Texas Franchise (Margin) Tax

Transcription

1 Texas Franchise (Margin) Tax FT

2 Texas Franchise Tax 2014 This teaching manual/outline provides information on general tax issues and is not intended to provide advice on any specific legal matter or factual situation. This information is not intended to create, and receipt of it does not constitute, a lawyer-client relationship. Readers should not act upon this information without seeking professional counsel. James F. Martens ( ). All rights reserved. Last Revised June 30, 2014

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4 Instructor Jimmy Martens, trial attorney and CPA, is the founding partner with Martens, Todd, Leonard & Taylor, a tax litigation law firm located downtown, Austin, Texas. Mr. Martens has handled the trial of tax cases and related appeals all the way through both the Texas Supreme Court and the U.S. Supreme Court. He and other members of his law firm limit their law practices to Texas tax, multi-state, and federal tax controversies and litigation. He is board certified by the Texas Board of Legal Specialization in Tax Law. He is a former council member of the Tax Section for the State Bar of Texas and the former chair of the CLE Committee. Mr. Martens serves as the course instructor for the TSCPA s statewide course on the new Texas franchise tax and Texas sales & use tax. He also teaches Texas State Taxation and Tax Controversies and Litigation at the University of Texas School of Law. He represents clients in connection with audits, administrative appeals and in court. He is licensed by the Texas Supreme Court to practice in all of the state courts of Texas. He is also licensed to practice in U.S. Tax Court, Federal District Court, the 5th and D.C. Circuit Courts of Appeals, and the United States Supreme Court. He writes and speaks frequently on a variety of tax subjects and appears as a guest speaker on local television broadcasts. He received his B.B.A. and J.D. from University of Texas at Austin, both with honors. Mr. Martens may be reached by at jmartens@textaxlaw.com or by telephone at (512) Special Note: Martens, Todd, Leonard & Taylor maintains a website which provides Texas tax information, links to all of the websites referenced in this manual and links to all available state revenue officers websites. The site is located at: The service is free.

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6 Instructor Lacy Leonard, trial attorney, is a partner with Martens, Todd, Leonard & Taylor, a tax litigation law firm located downtown, Austin, Texas. She and other members of her law firm limit their practices to Texas tax, multi-state, and federal tax controversies and litigation. Ms. Leonard represents clients in administrative proceedings before the Texas Comptroller s office, the Texas State Office of Administrative Hearings, and in Texas state courts. She also represents federal tax clients in administrative appeals, before the United States Tax Court, and in the Courts of Appeals. Ms. Leonard has eight years of substantial trial experience. She has successfully tried numerous cases to judgment before courts throughout Texas. She speaks at Texas sales and use tax seminars throughout the state and assists in preparing the Texas sales and use tax course materials. Ms. Leonard received her J.D. degree from Southern Methodist University School of Law in May of She also earned a bachelor of arts in government from the University of Texas. She may be reached by at lleonard@textaxlaw.com and by phone at (512) Special Note: Martens, Todd, Leonard & Taylor maintains a website which provides Texas tax information, links to all of the websites referenced in this manual and links to all available state revenue officers websites. The site is located at: The service is free.

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8 Table of Contents Chapter I. Basic Concepts... 1 Nature of the Texas Franchise (Margin) Tax... 1 Franchise Tax Constitutionality... 1 Is it a Net Income Tax?... 3 What Types of Entities Are Taxable?... 6 What Types of Entities Are Nontaxable? Anti-Conversion Partnership Termination Rules Charges to Customers to Recover the Franchise Tax Power to Tax Tiered Partnerships Statute of Limitations Amended Franchise Tax Reports Chapter II. Computations & Reporting Calculating the Margin Apportioning Margin to Texas Calculating the Tax Retailer/Wholesaler Tax Rate Temporary Credit on Taxable Margin Business Incentive Credits & Special Deductions E-Z Tax Computation Small Entity Exemption Converted to a Deduction Annualized Revenue Computation Exit Tax Payment & Reporting Requirements When to File Initial Franchise Tax Reports Extensions Less Than $1,000 Due Combined Reporting Tax Liability Issues Chapter III. Determining Revenue Piggyback to Federal Forms Federal Total Income Federal Gross Income Reporting Reductions & Exclusions Consistency Requirements Federal Consolidated Groups

9 Page ii Table of Contents Chapter IV. Cost of Goods Sold Deduction Capitalization Election Is the Entity Eligible to Deduct Cost of Goods Sold? Benefits Burdens Real Estate Industry Service Providers Does the entity sell goods? Not Goods If the Entity is Eligible, What is the Amount? What Costs are Not Included? Comptroller Interpretations Applied to Industries Special Industry Provisions Unitary Tax Effects on Cost of Goods Sold Federal Tax Effects on Cost of Goods Sold Annual Election Chapter V. Determining Compensation Overview Compensated Individuals Wages and Cash Compensation Benefits Compensation Paid to Individuals Serving on Active Duty Chapter VI. Industry Tax Preferences Who Did the Franchise Tax Hit Particularly Hard? Are Any Industries Better Off? Specific Industry Provisions Attorneys Banks and Savings & Loans Construction Industry Crop Dusters Destination Management Companies Lending Institutions Health Care Industry Insurance Companies Live Entertainment Event Promotion Companies Management Companies Manufacturers Movie Theatres Oil & Gas Industry Professional Employer Organizations Real Estate Industry

10 Table of Contents Page iii Temporary Employment Service Transportation Companies Utility Industry Chapter VII. Apportionment Allocation and Apportionment Texas s Single Factor Formula Gross Receipts Combined Apportionment Texas Gross Receipts Banks and Savings & Loans Trademarks, Licenses and Franchises Special Situations Chapter VIII. Combined Reporting Requirements for Combination Taxable Entity Requirement Affiliated Group Requirement Unitary Requirement Water s Edge Requirement Sale, Acquisition, and Combined Reporting The Reporting Entity Accounting Period Consistency Combined Report Calculation

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12 Texas Franchise Tax Page 1 Chapter I. Basic Concepts Nature of the Texas Franchise (Margin) Tax Tax on Privilege. Texas imposes the franchise (margin) tax for the privilege of doing business in Texas. More specifically, the State collects it annually from taxable entities for the privilege of doing business in Texas. It is, in part, a prepaid tax. It is imposed on the entity s taxable margin. 1 An entity is liable for the tax when it is classified as taxable and otherwise has sufficient contact with Texas. Outer Limits. The margin tax extends to the limits of the United States Constitution and federal law adopted under it. 2 This provision relates to Texas s power to tax out-of-state entities. It means that Texas s power to tax an out-of-state business reaches the boundaries set by the United States Supreme Court in its cases ruling on states authority to tax under the due process and interstate commerce clauses of the United States Constitution. Equality & Uniformity. The Texas Constitution permits taxation based upon the value of property only if the tax is equal and uniform as between individuals and corporations. 3 The margin tax is not a tax on the value of property. However, Texas courts routinely imposed the equal and uniform requirement to the various provisions of the revised franchise tax which was not a tax on the value of property. 4 Franchise Tax Constitutionality Bullock Amendment. Article VIII, Sec. 24(a) of the Texas Constitution (the Bullock Amendment ) states generally that any tax on the net incomes of natural persons, including a person s share of partnership and unincorporated association income requires voter approval in a statewide referendum before enactment Texas Tax Code (a). Texas Tax Code (a). Texas Constitution Art See Bullock v. Sage Energy 728 S.W.2d 465 (Tex. App.-- Austin, 1987, writ ref d, n.r.e.), Bullock v. Samedan Oil Co. (unpublished), and Rylander v. 3 Beall Brothers 3, Inc., 2 S.W.3d 562 (Tex. App. -- Austin 1999, pet. denied).

13 Page 2 Texas Franchise Tax Franchise Tax Does Not Violate Bullock Amendment. In re Allcat Claims Service, L.P. and John Weakly, the Texas Supreme Court held that the Texas revised franchise tax did not violate the Bullock Amendment. 5 The Court did not decide whether the revised franchise tax was a net income tax. Instead, it grounded its holding entirely in the entity theory of partnership taxation. It found that a tax directly imposed on a partnership is not the same as a tax on a person s share of partnership income because a partnership is not a flow-through entity. Instead, the Court ruled that a partnership is an entity separate from its partners. As a result, according to the Court, the state income tax prohibition applies only to taxes directly imposed on people, not business entities. Note. It is unclear how the Court s opinion may affect a partnership s federal tax classification, although under the Supremacy Doctrine, the check-the-box election may mitigate any attempt by the Internal Revenue Service to enforce the Court s opinion for federal purposes. Franchise Tax Reform? The Court s opinion paves the way for the Texas Legislature to amend the Texas revised franchise tax to follow a more traditional net income calculation, if it chooses to do so. The Legislature may do this because the decision implies that the revised franchise tax would not violate the Texas Constitution even if it were a net income tax. Constitutional Challenge Procedure. The Texas Supreme Court heard the Allcat case because the margin tax statute requires that constitutional challenges to the margin tax bypass review by all of the lower courts and go straight to the Texas Supreme Court. 6 This makes the Texas Supreme Court a court of original jurisdiction that, presumably, may hear testimony and receive evidence, just like a trial court. It also requires the Supreme Court to issue a decision within 120 days after the date the case is filed S.W.3d 455 (Tex. 2011). Martens, Todd, Leonard & Taylor represented Allcat and Mr. Weakly. H.B. 3 as enrolled, Section 24.

14 Texas Franchise Tax Page 3 Texas Supreme Court Rejects Second Constitutional Challenge. The Texas Supreme Court rejected Nestle s constitutional challenge to the Texas revised franchise tax. 7 Nestle argued that the Texas revised franchise tax violated both the US and Texas Constitutions because it allowed taxpayers in certain industries the benefits of enhanced deductions and a reduced tax rate while denying the same to Nestle. Nestle manufactures its products throughout the United States, but not in Texas. In Texas, Nestle s business is solely limited to the wholesale of Nestle s products. Nestle paid the revised franchise tax at the 1% rate. Nestle claimed that the revised franchise tax laws treated it unequally because other businesses located in Texas -- whose only activity was wholesale paid tax at the ½% rate. The Texas Supreme Court held that the disparities in taxation didn t create constitutional violations. Is it a Net Income Tax? Why Do We Care? To the surprise of many commentators, the Texas Supreme Court decided that the Texas revised franchise tax did not violate the Bullock Amendment without determining whether the tax constitutes a net income tax. The question of whether the Texas revised franchise tax constitutes a net income tax remains important for purposes of multi-state tax administration. In particular, it remains unclear whether Public Law applies to the Texas revised franchise tax. MTC Election. The issue is whether a Texas franchise taxpayer may elect to apportion the margin tax base using a three-factor formula instead of the single gross receipts factor formula. Texas agreed to be a member of the Multi-state Compact and our legislature enacted Chapter 141 of the Texas tax code pursuant to that agreement. Chapter 141 provides that a taxpayer who is subject to an income tax, as defined in Chapter 141, may elect apportion the tax base using a factor based upon sales, payroll and property. So, the ultimate question is whether the Texas revised franchise tax constitutes an income tax, as defined by Chapter In re: Nestle USA, Inc. et al., No (Tex. Oct 19, 2012).

