 tax reform was simplicity, and that the margin tax is far from simple to compute. Mr. Craymer also inferred that the Legislature’s previous attempts to make the tax “more fair” actually resulted in making the tax even more unequal. His suggestions on fixing the tax’s problems were therefore fairly broad-based.

TTARA’s Suggestion to Fix Qualification for the Half-Percent Rate

One of his ideas appeared to gain quite a bit of traction with the Committee. It involved qualification for the .5% rate, which is available to wholesalers and retailers (other taxpayers must generally pay 1% of margin). Mr. Craymer suggested that the Legislature amend the tax so that the .5% rate applies to a taxpayer’s wholesale or retail line of business, not to the taxpayer itself. In other words, a particular business could pay both the .5% and 1% rate for any particular year if it had some revenue that qualified for the lower rate and some revenue that did not.

Mr. Craymer acknowledged that the current requirements to pay the tax at the .5% rate were not particularly rational. The SIC Manual is used to determine which entities qualify for the lower rate, and the Manual was not meant to  classify businesses that have multiple revenue streams. Mr. Craymer’s example involved the Alamo Drafthouse, a movie theater that is also a restaurant. Restaurants qualify for the .5% rate; movie theaters do not. If over half of Alamo’s revenue is from ticket sales, all of its revenue (including revenue from the restaurant business)  is taxed at 1%. If over half of Alamo’s revenue is from restaurant sales, all of its revenue (including the revenue from ticket sales) is taxed at .5%. Other witnesses provided other examples. Auto body shops, as service providers, must generally use the 1% rate. These businesses compete with the service departments of car dealerships and auto-parts stores. Because a car dealership often earns more than half of its revenue from the retail sale of automobiles, revenue from its service department is taxed at only the .5% rate. The competing body shop must  use the 1% rate even though it is providing exactly the same service.

Mr. Craymer proposed a potential solution–a taxpayer could be subject to both rates for a particular year. For instance, Alamo Drafthouse could pay 1% of its margin on ticket sales and .5% of its margin on food sales. The auto-body shop would then be on a level playing field with the car dealership’s service department. Washington State has a system somewhat similar to this.

Members of the Committee seemed fairly interested in this solution–several members brought the solution up again later during the hearing. Most of the witnesses testifying about the .5% rate agreed that such a change would provide them with at least some relief.

My Thoughts Regarding the Texas Franchise Tax Half-Percent Rate

Here are my thoughts on these potential Texas franchise tax changes. While this solution would certainly make the tax more fair, it would also increase the complexity of an already complicated tax. It’s fairly easy to determine how much revenue is derived from a particular activity–but without further changes the rate must be applied to margin, not revenue. Figuring out which deductible expenses apply to each business activity could be quite difficult.

Moreover, if taxpayers are still required to elect between the compensation deduction or the cost of goods sold deduction, allowing multiple rates would make this decision even more difficult. In some cases, a business would owe less tax by selecting the lower deduction.

post image for texas franchise tax half percent rate auto repair shop exampleHere is an example of this. Take a car-repair shop that also retails parts. It earns $20 million from service revenue and $20 million from parts sales. It earns a healthier margin for its repair business: compensation paid to the repair technicians is only $8 million while the cost of parts sold is $14 million.

If you assume that the business is still limited to either deducting compensation or cost of goods sold, but can apply the .5% rate to the “margin” from the parts business while applying the 1% rate to the “margin” from the repair business, the business would actually owe less tax if it elects the compensation deduction–the lower of the two deductions. Here is the calculation of the Texas franchise tax due under various scenarios.

For a system that is now supposedly more “rational,” that’s a pretty bizarre result. It’s also a result that will be difficult to explain to the owner of that particular auto-body shop.  Nevertheless, it’s a result that leads to less tax owed for this particular business. Under the current statute this entity would owe $260 thousand in tax; with the change it would owe $220 thousand.

What this example really demonstrates is that the whole Texas franchise tax is irrational–the qualification for the .5% rate, the forced choice between compensation and cost of goods sold–all of it. Therefore I believe the best solution is still to scrap the entire convoluted system and use a calculation closer to the standard definition of “income.” TTARA testified that it is not in favor of this solution because determining what a partnership’s “income” is creates too many “political questions.” Those are questions that nevertheless should be asked and answered.

(photo: http://www.flickr.com/photos/valeriebb/2225441940/)

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