Texas Franchise Tax Hearing on June 5

The Texas House Ways & Means Committee recently announced a hearing on changes to the Texas franchise tax, also known as the margin tax. The hearing is scheduled for June 5. The notice for the meeting is posted here. The Committee wishes to discuss “equity and administrative issues” about the margin tax, including but not limited to “pass through, definition of retailer, cost of goods sold, and compensation deduction.” They’ve invited testimony from the public. Those wishing to testify should contact the committee at 512-463-0822.

The Committee appears to be well aware of the hot-button issues surrounding the Texas franchise tax:

  •  “Pass through” likely refers to receipts that certain companies report as gross receipts on the federal tax return, but which aren’t actually “kept” by the companies. Instead, the companies “pass the receipts through” to subcontractors or other vendors. Comptroller auditors often claim that a company with pass-through receipts must report the receipts as revenue for the franchise tax calculation. The auditors then disallow deductions for the payment to the subcontractor. This is a common problem in the trucking industry, the insurance claims processing industry, and many other businesses that receive funds to provide a service, but then hire unrelated companies to actually perform that service. Under the Comptroller’s interpretation of the statute, these companies pay a very large amount of tax relative to other industries. Perhaps the committee will consider amending or clarifying the statute to make it more equitable.
  • “Definition of retailer” refers to the provisions in the statute that allow “wholesalers and retailers” to pay tax on only .5% of their margin; all other industries must pay at a 1% rate. The statute determines who is a wholesaler or a retailer primarily by relying on the classifications in the 1987 Standard Industrial Classification (SIC) Manual. The SIC Manual is woefully inadequate for this purpose–the descriptions provided by the Manual were not meant to be used as statutory definitions, and the economy described by the 1987 Manual no longer exists. There are other complications involving the .5% rate–the Comptroller claims that an entity that sell goods that are either manufactured by the entity itself or one of its affiliates won’t qualify; entities that earn revenue from non-wholesale or retail activities may not qualify; and those that provide “utilities” don’t qualify. I explain other issues in this blog post (see the subheading for “The SIC Code: a Big Franchise Tax Audit Flag.”) Auto repair shops are one industry that could benefit from clarification in this area.
  • There is still much controversy surrounding which entities qualify for the cost of goods sold deduction. For instance, the Comptroller argues that rent-to-own stores cannot use the cost of goods sold deduction because renting a good is not the same as selling a good. Also, when a seismic company sells its data to an oil company, is it selling a good, a service, or an intangible? There are many other questions regarding this deduction. The Comptroller is aggressively pursuing many companies that have been taking the cost of goods sold deduction due to the uncertainties surrounding this area.
  • Finally, there is the compensation deduction. Historically, the compensation deduction has not been particularly useful for most industries because it has severe statutory restrictions. The most significant of these restrictions is that a company is not allowed to deduct as compensation amounts it pays to independent contractors (i.e. compensation reported to the recipient on a Form 1099 instead of a Form W-2). This restriction leaves  no deduction for industries that rely heavily on independent-contractor labor and do not sell goods. Perhaps the Committee will agree to changing the deduction to make it more useful.

It will be interesting to see how receptive the members of the Committee will be to the testimony. Ultimately, I hope that the Legislature considers entirely scrapping the tax, and replacing it with a system that more closely piggybacks off of federal taxable income. The Legislature has been cleared for this by the Texas Supreme Court’s Allcat decision.

I’ll post a summary of the hearing on or shortly after June 5.

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