15 Page 4 Texas Franchise Tax The Comptroller has rejected all refund claims filed by taxpayers electing the use of the three-factor formula. Graphic Packaging has a pending lawsuit challenging the Comptroller s refusal to allow the use of the three-factor formula. 8 The following example illustrates the potential impact of the three-factor formula as contrasted with the single factor of gross receipts: Example XYZ Company manufactures furniture outside the state of Texas. XYZ Company sells furniture to buyers located throughout the United States, including Texas. During 2013, XYZ Company generated taxable margin of $100 million. XYZ s relative sales, payroll and property are (in the millions): Sales Payroll Property Texas Everywhere 1,000 1,000 1,000 Under the single factor gross receipts formula, XYZ would apportion $30 million of its margin tax base to Texas. If XYZ is allowed to elect the MTC three-factor formula, XYZ would apportion $10 million of its margin tax base to Texas. Public Law The U.S. Congress passed Public Law in 1959 in response to a practice by several states who taxed out-of-state corporations that were merely soliciting sales within the state. This federal law prevents states from enacting state income tax laws that impose state net income tax on entities whose only activity in the state is soliciting orders within the state. 8 Graphic Packaging Company v. Combs, No CV. Martens, Todd, Leonard & Taylor represents Graphic Packaging.

16 Texas Franchise Tax Page 5 Example NY Mfg owns and operates a manufacturing plant in New York. Its only physical presence outside New York is its employment of a sales person that lives and works exclusively in California. The sales person visits existing and potential customers within California and solicits orders for the purchase of NY Mfg s products. Under Public Law , California may not impose its net income tax on NY Mfg. So, if the revised franchise tax is a net income tax, then Public Law applies to it. If so, then Texas may not impose the revised franchise tax on businesses whose only activity in Texas is soliciting orders, and any such business that paid the revised franchise tax would be entitled to a refund. Uncertain Scope in Texas. We can t presently say whether the revised franchise tax is limited by Public Law The revised franchise tax statute expressly states that it is not an income tax and that P.L does not apply. 9 Supremacy Doctrine. But, if it s really a net income tax, then P.L will apply. And it wouldn t matter what the Texas statute said. Under the federal supremacy doctrine, the provisions of Public Law supersede those of conflicting provisions found in state law, including Texas s statement that P.L does not apply. Is it a net income tax? Many commentators believe that the revised franchise tax is a net income tax. Most notably, former Comptroller Carole Keeton Strayhorn stated that the revised franchise tax is a net income tax in a letter to Attorney General Greg Abbott dated April 21, While her letter only directly addressed whether the revised franchise tax violates the Bullock Amendment, her analysis remains relevant to whether the revised franchise tax constitutes a net income tax. 9 H.B. 3 as enrolled, Section 22.

17 Page 6 Texas Franchise Tax Her letter provides this analysis: Chapter 141, Texas Tax Code, was in effect at the time the Bullock Amendment was adopted. Article II, Paragraph 4 defines income tax as follows: Income tax means a tax imposed on or measured by net income including any tax imposed on or measured by an amount arrived at by deducting expenses from gross income, one or more forms of which expenses are not specifically and directly related to particular transactions. She says this provision means that if the tax is determined by deducting from gross income any items of expense that are not specifically and directly related to transactions that created the income, it is an income tax. She further states that revised franchise tax sections (relating to the cost of goods sold deduction) and (relating to the compensation deduction) include indirect and overhead costs of production and/or compensation that make the revised franchise tax an income tax under the preexisting Texas definition of net income found under Chapter 141. She also says that it s a net income tax as defined in Black s Law Dictionary, Fifth Edition. This prominent resource tool, used by most lawyers, defines net income as income subject to taxation after allowable deductions and exemptions have been subtracted from gross or total income. She reasons that the margin tax base, whether resulting from deduction of cost of goods sold or labor related charges, fits within this definition too because it results from income subject to taxation after some allowable deductions are subtracted. Based upon this analysis, former Comptroller Strayhorn stated that the revised franchise tax is a net income tax. What Types of Entities Are Taxable? Background. Texas law lists the categories of businesses or entities that are subject to the tax and also lists the categories that are not. State v. Federal Law. Businesses or entities are formed or organized under the laws of the several states or foreign countries. However, in certain instances, the Internal Revenue Code allows an entity to choose a form of federal taxation that is different than the classification of the entity under state law. When the federal tax laws and state (or foreign) laws clash in their classification of the entity, the state (or foreign) law classification prevails.

18 Texas Franchise Tax Page 7 Example Fast Stop Company is a Delaware LLC (limited liability company) that owns and operates a neighborhood convenience store in Dallas, Texas. Its owner, Bob Smith, has filed a federal tax election to treat the entity as a sole proprietorship. For the revised franchise tax, it is treated as a corporation which is subject to the revised franchise tax. Expanded List. Under the old franchise tax laws, the tax was only imposed on corporations and limited liability companies. Many corporations reorganized as limited partnerships, limited liability partnerships or in some other nontaxable entity form in order to avoid liability for the tax. This led to a drastic reduction in the amount of tax revenue generated by the old tax. To remedy this problem, the Legislature expanded the tax to most all types of business entities. Limited Liability for Owners. The Legislature decided who was on the new list of taxable entities and who wasn t based upon whether Texas law or the law of the state of formation provided some form of limited liability protection. Those that had it were on the list; those that weren t were not. Taxable Entities. The statute has a long list of the types of entities that are taxable. And the list ends with other legal entity. The safest interpretation of this provision is that all entities are taxable unless they are expressly defined as non-taxable. Corporations. Corporations were subject to the old franchise tax and continue to be subject to the revised franchise tax. There are two common types of corporations: regular and S Corporations. Both are subject to the tax. Regular Corporations. Most corporations fall into this category. Unlike an S Corporation, a regular corporation pays federal income tax on its own income; it does not pass-through income to its shareholders. Texas law provides for the creation of corporations. This law is commonly-known as the Texas Business Corporations Act. It provides for the creation of two classes corporations: regular corporations and close corporations. Both are subject to the revised franchise tax. A corporation is formed by filing articles of incorporation with the Secretary of State of Texas, and by adopting bylaws for its operation. The Secretary of State charges a filing fee to record the articles of incorporation and issue a corporate charter. A corporation will live forever unless its articles of incorporation limit its

19 Page 8 Texas Franchise Tax duration. It must use the word Corporation, Incorporated, Company, or an abbreviation of one of those words in its name. A corporation is a separate person under the law, and therefore, if it is properly organized and managed, it should protect its owners from any personal liability for corporate debts and obligations and from claims against the corporation. If a plaintiff pierces the corporate veil, the shareholders are liable only to the extent of their individual ownership interests. There is no joint and several liability of shareholders. 10 S Corporations. An S Corporation is a taxable entity. It is different from a regular corporation solely as a result of an election provided under the federal income tax laws. S Corporations pass profits and losses through to their owners much like partnerships. In Texas, the rules governing S Corporations are identical to those governing a regular (Subchapter C) corporation. A regular corporation may become an S Corporation by electing that status at the time of its incorporation or a later date by filing the appropriate election with the Internal Revenue Service. Limited Liability Companies. These companies are characterized by limited liability, management by members or managers, and limitation on ownership transfer. 11 An LLC must use the term, Limited Liability Company, Limited Company, L.L.C., LLC, L.C., or LC in its name. Typically, it has a limited term of existence in its articles of organization. If properly formed and operated, the limited liability company will shield its owners from personal liability for the business s debts and claims against it. This is very important, because if the business enterprise were to be classified as a partnership, the owners could have joint and several liability for the debts and claims Types of Business Entities in Texas, by James J. Burnett, Attorney at Law. Black s Law Dictionary, 2001 ed. Types of Business Entities in Texas, by James J. Burnett, Attorney at Law.

20 Texas Franchise Tax Page 9 Note. Disregarded Entities. The federal income tax laws allow shareholders of certain types of entities to elect to disregard the separate legal status of the entity for which the election is made. One common example is the federal tax election by an individual to treat his wholly-owned LLC as a Form 1040, Schedule C, Sole Proprietorship. For the Texas revised franchise tax, as a general rule, we recognize and report separately the entities that the federal income tax laws disregard. In the above example, the wholly-owned LLC would be required to file its own Texas revised franchise tax report. Exception for combined group members. If the disregarded entity is a member of a combined group, the reporting entity may elect to treat it as disregarded as well and the Comptroller will not require it to unwind its financial information from its parent. In this instance, the Comptroller will presume that both the disregarded entity and its owner have taxing nexus with Texas. In the event the disregarded entity does not have nexus with Texas, it should blacken the no nexus circle on the Affiliate Schedule. 13 Exempt Parent Entities. Special rules apply if the parent of the disregarded entity is exempt from both federal and Texas revised franchise tax. In this case, the disregarded entity must be unwound and reported separately from the exempt parent entity since the applicable rules don t allow an exempt entity to file with a combined group. The disregarded entity will file its own Texas revised franchise tax report based upon the amounts reported to the IRS as unrelated business income on IRS Form 990T. Professional Associations. A professional association is a corporation organized under article 1528(e) of the Texas Civil Statutes. They exist for the sole and specific purpose of rendering professional services. They may only have as shareholders individuals who themselves are duly licensed or otherwise duly authorized within this state to render the same professional services as the corporation. 13 Tax Policy Newsletter (Mar. 2009)

21 Page 10 Texas Franchise Tax Only the licensed professionals specifically described in Section 2 of the Texas Professional Association Act may form professional associations. Those licensed professionals are: 1) doctors of medicine; 2) doctors of osteopathy; 3) podiatrists; 4) mental health professionals (such as psychologists, family therapists, and licensed professional counselors); 5) optometrists and therapeutic optometrists; 6) chiropractors; 7) dentists; and 8) veterinarians. Banking Corporations. Banking corporation means each state, national, domestic, or foreign bank, whether organized under the laws of this state, another state, another country, or under federal law. The definition includes a limited banking association organized under the Texas Banking Act, and each bank organized under the Federal Reserve Act 14 (edge corporations), but does not include a bank holding company as that term is defined by Section 2 of the Bank Holding Company Act of Savings and Loan Associations. These include a savings and loan association or savings bank, organized under Texas law, law of another state or country, or federal law. Partnerships. A voluntary association of two or more persons who jointly own and carry on a business for profit. Under the Uniform Partnership Act, a partnership is presumed to exist if the persons agree to share the business s profits or losses proportionally. 16 General Partnerships. As a general rule, general partnerships are subject to the revised franchise tax. A general partnership is an enterprise between two or more partners. It is perhaps the simplest of business entities. In Texas, two statutes are especially important concerning partnerships; The Texas Uniform Partnership Act and the Texas Revised Partnership Act. A general partnership is classified as a taxable entity unless it is entirely owned by natural persons. 17 If one or more partners are not natural persons, then a general partnership is exempt only when it qualifies as a passive entity U.S.C U.S.C Black s Law Dictionary, 2001 ed. Texas Tax Code (b)(2). Texas Tax Code (c)(6).

22 Texas Franchise Tax Page 11 Limited Partnerships. This is a partnership composed of one or more persons who control the business and are personally liable for the partnership s debts (called general partners), and one or more persons who contribute capital and share profits but who cannot manage the business and are liable only up to the amount of their contribution (called limited partners). 19 A limited partnership must use the term, Limited, Limited Partnership, Ltd., or L.P. in its name. 20 A foreign limited partnership is a partnership formed under the laws of another state and having as partners one or more general partners and one or more limited partners. 21 Limited Liability Partnerships. Limited liability partnerships (LLPs) are subject to the revised franchise tax. The 2007 Act (H.B. 3928) clarified this result by stating that a general partnership is subject to the revised franchise tax if it registers as a limited liability partnership under state law. 22 The Texas statutes under which partners may form an LLP are the Revised Partnership Act, Article 6132b-3.08 and Business Organizations Code, Title 4, Chapters 152 and 153, Subchapter H. LLPs may also be formed under similar statutes of other states. 23 Trusts. Generally, an ordinary (non-business) trust arises when trustees take legal title to property for the purpose of protecting or conserving it for the beneficiaries under the ordinary rules applied in probate courts. As a result, the trust is not considered a joint venture operated for profit. 24 However, the federal tax rules classify certain arrangements that look like trusts as corporations. In these cases, the grantor has conveyed legal title of property to trustees for the benefit of beneficiaries, but for a purpose other than simply protecting or conserving the property for the beneficiaries Black s Law Dictionary, 2001 ed. Types of Business Entities in Texas, by James J. Burnett, Attorney at Law. Art. 6132a-1. Texas Revised Limited Partnership Act. Section 1.02 (3). Texas Tax Code (b)(2). Comptroller Rule 3.581(b)(12). Treas. Reg (a).

