Good news about the Texas Franchise Tax–the Comptroller has recently conceded that more taxpayers qualify for the special half-percent rate.
As you may know, the usual tax rate for the Texas Franchise Tax is 1%: most taxable entities must pay tax equal to 1% of their “taxable margin” apportioned to Texas. But Texas tax law allows some taxpayers–primarily wholesalers and retailers–to pay only half as much tax as everyone else. These taxpayers are allowed to use a half-percent rate instead of a 1% rate. The House Ways & Means Committee may soon propose changes to which taxpayers qualify for the half-percent rate during the next legislative session; I discussed those potential changes in my June 19 article.
When determining whether a taxpayer qualifies for the half-percent rate, the big question is whether it is a wholesaler or retailer. The statute instructs us to make this determination by referring to the 1987 Standard Industrial Classification Manual. This Manual contains a long list of codes that are meant to describe virtually any business (or at least those business types that existed in 1987). The Texas franchise tax statute states that a taxable entity is primarily engaged in wholesale or retail trade if over half of the taxable entity’s revenue is described by an SIC Code listed in the 5000s. Such an entity may qualify for the half-percent rate if it can meet certain other requirements. The 1987 SIC Manual is available online.
The SIC Manual was obviously not written for this purpose. It was meant to classify businesses for the federal government’s statistical purposes, not define what a business “is” when many tax dollars are on the line. The descriptions in the Manual are not precise, and several SIC codes may describe any particular business activity. This is particularly true for certain business types. Take, for example, a store that both sells and installs home furnishings like hardwood floors, cabinets, doors and windows, countertops, or window treatments. These businesses often have storefronts open to the public. Customers walk in off of the street or come in by appointment, examine samples, obtain advice from salespeople, and select which improvements they want in their home. But the customer does not leave the store with the product. Instead, the store later sends an employee or a contractor to install the new floor, cabinet, window, etc. on the customer’s behalf.
The revenue from this business model may be described by at least two SIC codes. First, in the Construction Contractor Division of the Manual, there is Code 1751. This code describes “[s]pecial trade contractors primarily engaged in carpentry work,” and specifically lists installers of cabinets, doors, and windows. The business I describe in the previous paragraph does install the vast majority of products sold, so this code certainly appears applicable. However, Code 5211–in the retail section–also describes this business. This code describes “[e]stablishments engaged in selling primarily lumber . . . to the general public.” The code description further clarifies that “lumber” includes items made from wood, like flooring, molding, doors, frames, etc. Two codes are therefore applicable–one in the 5000s and one out. Is this store a retailer or a construction contractor? Does it qualify for the half-percent rate?
This provides a perfect example of how poorly suited the SIC Manual is for making such a determination. Until recently, the Comptroller’s position has been that these businesses were NOT retailers, even though they had showrooms open to the public. The Comptroller claimed that these taxpayers therefore could not qualify for the half-percent rate. Nevertheless, many of these taxpayers considered themselves to be retailers and filed reports using the half-percent rate. Once the Comptroller noticed this, it issued assessments and doubled their taxes. In response, some of the assessed taxpayers filed for administrative redetermination.
Thankfully, the administrative law judges appear to be agreeing with the taxpayer positions. For instance, Hearing No. 103,624 involved a seller and installer of windows and doors. In this case, Judge Victor John Simonds determined that the Comptroller must weigh the importance of the installation service versus the business activities that occur in the showroom. The taxpayer demonstrated that the sales activities that occurred on the showroom floor were a critical aspect of the taxpayer’s business, and the installation services were only secondary. The Judge therefore concluded that this taxpayer was indeed a retailer, and could use the .5% rate. However, Judge Simonds qualified his holding, stating that “[d]ifferent taxpayers will present different facts that will lead to different conclusions because, as the SIC Manual provides, classifications involving establishments primarily engaged in the distribution and construction or installation of equipment often present classification problems that require analyzing various factors.”
Although this was a loss for the Comptroller’s Office, the Judge’s qualifying statement encouraged it, and the Tax Division continued to challenge various installers who used the .5% rate. But here is the good news: I’ve received word that the Comptroller has been losing even more of these .5% Texas franchise tax cases in administrative hearings. So far, the Comptroller has not published any of these hearings. Nevertheless, the new losses have caused the Comptroller’s hearings attorneys to reconsider whether its worth continuing challenges like these. In some cases, the attorneys have reduced audit assessments to zero, without a hearing.
Therefore, if you are a taxpayer that installs equipment or construction materials, but also has a significant sales force, you should carefully consider whether you qualify for the .5% rate. It you’ve historically paid tax using the 1% rate, consider filing a refund claim. I can assist you in presenting your facts to the Comptroller in a way that maximizes the likelihood of victory. Each case, of course, depends on the facts.
Additionally, the .5% rate may soon be a hot topic even in the general media. Nestle U.S.A. has filed another challenge with the Texas Supreme Court that challenges the constitutionality of the .5% rate. The Court will hear the parties’ arguments next Tuesday, September 18. I’ll provide an update then.