COVER STORY, MAY 2008

FRANCHISE TAX COMPLEXITY
As filing deadline nears, real estate companies may see tax uncertainties.
Labry Welty

In an attempt to find new funding for public schools, reduce property tax rates and close loopholes in the Texas Franchise Tax, the Texas legislature enacted a significant revision of the franchise tax, commonly known as the margin tax, on May 18, 2006. As part of the loophole closing, the revised franchise tax is now imposed on most limited liability entities including some previously exempt entities, most notably limited partnerships.

As the May 15, 2008 filing deadline approaches, real estate companies operating in Texas are beginning to realize the true complexity of the revised Franchise Tax and are working through the uncertainties of the revised tax.

As the May 15, 2008 filing deadline nears, real estate companies operating in Texas are beginning to realize the true complexity of the revised Franchise Tax and are working through the uncertainties of the revised tax.

Entities Subject to Tax

Texas has significantly expanded the definition of taxable entity to include nearly every entity that enjoys limited liability protection. Taxable entities subject to the revised Franchise Tax include partnerships; corporations; limited liability companies; business trusts; professional associations; business associations; joint ventures; joint stock companies; holding companies; or other legal entities with limited liability protection. Specifically excluded entities are passive entities; certain real estate investment trusts and real estate mortgage investment conduits; sole proprietorships; certain grantor trusts and estates; and general partnerships with direct ownership entirely composed of natural persons.

A passive entity is defined as a general or limited partnership or a trust, other than a business trust for which gross income comprises at least 90 percent of certain types of income, including dividends; interest; distributive shares of partnership income; and net capital gains from the sale of real property, commodities and securities, among others. Rental income is statutorily defined as active trade or business income.

Tax Computation

In general, the tax is computed based upon the lesser of:

• 70 percent of total revenue;

• Total revenue minus employee compensation (including benefits); or

• Total revenue minus the cost of goods sold (“COGS”).

The tax due will be 1 percent of the apportioned tax base with the exception of retailers and wholesalers who are subject to a 0.5 percent tax rate.

The starting point for total revenue is the entity’s total income as reported on its U.S. federal income tax return. Subtractions from this amount include bad debts; foreign royalties; certain dividends; net distributive income from partnerships, trusts and LLCs treated as partnerships; and certain other deductions.

Compensation is generally defined as all wages and cash compensation paid by the taxable entity as reported on Form W-2 to its officers, directors, owners, partners and employees, up to $300,000 per person plus the cost of all benefits the taxable entity provides to such officers, directors, owners, partners and employees. This includes workers’ compensation benefits; healthcare; employer contributions made to employees’ health savings accounts; and retirement to the extent deductible for Federal income tax purposes.

COGS includes certain identified direct costs of acquiring or producing real or tangible personal property sold in a taxable entity’s ordinary course of business, and certain other related costs.

An entity’s margin is apportioned to Texas using a single gross receipts factor. The apportionment factor is determined by dividing Texas receipts by total receipts. For apportionment purposes, gross receipts sourced to Texas include only the gross receipts of combined group members having nexus with Texas.

E-Z Tax Computation

Taxable entities with less than $10 million of total revenue are allowed to compute tax using the E-Z tax computation. Tax is calculated on apportioned revenue at a rate of 0.575 percent. No deductions, credits or other adjustments are allowed if the company chooses to pay the E-Z tax.

Small Business Relief

The law provides a discounted tax rate for taxpayers with less than $900,000 in total revenue:

• 80 percent discount for a taxable entity with total revenue greater than $300,000 but less than $400,000;

• 60 percent discount for an entity with total revenue equal to or greater than $400,000 but less than $500,000;

• 40 percent discount for an entity with total revenue equal to or greater than $500,000 but less than $700,000; and

• 20 percent discount for a taxable entity with total revenue equal to or greater than $700,000 but less than $900,000.

Combined Reporting

One of the more complex changes to the Franchise Tax involves combined reporting. Unitary businesses must file a combined report and all members of a combined report are jointly and severally liable for the Franchise Tax of the combined group. Most affiliated entities with 50 percent or more common ownership will be a unitary business. However, additional factors indicating that a unitary business exists are:

• activities within the same line of business;

• a vertically structured enterprise or process; or

• a functional integration with strong centralized management.

Once a combined group is identified, each entity must determine its revenue and deductions for compensation or COGS. Each entity’s amounts are then added to the other entities, and any intercompany transactions are eliminated. The election to subtract COGS or compensation is made by the combined group and applies to its members.

For real estate concerns, determination of whether a combined group exists may be rather troublesome. While some professionals in the real estate industry abjectly deny that one property could be unitary with another, determining whether certain affiliated entities, especially partnerships, are unitary may require an analysis of which owner controls the entity, whether there are economies of scale or sufficient synergies such that combined reporting is required.

Effective Date

The revised Franchise Tax is effective for reports due on or after Jan. 1, 2008 with most reports due May 15, 2008.

Credit Carryovers:

With limited exception, credits currently available against the Franchise Tax are repealed. But, taxable entities with certain unused credits accrued prior to the revised Franchise Tax’s effective date can use those credits against their revised Franchise Tax liability.

Temporary Credit

A taxable entity may take a credit based on the unexpired business losses accrued under the previous Franchise Tax. The annual credit is then computed at 10 percent of those business losses multiplied by the appropriate revised Franchise Tax rate, with the credit expiring on Sept. 1, 2016.

Labry Welty is a shareholder with Munsch Hardt Kopf & Harr PC in the firm’s Dallas office. He has more than 16 years of tax-specific experience.

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