23 Page 12 Texas Franchise Tax These types of trusts often called business trusts, commercial trusts, Massachusetts trusts, or common law trusts are created by the beneficiaries simply as a device to carry on a profit-making business that is normally carried on through business organizations properly classified for tax purposes as corporations or partnerships. 25 Trusts are generally classified as taxable entities. They are exempt only when they qualify in one of the following categories: Grantor Trusts. All of the grantors and beneficiaries of which are natural persons or charitable entities as described in Internal Revenue Code, 501(c)(3) excluding a trust taxable as a business entity pursuant to Treasury Regulation, (b); 26 Estate trusts. This includes trusts for which an election under IRC 645 has been made under which the trust will be treated and taxed as part of an estate for federal income tax purposes; 27 REITs. Or qualified REIT subsidiaries provided that 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; 28 Non-profit self-insurance trusts; 29 Trusts qualified under Internal Revenue Code, 401(a); 30 Passive trusts, 31 or Trusts or other entities that are exempt under Internal Revenue Code, 501(c)(9) Treas. Reg (b); Hecht, Simon v. Malley, (1924, S Ct). Comptroller Rule 3.581(d)(5). Comptroller Rule 3.581(b)(1). Comptroller Rule 3.581(d)(8). Comptroller Rule 3.581(d)(10). A qualifying self-insurance trust must be created and operated according to the provisions of Texas Insurance Code Chapter 2212 or a predecessor statute. Comptroller Rule 3.581(d)(11). Comptroller Rule 3.581(d)(3). Comptroller Rule 3.581(d)(12).

24 Texas Franchise Tax Page 13 Combined Entity. The statute defines a combined entity as a single taxable entity. This is significant because it affects the calculation of the revised franchise tax. Combined groups must file a combined revised franchise tax report. 33 A combined group consists of otherwise taxable entities that comprise an affiliated group that is engaged in a unitary business. 34 We discuss the affiliated group and unitary tax concept in detail in Chapter VIII. Joint Ventures. A business undertaking by two or more persons engaged in a single defined project. 35 The necessary elements are: an express or implied agreement; a common purpose that the group intends to carry-out; shared profits and losses; and each member s equal voice in controlling the project. Holding Company. An entity that owns a majority of stock or securities of one or more other corporations, thus obtaining control of the other corporations. Joint Stock Company. An unincorporated association of individuals possessing common capital. The members receive shares in amounts proportionate to the members investment. A joint stock can also be a partnership in which the capital is divided into shares that are transferable without the express consent of the partners. 36 Other Legal Entities. This category of taxable entity likely includes any other legal entity for which state law liability protections exist and that the statute does not expressly exempt from the revised franchise tax. What Types of Entities Are Nontaxable? The revised franchise tax exempts certain entities from reporting and liability. Unless an entity is explicitly listed as non-taxable, it is likely that it will be taxed. Sole Proprietorship. Very simply, a sole proprietorship is a business conducted directly by a natural person. With all the attention directed toward corporations, partnerships, limited liability companies, and the other more complex business Texas Tax Code (a). Texas Tax Code (7). Black s Law Dictionary, 2001 ed. Black s Law Dictionary, 2001 ed.

25 Page 14 Texas Franchise Tax vehicles in the commercial world, it is still true that many businesses, especially small ones, are organized as sole proprietorships. This should not be all that surprising. Many young businesses are mom and pop enterprises, with both the decision-making and the work output resting in the hands of a very small, even one, number of people. Many professionals, too, practice their work by themselves and avoid the record-keeping and report-filing responsibilities that the government imposes on other entities. There are no special requirements in Texas for forming a sole proprietorship. All one does is start one s business. Many sole proprietors register under a business name called a dba (which stands for doing business as... ) For example, John Smith, a contract programmer, may desire to market his services as Smith Programming Consultants. This is entirely legal; however, he ll need check with the county clerk in his county to see if the name he wants to use has already been registered to another. A sole proprietorship has no legal status in Texas apart from its owner; the two are one. This means that a sole proprietor will be personally responsible for all debts and obligations of the business as well as all claims made against it. There is no shield to protect the sole proprietor from creditors or claimants. There are no shares of stock or certificates or other papers to confer ownership of a sole proprietorship. The owner simply owns all of the assets and liabilities of the business. He may buy, sell, swap, trade, or give away those assets and liabilities freely, although certain kinds of property often have to be registered (for example, motor vehicles). Tax considerations and the application of special laws dealing with the liquidation of a business, for example, the Bulk Sales Act, may also affect how one goes about acquiring or selling a sole proprietorship. Since there is no stock in a sole proprietorship, the provisions of the Securities Act of 1933 do not apply. Income is taxed at the owner s personal level. Similarly, the deductions that the business would be allowed to take pass through to the owner. 37 General Partnerships. A general partnership is an enterprise between two or more partners. It is perhaps the simplest of business entities. In Texas, two statutes 37 Types of Business Entities in Texas, by James J. Burnett, Attorney at Law.

26 Texas Franchise Tax Page 15 are especially important concerning partnerships; The Texas Uniform Partnership Act and the Texas Revised Partnership Act. Not all general partnerships qualify as exempt. General partnerships are exempt when they are entirely owned by natural persons. 38 If one or more partners are not natural persons, then a general partnership is exempt only when it qualifies as a passive entity. 39 Natural Persons. The term natural person includes both a living human being and the estate of a deceased person. By rule, the Comptroller also treats estate trusts, electing under IRC section 645, as natural persons. 40 As a result, if a natural person dies, the general partnership in which he or she is a partner will continue to be exempt from the revised franchise tax. 41 However, the Comptroller s view is that bankruptcy estates 42 and IRAs 43 are not natural persons. Therefore, a general partnership owned by either of these entities will be treated by the Comptroller as taxable. Example Mr. Davis and Mr. Smith each own a 50% interest in ABC General Partnership. Mr. Davis dies. ABC General Partnership will continue to qualify as a non-taxable entity. Forming a partnership is easy. All that one needs is an agreement between two or more partners to associate for a common enterprise, and share the profits and losses from that enterprise. A partnership does not have to use a special name, and it does not have to file with the Secretary of State of Texas. A partnership may exist even when there is no written or oral agreement; the mere association and sharing of profits and losses can create a partnership. A partnership may be perpetual in nature, although typically the partnership agreement limits its term Texas Tax Code (b)(2). Texas Tax Code (c)(6). Comptroller Rule 3.581(b)(5). Texas Tax Code Comptroller FAQs Taxable Entities, No. 16. Comptroller FAQs Taxable Entities, No. 10. Types of Business Entities in Texas, by James J. Burnett, Attorney at Law.

27 Page 16 Texas Franchise Tax Grantor Trusts. In general, the term trust refers to an arrangement\created either by a will or by a declaration made during the creator s life under which a trustee takes title to property for the purpose of protecting or conserving it for one or more the beneficiaries. 45 A grantor trust is a trust in which the settlor (creator) retains control over the trust property or its income to such an extent that the settlor is taxed on the trust s income. 46 The federal income tax rules require the settlor to report the income from the grantor trust directly on his, her or its federal income tax return. Grantor trusts are exempt only when all of the grantors and beneficiaries of which are natural persons or charitable entities as described in Internal Revenue Code, 501(c)(3) excluding a trust taxable as a business entity pursuant to Treasury Regulation, (b). 47 A business trust is one that is created by the beneficiaries simply as a device to carry on a profit-making business which normally would have been carried on through business organizations that are classified as corporations or partnerships under the Internal Revenue Code. 48 Passive Entities. A passive entity must meet three general requirements. 49 discuss each requirement, in turn, below. Qualified Entity. The first requirement is that it must be organized as either a general partnership, limited partnership, or a trust. A trust will not qualify, however, if it meets the definition of a business trust. 50 Qualified entities also include limited liability partnerships. While the statute is silent on this point, the Comptroller s rule provides this eligibility. 51 We Treasury Regulation, (a). Black s Law Dictionary, 2001 ed. Comptroller Rule 3.581(d)(5). Treasury Regulation, (b). Texas Tax Code Texas Tax Code (a)(1). Comptroller Rule 3.582(c)(1)(C).

28 Texas Franchise Tax Page 17 Entire Reporting Period. Under Comptroller policy, the entity must have been a qualified entity for the entire reporting period. 52 This policy is apparently intended to prevent the avoidance of tax on gains by converting an ineligible entity (eg. S Corporation) to an eligible entity ( eg. limited partnership) prior to the sale of appreciated property with the intention of gaining passive entity status. Example Mr. Smith owns 100% of ABC Corp., an S Corporation. ABC Corp. holds a valuable parcel of land which it intends to sell at a significant gain. ABC Corp. reports on a calendar year basis. On September 1, 2012, it converts to a limited partnership. One month later it sells the land, incurring a huge capital gain, the amount of which exceeds 90% of federal gross taxable income (the passive income threshold). Notwithstanding, the new entity will not qualify as passive because it wasn t an eligible entity for the entire reporting period (January 1, 2012 through December 31, 2012). Passive Income Test. The second requirement is that at least 90% of federal gross income during the reporting period must arise from a specific list of sources. 53 The sources are: Interest Dividends Foreign currency exchange gain Notional principal contract payments Option premiums Cash settlement payments LLC flow-through income Distributive partnership income Net capital gains from selling real estate Net gains from selling commodities traded on an exchange Net gains from selling non-controlling interests in securities Comptroller Rule 3.582(c)(1). Texas Tax Code (a)(2).

29 Page 18 Texas Franchise Tax Royalties, delay rentals and bonuses from oil & gas interests Income from non-operating working interests Passive Income Calculation. The 90% passive income calculation is made by adding the amounts in the various categories of passive income, as set forth above, and then dividing the sum by the federal gross income incurred for the same reporting period. Comptroller Rule 3.582(b)(3) defines federal gross income as gross income as defined by Internal Revenue Code 61(a). Federal Gross Income. Internal Revenue Code 61(a) defines gross income to mean all income from whatever source derived, including (but not limited to) these items: Compensation for services, including fees, commissions, fringe benefits, and similar items; Gross income derived from business; Gains derived from dealings in property; Interest; Rents; Royalties; Dividends; Alimony and separate maintenance payments; Annuities; Income from life insurance and endowment contracts; Pensions; Income from discharge of indebtedness; Distributive share of partnership gross income; Income in respect of a decedent; and Income from an interest in an estate or trust.

30 Texas Franchise Tax Page 19 Passive Entity Reporting. Passive entities that have registered with the Texas Secretary of State s office or have registered with the Comptroller s office must file the No Tax Due Information Report, Form no However, they don t have to file either the Public Information Report, Form no or the Ownership Information Report, Form no Issues with Passive Income Categories. Numerous issues have surfaced in the definitions and characterization of passive income. We address them below: Capital gains from selling real estate. The 2007 Act modifies the term gains from the sale of real estate by adding the word capital. 55 This modification affects the gains that are treated as passive for purposes of the 90% passive income test. We believe the drafters added the word capital to limit the type of qualifying gains to non-inventory sales of real estate. This rationale is consistent with the Internal Revenue Code s definition of a capital asset. Note: The statute associates the word capital only with real estate gains, not gains from the sale of other items, such as securities. Net capital gains or gains. Comptroller s rule 3.582(c)(2)(C) requires taxpayers to compute passive income by netting gains and losses. The applicable statute imposes no such netting requirement. 56 Various professional and industry groups noted this inconsistency with the statute s language and urged the Comptroller not to adopt restrictive language that wasn t present in the statute. 57 The Comptroller declined to follow the comments stating that net gains and net capital gains are included in federal gross income. 58 We believe that the netting position adopted by the Comptroller s rule will probably invite litigation in this area Tax Policy News (Feb. 2008). Texas Tax Code (a)(2)(c). See Texas Tax Code (a)(2)(C). The State Bar of Texas, the Texas Society of CPAs and other industry groups raised this concern. See Preamble to Comptroller Rule

31 Page 20 Texas Franchise Tax Example ABC, LLP generated federal gross income of $10,000,000 during calendar year 2012 which included a $9,500,000 gain from selling shares of Exxon stock and a ($600,000) loss from selling shares of Dell Computer stock. The remaining gross income of $1,100,000 is from rental activities. Per the statute, ABC passes the 90% test (95% of federal gross income is from passive sources) but still fails the 10% test (11% of federal gross income is from active sources.) Therefore, ABC does not qualify as a passive entity. Under the Comptroller s Rule, ABC would pass neither the 90% test nor the 10% test This may be why the Comptroller adopted the rule that losses must be netted against gains when computing passive income. Securities. By rule, the Comptroller defines securities as non-controlling interests in shares of stock in a corporation; partnership or beneficial ownership interest in a widely held or publicly traded partnership or trust; note, bond, debenture, or other evidence of indebtedness; interest rate, currency, or equity notional principal contract; an interest in, or a derivative financial instrument in, any security described above or any currency, including any option, forward contract, short position, and any similar financial instrument in such a security or currency; and hedges or any type of interest in a notional principal contract for commodity; an interest in, or a derivative instrument in, any commodity, including any option, forward contract, futures contract, short position, and any similar instrument in such a commodity, and a hedge position involving commodities. Non-controlling interests in securities. Comptroller s rule 3.582(b)(10) limits the classes of securities eligible for passive income treatment to those where the taxpayer holds a non-controlling interest. The applicable statute imposes no such non-controlling interest requirement. 59 Various professional and industry groups noted this inconsistency in the statute and rule at the outset and urged the Comptroller not to adopt restrictive language that wasn t present in the statute. 60 The Comptroller declined to follow the comments stating that it was reasonably See Texas Tax Code (a)(2)(C). The Texas Taxpayers and Research Association and the Texas Society of CPAs raised this concern.

32 Texas Franchise Tax Page 21 implied in the statute that gains from the sale of controlling interests in securities were not passive. 61 We also believe that the non-controlling position adopted by the Comptroller s rule will probably invite litigation in this area. Example DEF, LLP manufactures toys. Decades ago, it purchased, with its excess working capital, a 51% interest in a software company. It held the stock solely as an investment. In the following years, the value of the shares of the software company skyrocketed. DEF sold them all during 2008 and generated a $100,000,000 gain. The gain exceeds 90% of DEF s federal gross income. Does the entity qualify as passive? Answer: Issue: What tax consequences would ensue if DEF LLP sold 1% of its interest in 2012 and the rest in 2013? Answer: 61 See Preamble to Comptroller Rule

33 Page 22 Texas Franchise Tax Depreciation Recapture. Passive income does not include the ordinary income depreciation recapture component of a gain. Internal Revenue Code 1245 and 1250 convert portions of capital gains to ordinary income. The rationale for the depreciation recapture provisions is to prevent the parlay of deductions against ordinary taxable income into capital gains. Uncertainty arises, however, because sometimes the recapture provisions don t convert the gains into ordinary income; instead they may convert the gains (or portions of them) into capital gains taxed at higher rates. Example ABC, LLP owns rental property located in Texas. During 2012, ABC sold the rental property. During 2012 and prior to the sale, the property generated gross rents of $1,000,000. The gain on sale of the property was $12,000,000. This entire gain arises from the sale of real property (governed by Internal Revenue Code Section 1250 property); none of the gain is attributable to Code Section 1245 property (personal property). Of this $12,000,000 gain, $2,000,000 is short term and $500,000 is Section 1250 unrecaptured depreciation. Section 1250 unrecaptured depreciation is reported as Section 1231 gain (sale of business use property) on the federal partnership return with an additional disclosure identifying that it is subject to a higher flat rate of 25%, as contrasted with a 15% rate. Thus, the receipts of this partnership are comprised of the following:

34 Texas Franchise Tax Page 23 Gross Rents $ 1,000,000 Gain on Sale of Real Property: Long Term 1231 Gain: Taxed at 15% 9,500,000 Taxed at 25% 500,000 Ordinary Income recapture: Taxed at ord. rates -0- Short Term 2,000,000 Total Gross Receipts $13,000,000 Comptroller Rule refers to the Internal Revenue Code for the definition of net capital gains. IRC Regulation (a) defines a gain as the excess of the amount realized over the unrecovered costs or other basis for the property sold or exchanged. Code Section 64 defines ordinary income to exclude gains derived from the sale of capital assets or trade or business property. How much of the $13,000,000 constitutes passive income for purposes of the 90% passive income test? Answer:

35 Page 24 Texas Franchise Tax Active Income. The third requirement is that during the tax year no more than 10% of the entity s federal gross income may be derived from conducting an active trade or business. 62 Federal gross income, defined in detail, above, consists of income as defined in Internal Revenue Code, 61(a). 63 Generally, conducting an active trade or business means that the entity performs active management and operational functions. The Comptroller s policy is that 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. 64 An entity is not passive if more than 10% of its income comes from one or more of these sources: Active Trade or Business. Income arising from the management and operation of an active business. 65 Note that a business may not avoid active classification by outsourcing its operations and management functions. 66 This anti-abuse provision does not extend to financial services and legal services provided by outsiders. 67 Moreover, the mere holding a seat on a board of directors by itself does not constitute the conduct of an active trade or business. 68 Rental Income. The statute expressly provides that rental income is not passive. The Comptroller s office initially announced in November 2008 that, in the Agency s view, rental income did not lose its character when it flowed from a partnership to a partner. However, the Comptroller s office later stated that they will not adopt the rule Texas Tax Code (a)(3). Comptroller Rule 3.582(b)(3). Comptroller Rule 3.582(b)(1)(A). Texas Tax Code (b)(1) &(2). Texas Tax Code (c). Texas Tax Code (e)(2). Texas Tax Code Tax Policy News (Feb. 2009).

36 Texas Franchise Tax Page 25 Operating Working Interest Income. If the entity serves as the operator of one or more oil & gas wells, then the income from those wells is classified as active income. In addition, the working interest income is treated as active if a member in the same affiliated group serves as the operator of the oil & gas wells under the same joint operating agreement. 70 Note: Income that falls within one or more of the passive income categories may still be treated as active if the income was generated from an active business. 71 Issue: In most cases, entities that pass the 90% test will also pass the 10% test. However, it is possible to pass the 90% test under the statute and still fail the 10% test. Example ABC, LLP generated federal gross income of $10,000,000 during calendar year 2012 which included a $9,500,000 gain from selling shares of Exxon stock and a ($600,000) loss from selling shares of Dell Computer stock. The remaining gross income of $1,100,000 is from rental activities. Per the statute, ABC passes the 90% test (95% of federal gross income is from passive sources) but still fails the 10% test (11% of federal gross income is from active sources.) Therefore, ABC does not qualify as a passive entity. Under the Comptroller s Rule, ABC would pass neither the 90% test nor the 10% test. This may be why the Comptroller adopted the rule that losses must be netted against gains when computing passive income Texas Tax Code (b)(2). The preamble to Comptroller Rule mentions that the Comptroller rejected a request by the State Bar of Texas to adopt a policy that would treat income as passive if it fell within one of the enumerated passive categories, regardless of whether the income was derived from an active business. The Comptroller refused to follow the State Bar of Texas s comment stating that the statute didn t support it.

37 Page 26 Texas Franchise Tax Anti-Abuse Rule. An obscure section of the Tax Code states that [a]n entity conducts an 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. 72 This is also known as the anti-geoffrey s rule. In this case, 73 Geoffrey, Inc., a subsidiary of Toys R Us, Inc., owned the Toys R Us trademarks and collected licensing fees for their use by the various stores. Geoffrey had no physical presence in South Carolina. Nevertheless, the South Carolina Supreme Court held that payment of royalties from the retailers to the trademark holder was sufficiently a part of the unitary business of the company to subject it to South Carolina income taxes. The United States Supreme Court denied review of the state s decision, leaving substantial uncertainty in this area. The Texas Supreme Court subsequently resolved this issue in favor of the taxpayer. In Bandag Licensing Corporation v. Rylander, 74 the court refused to hold that BLC s licensing of patents for use in Texas made it liable for the revised franchise tax. 75 Mechanics. The statute apparently attempts to negate the result in Bandag Licensing Corporation by preventing abuse arising from the use of a royalty company to avoid revised franchise tax. However, even without the anti-abuse rule, the royalty company would not qualify as a passive entity because royalty income is not passive income. It is unclear what abuse could actually be prevented by this rule. The Rule says it applies to assets used in the active trade or business of related entities but neither the statute nor the rule define what a related entity is. It s possible that it could mean an entity outside the affiliated group definition, further explained in Chapter VIII Texas Tax Code (d); Comptroller Rule 3.582(b)(1)(C). See Geoffrey, Inc. v. South Carolina Tax Commission, 437 S.E.2d 13 (South Carolina 1993), cert. denied 114 S. Ct. 550 (1993). Bandag Licensing Co. v. Rylander, CV, 18 S.W.3d 296, (Tex. App.-Austin 2000, pet. denied). Strayhorn v. Raytheon E-Systems, 2003 Tex. App. LEXIS 2522 (Tex. App. Austin, January 30, 2003) limits the reward of attorneys fees under the Uniform Declaratory Judgments Act (UDJA) where a different statutory remedy exists. The court distinguished the case from Bandag because Bandag s UDJA claims went beyond its tax refund request and sought the court s interpretation of a statute.

38 Texas Franchise Tax Page 27 Taxable Entity Owning Passive Entity Interest. A passive entity s income doesn t necessarily escape the revised franchise tax. A taxable entity must include and pay franchise tax on its share of the net income of a passive entity. 76 Example Texas Corp owns 50% of Passive LP. Texas Corp is a taxable entity. Passive LP is an exempt entity. Passive LP generates the following net income: O&G Revenues $1,000 Lease Operating Expense 600 Net Income $ 400 Texas Corp must include its 50% share of $400 (equals $200) in its revenue. Exception: A taxable entity will not include and pay franchise tax on its share of net income from a passive entity to the extent the net income was generated by taxable margin of another entity. Passive Entity Reporting. If the passive entity is registered with the Comptroller s office or the Texas Secretary of State s office, the Comptroller requires it to file a no tax due information report for the period upon which the tax is based. 77 This is done using Form Texas limited partnerships are an example of an entity registered with the Texas Secretary of State s office. If the passive entity is not registered with the Comptroller s office or the Texas Secretary of State s office, the Comptroller will not require it to register or to file a franchise tax report. If the passive entity later loses its passive entity status, the Comptroller s office will require it to file the Texas Nexus Questionnaire, Form no. AP-114 or the Texas Business Questionnaire, Form no. AP-224 to register with the Comptroller s office so that it may begin filing franchise tax reports. 78 A registered passive entity must file the no tax due information report each year Texas Tax Code (e). See Comptroller FAQs for Passive Entities, Question and Answer No. 8 (April 16, 2008). See Comptroller FAQs for Passive Entities, Question and Answer No. 8 (April 16, 2008). Tax Policy News (Apr. 2011).

39 Page 28 Texas Franchise Tax Estate of a Natural Person. An Estate of a natural person is the legal entity that holds the collective assets and liabilities of a dead person. 80 Certain Joint Operating or Co-ownership Arrangements. Joint ventures that qualify as an operating agreement group and elect out of federal partnership treatment are nontaxable. To qualify, the operating agreement group cannot be incorporated and its members must: Participate in the joint production, extraction or use of property; Own the property as co-owners, either in fee or under a lease or other form of contract that grants exclusive operating rights; Reserve the right separately to take in kind or dispose of their shares of any property produced, extracted, or used; and Not jointly sell services or the property produced or extracted. However, each participant may delegate authority to sell its share of the property produced or extracted for its account for a period not to exceed the minimum needs of the industry, and in no event for more than one year. An entity seeking nontaxable treatment under this provision must file the appropriate election required under Treasury Regulation (a)(3). Additionally, joint ventures owned entirely by natural persons are nontaxable. 81 An Escrow. An escrow is [a] writing, deed, money, stock or other property delivered by the grantor, promisor or obligor into the hands of a third person, to be held by the latter until the happening of a contingency or performance of a condition, and then by him delivered to the grantee, promisee or oblige. 82 Real Estate Investment Trust (REIT). A REIT is a company that buys, develops, manages and sells real estate assets. REITs allow participants to invest in a professionally-managed portfolio of real estate properties. REITs qualify as passthrough entities, companies who are able distribute income to investors without taxation at the corporate level (providing that certain conditions are met) Black s Law Dictionary, 2001 ed. Comptroller Letter No L. Black s Law Dictionary (5th ed., 1979).

40 Texas Franchise Tax Page 29 A REIT s business activities are generally restricted to generating rental income as a passive landlord. Another major advantage of REIT investment is its liquidity (ease of liquidation of assets into cash), as compared to traditional private real estate ownership which are not very easy to liquidate. One reason for the liquid nature of REIT investments is that its shares are primarily traded on major exchanges, making it easier to buy and sell REIT assets/shares than to buy and sell properties in private markets. 83 In the absence of special Internal Revenue Code provisions, a REIT would be taxable as a corporation. Under the federal regime of income taxation, corporations are not allowed to deduct dividend payments from taxable income. A qualifying REIT, however, is allowed to deduct dividend payments to its members. Accordingly, many real estate investments are organized as REITs in order to gain this preferential federal income tax treatment. The revised franchise tax statute provides preferential treatment as well. It provides that REITs (and their qualified subsidiaries) are not taxable entities so long as they hold all of their real estate indirectly, through limited partnerships or other legal entities. However, there s an exception, a REIT may directly own real estate that it uses for own purposes, such an office building for its administrative staff. Real Estate Mortgage Investment Conduit (REMIC). A REMIC is an entity that is taxed under federal law in a manner similar to REITs. REMICs are organized as trusts to hold various categories of mortgages and bonds. For operational purposes, REMICs must offer multiple types of investments in the form of beneficial interests. These beneficial interests have unique characteristics, depending upon the particular needs of the potential investor. In the absence of the special REMIC provisions, the presence of the varying characteristics of the beneficial interests would force the REMIC to be taxed as a corporation. Like a REIT, if the REMIC meets certain strict federal income tax requirements it will be afforded the preferential dividend treatment afforded REITs and mutual funds. Benefit Plans. Self-insurance trusts, qualified pension plans, profit sharing plans, stock bonus plans, and voluntary employees beneficiary associations are exempt from the tax as well Texas Tax Code (c)(6),(7) and (8).

41 Page 30 Texas Franchise Tax Political Committees. Exempt entities include an unincorporated entity organized as political committee under the Texas election code or the federal election campaign act of Former Exempt Entities. The revised franchise tax statute extends the existing exemptions for tax-exempt corporations to all types of entities. 86 As a result, the following entities don t have to be organized in corporate form to receive the franchise tax exemption. Exempt entities must furnish a copy of their IRS exemption letters to the Comptroller as a condition of obtaining exemption from Texas taxes. 87 However, organizations that are currently exempt from the Texas revised franchise tax do not need to re-apply for the exemption. 88 Exempt entities do not have to file any Texas franchise tax reports or any related Public Information reports. 89 Unrelated Business Income. If an exempt entity has unrelated business income within the meaning of the Internal Revenue Code, it does not have to file a franchise report to report the unrelated business income, notwithstanding there may be additional federal tax reporting requirements. 90 Exempt entities include: Non-Profit Entities. Non-profit entities organized for religious worship; 91 educational purposes, including student loans and scholarships; 92 public charities; 93 and entities exempt from federal income tax under IRC 501(c) (2), (3), (4), (5), (6), (7), (16) or (25) Texas Tax Code (c)(9). See Texas Tax Code to.086 (Vernon 1992); Comptroller Rule also sets out the procedure for obtaining a temporary franchise tax exemption while a corporation awaits its exemption from the Internal Revenue Service. See Texas Tax Code See Comptroller FAQs for Exemptions, Question and Answer No. 1 (April 16, 2008) See Comptroller FAQs for Exemptions, Question and Answer No. 4 (April 16, 2008) See Comptroller FAQs for Exemptions, Question and Answer No. 5 (April 16, 2008) Texas Tax Code Ann (Vernon 1992). Texas Tax Code Ann (Vernon 1992). Texas Tax Code Ann (Vernon 1992). Texas Tax Code Ann (Vernon 1992).

42 Texas Franchise Tax Page 31 Note: Texas exempts nonprofit organizations organized for the purpose of religious worship. 95 Until recently, the Comptroller interpreted the exemption to apply to groups demonstrating a belief in a supreme being. The Third Court of Appeals recently held the Comptroller s interpretation unconstitutional because it failed to include the whole range of belief systems meriting First Amendment protection. 96 Insurance Companies. Insurance companies, sureties, guaranty corporations, title insurance companies, title insurance agents, or fidelity companies are exempt because they are already taxed under the grossreceipts tax provisions of the insurance code. 97 However, the exemption is not available to any entity that operates at any time during year in violation of an order issued by the Texas Department of Insurance under Insurance Code (b). The Comptroller s former position was that only insurance companies that paid the Texas gross premiums taxes qualified for this exemption. 98 The Texas Legislature amended the Texas revised franchise tax statute in 2013 to provide that the exemption applies when the nonadmitted insurance company is subject to an occupations tax, privilege tax or gross premiums tax in another state. 99 The legislative amendment adopts the position advanced by Atlantic Casualty Insurance Co. in its suit against the Comptroller Texas Tax Code Ann (West 2003). See Ethical Society of Austin v. Strayhorn, 2003 Tex. App. LEXIS 1912, Tex. App. Austin (March 6, 2003). Under the court s test, the Ethical Society of Austin, which bases its beliefs on the ethical culture of society, qualifies as an exempt religious organization because it addresses fundamental and ultimate questions, has a comprehensive belief system, and shows outward external signs of being a religion. Texas Tax Code Ann (Vernon Supp. 1995). This also includes nonadmitted captive insurance companies if they pay a gross premium receipts tax during the same year they re requesting the franchise tax exemptions. Comptroller Letter No L (Sept. 30, 2011). Texas Tax Code Ann (a) eff. Jan. 1, 2014).

43 Page 32 Texas Franchise Tax Settled Litigation. A surplus lines carrier recently settled its lawsuit challenging the Comptroller s position that only insurance companies that pay Texas gross premiums taxes qualify for the exemption. 100 Texas imposes a tax on gross premiums for surplus lines insurance, and surplus lines carriers typically pay gross premiums taxes to states in which they hold certificates of authority. Atlantic Casualty argued that the payment of a gross premiums to another state (besides Texas) was sufficient to invoke the franchise tax exemption. The revised franchise tax statute has now been amended to comport with the result sought by Atlantic Casualty s lawsuit. Railway Terminal Corporations. Railway terminal corporations having no annual net income from its business are exempt from the revised franchise tax. 101 Agriculture Corporations. Non-profit corporations formed to hold agriculture fairs and encourage agricultural activities are exempt. 102 Agricultural credit associations regulated by the Farm Credit Administration are also exempt. 103 Nursing Homes. Non-profit convalescent homes, and housing for handicapped, disabled, or persons 62 years and older are exempt Atlantic Casualty Insurance Company v. Combs, et al., No. D-1-GN Martens, Todd, Leonard & Taylor represented Atlantic Casualty. Texas Tax Code Ann (Vernon 1992). Texas Tax Code Ann (Vernon 1992). Effective Sept. 1, The exemption also applies to entities organized under 12 U.S.C Texas Tax Code Ann (Vernon 1992).

44 Texas Franchise Tax Page 33 Other Exempt Corporations. Several other categories of corporations are exempt from the revised franchise tax. Some of the more common ones include: Farm mutuals, local mutual aid associations, and burial associations 105 Wind energy and solar energy 106 Open-end investment companies 107 Corporations manufacturing, selling or installing solar energy devices 108 Non-profit entities organized to provide burial places 109 Non-profit corporations organized to provide cities with water supply, sewer services, or natural gas 110 Electric and telephone cooperatives 111 Certain trade show participants 112 Credit unions 113 Non-profit homeowners associations 114 Non-profit emergency services corporations 115 Energy aggregation corporations S.B (77th Legis. Session) amending Texas Tax Code See Texas Tax Code (exempting corporations engaged solely in the business of manufacturing, selling or installing solar energy devices). See also Comptroller Letter No L (July 30, 2002) and Tax Policy News, Vol. XII, Iss. 9 (Sept. 2002) (explaining the Comptroller s position that wind energy qualifies for the exemption and deduction as well) Texas Tax Code Ann (Vernon 1992). Texas Tax Code Ann (Vernon 1992). Texas Tax Code Ann (Vernon 1992). Texas Tax Code Ann (Vernon 1992). Texas Tax Code Ann (Vernon 1992). Texas Tax Code Ann (Vernon 1992). Texas Tax Code Ann (Vernon 1992). Texas Tax Code Ann (Vernon 1992). Texas Tax Code Ann (Vernon 1992).

45 Page 34 Texas Franchise Tax Wind Energy and Solar Energy. The Comptroller found that a company that designed and installed wind farms was not entitled to the exemption from revised franchise tax for companies engaged solely in the business of manufacturing, selling, or installing solar or wind energy devices. 117 The Comptroller denied the exemption because the company also oversaw the construction of roads, buildings, and fences to support the wind farms. Anti-Conversion Partnership Termination Rules The statute contains rules that are designed to anticipate and prevent the rush to convert to entities not subject to the new tax. Terminating Partnerships. The statute prevents a partnership from terminating until every part of its business, financial operations, and ventures cease to be carried on by any of its partners in a partnership. 118 Important Note: Read literally, this would mean that two partners, each owning 1% of a partnership could not terminate the old partnership if they continued any part of the former partnership s business, financial operation or venture in another partnership. Example Smith and Jones are lawyers practicing law in a registered limited liability partnership. To avoid liability for the revised franchise tax, they terminate Jones & Smith, LLP and reorganize as Smith & Jones, GP. The statute treats Smith & Jones, LLP as continuing, even after its legal termination and reorganization. Merging Partnerships. The statute states that in the case of a merger or consolidation of partnerships, the resulting partnership is treated as a continuation of the former partnership if the partners hold 50% or more of the capital and profit interests of the surviving partnership Texas Tax Code Ann (eff. Jan 1, 2014) Local governments form these corporations under Local Gov t Code to purchase electricity for local entities. Comptroller Hearing No. 102,945 (Oct. 17, 2011). H.B. 3, 79th Legislature, Special Session, Section 22(c) & (d). H.B. 3, 79th Legislature, Special Session, Section 22(e).

46 Texas Franchise Tax Page 35 Dividing Partnerships. The statute states that in the case of a partnership division, the resulting partnerships are treated as continuations of the former partnership when the new partners were holders of 50% or more of the capital and profit interests of the former partnership. 120 Charges to Customers to Recover the Franchise Tax. The Comptroller allows businesses to recover the cost of the revised franchise tax as a line item charge on invoices. The Comptroller requires that the business NOT state that the item is a tax and may NOT state in on the invoice section for taxes and governmental fees. Instead, the taxpayer must identify the charge as a Recovery Charge and should disclose that the charge is not a tax the law requires the business to collect. 121 Power to Tax Texas has the power to tax entities defined as taxable that are chartered, organized or doing business in Texas. 122 An entity does business in Texas when its business activity in Texas reaches certain minimal levels. Scope of doing business in Texas. The Texas revised franchise tax is imposed on taxable entities doing business in the State of Texas. The Tax Code states that a taxable entity is doing business in Texas if it has sufficient contact with Texas to be taxed without violating the federal constitution. 123 This rather broad and unhelpful pronouncement has been and probably will continue to be the subject of much litigation. Constitutional Issues-Nexus and Minimum Contacts. At the outset, we must establish the constitutional boundaries of state taxation since Texas power to tax extends to the full U.S. Constitutional limits H.B. 3, 79th Legislature, Special Session, Section 22(f). Tax Policy Newsletter, p. 1 (Oct. 2010) Texas Tax Code (a). Texas Tax Code (b).

47 Page 36 Texas Franchise Tax Substantial Nexus & the Commerce Clause. The federal constitution grants the United States Congress the power to regulate interstate commerce (the Commerce Clause ). 124 While on its face the Commerce Clause is an affirmative grant of power, the courts have interpreted it to negate a state s power to unduly burden foreign or interstate commerce. It requires the states that seek to tax the multistate activities of an entity to show that the entity is doing business in the state. Doing business requires some level of physical presence within the taxing state, beyond products shipped by common carrier. This concept, known as constitutional or substantial nexus, must exist for the state to tax a corporation. If nexus does not exist, the corporation owes no tax to the state regardless of the source of its receipts. 125 Minimum Contacts & Due Process. The Due Process Clause of the federal constitution provides that in order for a state to tax any transaction, there must be some definite link, some minimum connection, between the state and the person, property or transaction it seeks to tax. 126 In other words, the entity being taxed must have enough minimum contacts with the state in order to justify its taxation. Although often erroneously grouped together with the nexus requirements of the Commerce Clause, the necessity for minimum contacts exists separate and part from the nexus requirements. One can exist without the other, and in order to tax, both must be present. 127 Quill Corp. v. North Dakota. 128 Quill Corporation sold office equipment and supplies by mail-order catalog. Quill had neither employees nor property within the State of North Dakota, and all of its solicitation in North Dakota was through catalogs, flyers, and advertisements in national periodicals. Quill delivered its products by mail and common carrier. Despite its lack of physical presence within North Dakota, Quill s volume of sales in North Dakota made it the seventh largest retailer in the state. The United States Supreme Court overturned North Dakota s The Congress shall have power... to regulate commerce with foreign nations, and among the several states.... U.S. Const. art. I, 8, cl. 3. Complete Auto Transport, Inc. v. Brady, 430 U.S. 274, 97 S. Ct (1977). Miller Bros. v. Maryland, 347 U.S. 340, 74 S. Ct. 535 (1954). Quill Corp. v. North Dakota, 504 U.S. 298, 112 S. Ct (1992). Quill Corp. v. North Dakota, 504 U.S. 298, 112 S. Ct (1992).

48 Texas Franchise Tax Page 37 attempt to assess a use tax on Quill s sales within the state as an unconstitutional burden on interstate commerce. According to the Supreme Court, Quill had minimum contacts with the state thereby justifying taxation under the federal due process clause. The minimum contacts arose because Quill purposefully availed itself of North Dakota s markets. However, Quill lacked sufficient nexus to overcome the burden such taxation placed upon interstate commerce. The reason for this was that Quill did not have property or employees in the state and thus lacked physical presence in the state. Extending Quill to Other Types of Taxes. Although the Quill case involved use taxes on catalog sales, courts have applied Quill s due process and commerce clause standards to other types of taxes as well. Gillette Case. A Michigan court applied the Quill test in a case involving a Single Business Tax that taxed the value added by the business s services. 129 Because it was not a tax on net income or a tax measured by net income the court decided that Public Law did not apply but that Quill s due process and commerce clause tests did. 130 Gillette was subject to the tax because it maintained a full-time sales force in Michigan, owned promotional and replacement merchandise in the state, and leased cars for its Michigan sales representatives. J.C. Penney National Bank Case. A Tennessee court applied the Quill standard to strike down Tennessee s imposition of its franchise tax upon J.C. Penney National Bank s (JCPNB) credit card activities in the state. 131 The court determined that credit cards did not create a physical presence in the state and JCPNB was therefore not subject to Tennessee franchise and excise tax Gillette v. Dept. of Treasury, 497 N.W.2d 595 (Mich. App. 1993), cert. denied 513 U.S (1995). The State of Michigan recently affirmed this decision and approved the retroactive application of Gillette in Topps Co., Inc. v, Dept. of Treasury, Docket No (Mich. App. 1999), cert. denied 531 U.S. 920 (October, 2, 2000). J.C. Penney National Bank v. Johnson, 19 S.W.3d 831 (Tenn. Ct. App. 1999), cert. denied 531 U.S. 927, 148 L. Ed. 2d 245, 121 S. Ct. 305 (2000). The court s view was that the credit cards themselves were worthless because their only value lay in the available credit.

49 Page 38 Texas Franchise Tax De Mimimis Activities. A Comptroller hearing decision found that a Missouri business s activities in Texas were de minimis even though the business made deliveries to Texas in its own trucks. 133 The taxpayer was a Missouri business that manufactured overhead highway signs, posts, bridge railings, and guardrails. The business s administrative offices and manufacturing facilities were in Missouri. The business owned no property and had no employees in Texas. Orders for materials were typically received in Missouri via mail, telephone or fax. After fabricating steel and aluminum products to fulfill the orders, the Missouri business used its own trucks to deliver the items to job sites in Texas. Texas Laundry List of Doing Business Activities. The following activities, even when conducted on a minor scale in Texas, constitute doing business in Texas. They will subject a company s franchise to tax in Texas. Making repairs or providing maintenance; Collecting current or delinquent accounts; Investigating credit worthiness; Installing items or supervising installation; Conducting training classes, seminars, or lectures for personnel; Providing technical assistance or services in order to facilitate any purpose; Investigating, handling, or otherwise assisting in the resolution of customer complaints; Approving or accepting orders; Repossessing property; Securing deposits on sales; Picking up or replacing damaged or returned property; Hiring, training, or supervising personnel; Providing shipping information and coordinating deliveries; Maintaining a sample or display room in excess of two weeks at any one location during the period upon which the earned surplus is based; 133 Comptroller Decision No. 36,590 (Jan. 20, 2000).

50 Texas Franchise Tax Page 39 Carrying samples for sale, exchange, or distribution in any manner for consideration; Owning, leasing, or maintaining any of the following: 134 repair shop; parts department; purchasing office; employment or recruiting office; warehouse; meeting place for employees; stock of goods other than samples used solely for sales; telephone answering service; mobile stores; real property or fixtures. Consigning tangible personal property to anyone; Maintaining by any employee an office or place of business at home or elsewhere that is financed directly or indirectly by the company which is formally attributed to the company; Using agency stock checks or any other instrument or process by which sales are made within the state by sales personnel; Performing any contract in Texas; Providing services; Staging shows or other theatrical performances; Carrying passengers or freight from one point in the state to another point in the state. 134 Note that the Comptroller s auditors will check the Yellow Pages to determine if a business is engaged in any of these activities.

51 Page 40 Texas Franchise Tax The following two examples illustrate how Texas law applies to multi-state businesses. Example 1 Acme Computers, a California corporation, solicits sales in Texas through its catalogs, which it delivers into Texas by mail. Other than shipping the catalogs and orders received there from into Texas from California, it has no presence or connection with Texas. Mailing the catalogs and fulfilling orders will probably be sufficient to establish minimum contacts under the due process clause. However, the United States Supreme Court has held that such an arrangement does not establish substantial nexus, and has forbidden states from taxing such activity. 135 Example 2 Tiered Partnerships Same facts as Example 1, except that Acme also includes on-site training with its sales price. Sending training personnel to Texas is enough to establish constitutional nexus and make the company liable for the revised franchise tax. 136 In General. The tiered-partnership reporting rules may be used to pass-through revenue of a lower-tier entity (partnership or S Corporation) to eligible upper-tier entities. The tiered-partnership provisions have been the subject of confusion and controversy since they were initially adopted in 2006 and amended in Only Revenue Passed Up. Upper-tier entities include their share of the total revenue of a lower tier entity in their margin calculation instead of including their share of the lower tier entity s margin. 137 The lower tier entity is required to file Form no stating the amount of revenue each upper tier entity should include in their calculation based on their ownership percentage. The problem is that the statute doesn t provide for the flow-through for deductions for COGS or compensation. As a result, lower-tier entities with substantial COGS may not benefit from making the election. Moreover, there is nothing in the statute that See Quill Corp. v. North Dakota, 504 U.S. 298, 112 S. Ct (1992). Comptroller Decision No. 32,349 (1995). Texas Tax Code (b).

52 Texas Franchise Tax Page 41 says the lower tier entity doesn t also have to pay the franchise tax on the revenue it has passed to the upper tier, and as a result, the lower tier entity s margin could be subject to the franchise tax twice. Comptroller Rule Fixes Double Tax Problem. The Comptroller announced that it will interpret the Tiered Partnerships provisions in a way that permits taxpayers to use them without incurring double tax. Applicable Rules. A lower tier entity elects tiered-partnership reporting under the following rules: 1. Only lower-tier partnerships and lower-tier S-Corporations are eligible to make the tiered-partnership reporting election Eligible Upper-Tier Entities. The upper-tier entities are partners of the lower-tier entity. They are eligible to receive the pass-through of revenue from a lower-tier entity only when they (the upper-tier entities) are subject to tax. As a result, corporations, limited liability companies, limited partnerships, limited liability partnerships, trusts as well as other taxable entities will qualify as upper-tier entities. An electing lower-tier entity may not pass-through revenue to an entity that is not subject to the franchise tax Revenue Pass-Through Choice. The lower-tier partnership may choose to report (pass-through) its revenue to any or all of the eligible upper tier entities. However, the total revenue reported to an upper-tier entity must equal the upper-tier s percentage ownership of the lower-tier s entire total revenue, not merely a portion Combined Groups. The tiered-partnership election is not available to any lower-tier entity that is required to be included in a combined report Remaining Lower-Tier Revenue. The lower-tier entity must file a franchise tax report that reports the remaining revenue that is not passed-through to eligible upper-tier entities. The lower-tier entity does not reduce its COGS Texas Tax Code (a). Comptroller Rule 3.587(c)(8)(B). Comptroller Rule 3.587(c)(8)(B). Comptroller Rule 3.587(c)(8)(E).

53 Page 42 Texas Franchise Tax or compensation deductions as a result of the pass-through of revenue to upper-tier entities No Tax Due, Discounts, E-Z Computations. These preferences are not available to any upper-tier entity if, before the pass-through of revenue to the upper-tire entity, the lower-tier entity does not meet the conditions imposed to qualify for these preferences The lower tier entity makes the election to file under the tiered-reporting rules. It does so by filing the Tiered Partnership Report, Form no The lower-tier entity reports the revenue passed-through to the upper tier entities on Form no : Comptroller Rule 3.587(c)(8)(A). Comptroller Rule 3.587(c)(8)(C). See

54 Texas Franchise Tax Page 43 Statute of Limitations As a general rule, the Comptroller must assess any additional type of tax (franchise, sales etc.) within four (4) years of the date the tax becomes due and payable. 145 Like most statutes of limitation, there are exceptions: Consent. The taxpayer may agree, in writing, to provide the Comptroller additional time to assess tax. Gross Error. The limitation period is extended from four (4) years to indefinitely if the report understates tax by more than 25%. 146 Failure to File Form. The limitations period does not begin until the form is filed. 147 Fraud. The limitations period never runs in the case of fraud. 148 Amended Franchise Tax Reports Two events now trigger the need to file amended Texas franchise reports: IRS Audit. An IRS audit adjustment changes margin, or Amended U.S. Tax Return. The taxable entity amends its U.S. Federal Tax Return in a manner that changes the amount of its items affecting margin. 149 Deadline. The taxable entity has 120 days to file an amended Franchise Tax Report or it faces a 10% penalty. Limitations Period Extended. When the IRS audits a taxpayer and makes a final determination, the normal 4 year limitations period is extended for one year from the date the Comptroller receives the IRS audit report or otherwise discovers the final determination Texas Tax Code Texas Tax Code (a)(3). Texas Tax Code (a)(2). Texas Tax Code (a)(1). Effective Date 9/1/97.

55 Page 44 Texas Franchise Tax Important Note: Under the IRS procedure, neither an audit report nor the statutory notice of deficiency constitutes a final determination of a federal tax liability. A final determination occurs when the taxpayer consents to the audit changes, fails to respond to a statutory notice of deficiency or when a tax court decision becomes final. Accounting Errors. Taxable entities may file an amended franchise report to correct an accounting error. An accounting error means: A mathematical mistake; or Oversight or unintentional misuse of the facts that existed on the date on which the tax is based. 150 Note: Subsequent events do not create accounting errors even if they tend to show error in the conditions or facts that existed on the date on which the tax is based. Procedure in filing an amended report, the taxable entity must: Type or print on the top of the report the phrase Amended Report: or Amended Refund if the amendment results in an overpayment; Include a signed letter, with taxpayer name and number, which states in detail the reason for the amended report. Include enclosures necessary to support the amendment Comptroller Rule 3.547(c)(5)(A). Tax Policy News (Feb. 2009).

56 Texas Franchise Tax Page 45 Claim for Refund. Taxpayers may file an amended report to support a claim for refund. 152 Election-Switching Policy Reversal. During 2012, the Comptroller recently reversed her prior policy on election changes. The Comptroller now allows taxpayers to amend their Texas franchise tax reports to switch to or from the cost of goods sold or compensation deductions at any time within the statute of limitations. 153 Previously, the Comptroller determined that taxpayers could not file amended reports to change their election after the due date of the report. 154 Many taxpayers believe the Comptroller s prior policy conflicted with the Texas Tax code and the Comptroller s own tax forms and instructions. Cases Challenge Comptroller Election Policy. Two cases filed in Travis County District Court before the Comptroller s policy change concern whether taxpayers who initially file using the E-Z computation form may elect the cost of goods sold deduction. 155 The Comptroller s policy reversal came shortly before the August 20, 2012 jury trial scheduled in one of these cases. District Court Allows Election Change. In the first Texas revised franchise tax case tried in the Travis County District Courts, the taxpayer prevailed in proving it qualified as a temporary employment service, rather than as a professional engineering firm as alleged by the Comptroller. In her order, the trial judge ruled that the taxpayer was entitled to claim the compensation deduction for the wages and benefits of the unassigned workers. The taxpayer had previously claimed the COGS deduction. 156 The district court decided this case prior to the Comptroller s policy change Tax Policy News (Feb. 2009). Texas Comptroller of Public Accounts, Important Information Concerning Cost of Goods Sold (COGS) and Compensation Deduction Elections available at See, e.g., Comptroller Hearing No. 105,037 (Nov. 15, 2011). Bigham Bros., Inc. v. Combs, No. D-1-GN Martens, Todd & Leonard represented the plaintiff. Sunbelt Custom Mineral, LLC v. Combs, No. D-1-GN Martens, Todd & Leonard represented the plaintiff. Taylor & Hill v. Combs, No. D-1-GN , 53rd District Court, Travis County, Texas, July 7, James Martens and Lacy Leonard with Martens, Todd, Leonard & Taylor tried this case.

57 Page 46 Texas Franchise Tax Pending Litigation. A similar case involving a company in the advertising and marketing industry is currently pending in Travis County District Court. 157 The taxpayer alleges that it qualifies for the revenue exclusion for staff leasing services companies and to deduct compensation. The taxpayer initially filed using the COGS method. Comptroller Allows Election Change by Certain Combined Entities. The Comptroller interprets the Texas Tax Code to allow certain taxpayers to calculate margin under a different method than originally filed. This policy applies to taxpayers who originally filed separate reports in error and later filed a combined report. The Comptroller will allow the combined group to choose any method (COGS or Compensation) so long as one member of the group had previously filed a separate report electing that method. 158 Example Company A and Company B are affiliated. They file separate reports in which Company A calculates its margin based upon the COGS method and Company B files using the Compensation method. Later, and after the due dates for the reports have lapsed, the Comptroller forces the two companies to file a combined report. The Comptroller will allow the combined entity to elect to calculate its margin based upon either the COGS or Compensation method. (Note that EZ and the 30% minimum deduction are always available). The rationale for this policy is that the combined group is a distinct taxpayer from its members and is therefore making its reporting election for the first time on the late-filed combined report Liaison Resources, L.P. v. Combs, No. D-1-GN Martens, Todd, Leonard & Taylor represents the plaintiff. Comptroller Letter No L (Aug 9, 2011). Id.

58 Texas Franchise Tax Page 47 Chapter II. Computations & Reporting Texas businesses have been calculating their franchise tax under the revised franchise tax since This chapter explains the basics of the calculation. Calculating the Margin General. The tax is imposed on either taxable margin or, for certain electing taxpayers, on total revenues. Taxable margin is a concept similar to taxable income. As a result of the 2013 legislative changes, an entity s taxable margin is now the lesser of (A) 70% of total revenue or total revenue less $1 million; or (B) total revenue less the greater of (1) $1 million, (2) COGS, or (3) compensation. 160 The effect of these changes is to make the $1million exemption permanent. Taxable margin must then be apportioned to business done in Texas. We measure the proportionate share of business done in Texas by determining the ratio of gross receipts from business done in Texas to gross receipts from business done everywhere. Revenue. An entity must look to its federal income tax return to determine its revenue. It will add together the income amounts reportable on the top half of page one of its federal income tax form, and certain amounts from other forms. The income amounts generally include gross receipts (less returns and allowances,) dividends, interest, rents and royalties, capital gains, and other income. From this, the entity subtracts bad debt expense, foreign royalties and dividends, partnership distributions, and dividends that qualify for the federal deduction for dividends received. Certain flow-through funds mandated by law, fiduciary duty, or contract are excluded for all taxable entities. Additionally, two professions get very specific exemptions of revenue: doctors and attorneys both get certain exemptions based on pro bono services they ve provided, and doctors get to exempt all payments received from Medicaid, Medicare, and certain other governmental programs. Income received from certain low-volume oil and gas wells is also exempt. Dividends and interest received from federal obligations is exempt for everyone. 160 Texas Tax Code (a) eff. Jan 1, 2014.

59 Page 48 Texas Franchise Tax Cost of Goods Sold Deduction. While the revenue and compensation deductions rely heavily on federal tax calculations, the cost of goods sold calculation depends entirely on Texas rules that are similar but not identical to the federal rules. Moreover, taxpayers may elect to deduct cost of goods sold as incurred, rather than capitalize and inventory them. 161 The cost of goods sold deduction only includes costs required to produce or acquire a good. A good only includes real or tangible personal property, but the definition of tangible personal property is somewhat broad it includes the cost of developing films, sound recordings, or books if the tangible medium in which the property is embodied will be mass distributed. It also includes computer programs. It does not include intangible property (such as accounts receivable) or services (such as tax return preparation fees). The good must generally be owned by the entity in order for its cost to be deducted. The cost of these goods includes all direct costs of acquiring or producing the goods. This includes inbound freight, storage, research and development, geological and geophysical costs, depreciation of equipment used to produce the goods, and other costs specifically listed. The cost also includes certain costs for goods that weren t actually sold: costs of deterioration, obsolescence, and spoilage of goods. There is a list of costs specifically excluded from cost of goods sold, including selling costs, outbound freight, idle facility expenses, bidding costs, interest costs, income taxes, officers compensation, and compensation paid to undocumented workers. Up to 4% of indirect administrative costs can also be deducted, if the entity can demonstrate that the costs are allocable to the acquisition or production of goods. Compensation Deduction. Two types of expenses are deductible under the compensation election: wages and cash compensation and benefits. Wages and cash compensation covers most typical compensation expenses. The law states the starting point is the Medicare wages and tips box on Federal Form W-2. Any entity that is treated for federal tax purposes as a partnership or S corporation, or a limited liability company treated as a sole proprietorship, can add to this number the net distributive income it paid to natural persons. Entities can also add to wages and cash compensation stock awards and options that were deducted for federal tax purposes. The wages and cash compensation amount is capped to $300,000 for any person until 2010, at which point the cap automatically adjusts based on inflation. For 2013, cap is $330,000 per person Texas Tax Code Comptroller FAQs Compensation, No. 3.

60 Texas Franchise Tax Page 49 No deduction can be taken for payments to undocumented workers, i.e. not lawfully present and employed in the United States. Benefits are also deductible to the extent they are deductible for federal income tax purposes, and the amount of benefits provided to any person is not subject to the compensation cap. Payroll taxes are not deductible under either category. Both wages and cash compensation and benefits are only deductible if they are paid to employees, officers, directors, owners, or partners. There are specific rules for staff leasing companies (now called Professional Employer Organizations), temporary employment services, management companies, and the customers of these companies. Apportioning Margin to Texas Next, we apportion margin to arrive at margin taxable in Texas. We apportion based upon the same single factor of gross receipts, formerly used under the old franchise tax. Then, we apply the appropriate tax rate to determine the tax before credits. Calculating the Tax Next, we apply the appropriate tax rate to the apportioned margin to arrive at tax due. General Rates. These tax rates apply to everyone except retailers and wholesalers and EZ filers. The general rates vary depending upon the report year in issue and Prior. For report years 2013 and earlier, entities paid at the rate of one percent (1%) For report year 2014, taxpayers may elect to pay tax at the rate of.975%. 163 The term elect is used loosely. Taxpayers simply pay the lower rate For report year 2015, taxpayers will pay at the rate of.95% if the Comptroller certifies that probably revenue for the biennium ending August 31, 2015 will exceed the Comptroller s estimated revenue for that period. If the Comptroller does not certify, then the report year 2015 rate will revert to 1% and Later. For report years 2016 and later, taxpayers will pay at the rate of 1% Texas Tax Code (a) eff. Report year 2014 only. Texas Tax Code (a) eff. Report year 2015 only.

61 Page 50 Texas Franchise Tax Retailers and Wholesalers. These tax rates apply to the category of taxpayers defined as retailers and wholesalers and Prior. Retailers and wholesalers pay at the rate of one-half percent (1/2%) For report year 2014, taxpayers may elect to pay tax at the rate of.4875%. 166 The term elect is used loosely. Taxpayers simply pay the lower rate For report year 2015, taxpayers will pay at the rate of.475% if the Comptroller certifies that probably revenue for the biennium ending August 31, 2015 will exceed the Comptroller s estimated revenue for that period. 167 If the Comptroller does not certify, then the report year 2015 rate will revert to.5% and Later. For report years 2016 and later, taxpayers will pay at the rate of.5% Texas Tax Code (b). Texas Tax Code (b) eff. Report year 2014 only. Texas Tax Code (b) eff. Report year 2015 only.

62 Texas Franchise Tax Page 51 Qualification. Taxpayers qualify as retailers or wholesalers if their total revenue from retail and wholesale activities exceeds their revenue from other business activities. 168 Generally, retail trade means the activities described in Division G of the 1987 Standard Industrial Classification (SIC) manual and Wholesale trade means the activities described in Division F of the 1987 SIC manual. 169 These include businesses traditionally thought of as wholesalers and retailers, and also businesses such as bars and restaurants, car dealerships, gasoline service stations, mail-order houses, and vending-machine operators. Over the past several legislative sessions, several additional categories have been added: Apparel rental (SIC activity codes ) 170 Auto repairs shops (SIC Industry Group 753) 171 Rental-purchase agreement activities 172 Tool rentals 173 Party & event supplies rentals 174 Furniture rentals 175 Heavy construction equipment rentals 176 In addition, to qualify as a retailer or wholesaler, less than 50 percent of a taxpayer s total revenue from resale and wholesale activities can come from selling items that the taxpayer or an affiliated entity produces Texas Tax Code (c). Texas Tax Code (c-1). However, over the past several legislative sessions, various additional categories of businesses have been added as discussed later in this manual. Texas Tax Code (12)(B). Texas Tax Code (12)(C). (eff. Jan 1, 2014) Texas Tax Code (12)(D). (eff. Jan 1, 2014) Texas Tax Code (12)(E). (eff. Jan 1, 2014) Texas Tax Code (12)(E). (eff. Jan 1, 2014) Texas Tax Code (12)(E). (eff. Jan 1, 2014) Texas Tax Code (12)(F). (eff. Jan 1, 2014) Texas Tax Code (c)(2). This limitation does not apply to restaurants and bars.

63 Page 52 Texas Franchise Tax REPORT YEAR 2014 Cost of Goods Sold Method Revenue $ less Cost of Goods Sold Taxable Margin times Texas Factor Apportioned Taxable Margin times Tax Rate (x or.00975) less Temporary & Bus. Credits Net Margin Tax Due $ Compensation Method Revenue $ less Compensation Taxable Margin times Texas Factor Apportioned Taxable Margin times Tax Rate (x or.00975) less Temporary & Bus. Credits Net Margin Tax Due $

64 Texas Franchise Tax Page 53 REPORT YEAR 2014 Alternative (Default) Method Revenue $ less 30% of Total Revenue Taxable Margin times Texas Factor Apportioned Taxable Margin times Tax Rate (x or.00975) less Temporary & Bus. Credits Net Margin Tax Due $ E-Z Computation Revenue $ times Texas Factor Apportioned Revenue times E-Z Tax Rate (x.00575) Net Margin Tax Due $ * based on percentage of Texas gross receipts to total gross receipts.

65 Page 54 Texas Franchise Tax REPORT YEAR Cost of Goods Sold Method Revenue $ less Cost of Goods Sold Taxable Margin times Texas Factor Apportioned Taxable Margin times Tax Rate (x or.0095) less Temporary & Bus. Credits Net Margin Tax Due $ Compensation Method Revenue $ less Compensation Taxable Margin times Texas Factor Apportioned Taxable Margin times Tax Rate (x or.0095) less Temporary & Bus. Credits Net Margin Tax Due $ 178 For reports due during 2015, the reduced rates apply if the Comptroller certifies (on or after Sept 1, 2014) that the revenues forecasted for the biennium ending August 31, 2015 will exceed the Comptroller s original estimate, as adjusted. Tex. Tax Code (d).

66 Texas Franchise Tax Page 55 REPORT YEAR 2015 Alternative (Default) Method Revenue $ less 30% of Total Revenue Taxable Margin times Texas Factor Apportioned Taxable Margin times Tax Rate (x or.0095) less Temporary & Bus. Credits Net Margin Tax Due $ E-Z Computation Revenue $ times Texas Factor Apportioned Revenue times E-Z Tax Rate (x.00575) Net Margin Tax Due $ * based on percentage of Texas gross receipts to total gross receipts.

67 Page 56 Texas Franchise Tax Retailer/Wholesaler Tax Rate Generally, Texas imposes the revised franchise tax on retailers and wholesalers at the rate of 0.5%. All other taxable entities generally pay the 1% rate. The half-percent rate applies if the entity is primarily engaged in retail or wholesale trade. A business is primarily engaged in retail or wholesale trade if its total revenue from retail or wholesale trade is greater than its total revenue from other activities. The statute defines retail and wholesale trade by referring to the federal Office of Management and Budget s Standard Industrial Classification Manual. If the business activity has an SIC code numbered in the 5000 s, it s a wholesaling or retailing activity. Temporary Rate Reductions. During 2013, the Legislature passed temporary rate reductions for 2014 and Beginning 2016, the rates return to the normal 1% and ½% For report year 2014, retailers and wholesalers may elect to pay tax at the rate of.4875% For report year 2015, retailers and wholesalers will pay at the rate of.475% if the Comptroller certifies that probably revenue for the biennium ending August 31, 2015 will exceed the Comptroller s estimated revenue for that period. 180 If the Comptroller does not certify, then the report year 2015 rate will revert to.5% and later. For report years 2016 and later, taxpayers will pay at the rate of.5%. Note: This course manual collectively refers to the lower rate for retailers and wholesalers as the ½% rate or the.5% rate even though the rate is reduced for reports due during 2014 and The stated reason for the lower rate is that retailers and wholesalers already operate on low margins. This makes no sense the statute provides a low tax rate to companies that have higher cost of goods sold than others. If anything, retailers and wholesalers should pay a higher rate. The low tax rate should go to companies with high margins and low or non-existent cost of goods sold, such as rental or transportation companies Texas Tax Code (b) eff. Report year 2014 only. Texas Tax Code (b) eff. Report year 2015 only.

68 Texas Franchise Tax Page 57 Retailers. Retailers typically sell merchandise for household or personal consumption and may render services incidental to the sale of goods. Retailers generally sell to the public. They buy merchandise for sale, in contrast with manufacturers who create their own products. 181 The Standard Industrial Classification Manual classifies retailers according to the commodities they sell (e.g., grocery stores, hardware stores, etc.) or according to their usual trade designations (e.g., drug stores, cigar stores, etc. Most retailers sell primarily to the general public, but stores that also sell to businesses (e.g., lumber yards; paint glass, and wallpaper stores; gasoline service stations; etc.) may also be retailers. 182 Other entities, which we normally think of as retailers for sales tax purposes are actually wholesalers for purposes of the revised franchise tax. This includes entities that sell such merchandise as plumbing equipment, electrical supplies, used auto parts and office furniture. Also, farmers who sell only their own produce at or from the point of production are not retailers, even if they sell primarily to the general public. 183 Clothing Rental Business. Apparel rental activities qualify as retail or wholesale trade for purposes of the ½% tax rate Office of Management and Budget s Standard Industrial Classification Manual Division G: Retail Trade. Office of Management and Budget s Standard Industrial Classification Manual Division G: Retail Trade. Id. Texas Tax Code (12)(B) (as amended by SB1, 82 nd Legislature, 1st Called Special Sess. 2011). This change is effective for reports due on or after January 1, 2012.

69 Page 58 Texas Franchise Tax Auto Repairs Shops. 185 This category includes the following types of automotive businesses: Top, body & upholstery repairs shops Paint shops Tire retreading & repair shops Automotive glass replacement shops Automotive transmission repair shops General automotive repair shops Automotive repair shops, not elsewhere classified 186 Rental-purchase agreement activities 187 Tool rentals 188 Party & event supplies rentals 189 Furniture rentals 190 Heavy construction equipment rentals Texas Tax Code (12)(C) (as amended by HB 500, 83 nd Legislature, Regular Sess. 2013). This change is effective for reports due on or after January 1, It applies to SIC Industry Group 753. House Research Organization, Bill Analysis to CSHB 500 (5/7/2013). Texas Tax Code (12)(D) (as amended by HB 500, 83 nd Legislature, Regular Sess. 2013). This change is effective for reports due on or after January 1, Texas Tax Code (12)(E) (as amended by HB 500, 83 nd Legislature, Regular Sess. 2013). This change is effective for reports due on or after January 1, It applies to SIC Industry Group Texas Tax Code (12)(E) (as amended by HB 500, 83 nd Legislature, Regular Sess. 2013). This change is effective for reports due on or after January 1, It applies to SIC Industry Group Texas Tax Code (12)(E) (as amended by HB 500, 83 nd Legislature, Regular Sess. 2013). This change is effective for reports due on or after January 1, It applies to SIC Industry Group Texas Tax Code (12)(F) (as amended by HB 500, 83 nd Legislature, Regular Sess. 2013). This change is effective for reports due on or after January 1, It applies to SIC Industry Group 7353.

70 Texas Franchise Tax Page 59 Wholesalers. Wholesalers sell merchandise to retailers or other wholesalers. Wholesalers may sell to industrial, commercial, institutional, farm, construction contractors or professional business users. They may also act as agents or brokers buying merchandise for or selling merchandise to wholesalers or retailers. 192 Examples include drop shippers, truck distributors, retailer cooperative warehouses, terminal elevators, sales branches and sales offices, merchandise or commodity brokers, and commission merchants. 193 A commission merchant is a merchant that transacts business in its own name. Commission merchants physically control the goods consigned to them and negotiate their sale. Comment: Commission merchants and sellers of consigned goods are not permitted to take the cost of goods sold deduction, because they do not own the goods that they sell. 194 Nevertheless, even though these entities cannot take the cost of goods sold deduction, these type of entities appear to qualify for the.5% rate. Primarily Retail or Wholesale. The total revenue from the taxable entity s retail and wholesale activities must be greater than the total revenue from its activities other than retail and wholesale trade. 195 As a result, a retailer or wholesaler may sell services or engage in other non-retail or wholesale businesses, so long as it does not generate more revenue than selling goods. To determine if a combined group qualifies as an entity primarily engaged in retail or wholesale trade, the combined group should classify the revenue stream, of the entire combined group, after eliminations. 196 Likewise, the reporting entity of the combined group should report a SIC code based on the primary business activity of the combined group as determined by the revenue stream after elimination Office of Management and Budget s Standard Industrial Classification Manual Division F: Wholesale Trade. Id. Texas Tax Code (i). Texas Tax Code (c)(1). Comptroller s FAQs Combined Reporting, No. 12. Comptroller s FAQs Combined Reporting, No. 13.

71 Page 60 Texas Franchise Tax Example Greenbelt Nursery is in the nursery business. It sells its plants to homeowners to use in their yards. All of its revenue comes from the sale of plants. It grows almost all of the plants it sells. A Comptroller auditor is attempting to determine if it qualifies for the.5% rate. The auditor examines the 1987 SIC Manual and decides that two codes could describe the business. The first code is 5261: 5261 Retail Nurseries, Lawn and Garden Supply Stores Establishments primarily engaged in selling trees, shrubs, other plants, seeds, bulbs, mulches, soil conditioners, fertilizers, pesticides, garden tools, and other garden supplies to the general public. These establishments primarily sell products purchased from others, but may sell some plants which they grow themselves. Establishments primarily engaged in growing trees (except Christmas trees), shrubs, other plants, seeds, and bulbs are classified in Agriculture, Major Group 01 and those growing Christmas trees are classified in Industry The second code is 0181: 0181 Ornamental Floriculture and Nursery Products Establishments primarily engaged in the production of ornamental plants and other nursery products, such as bulbs, florists greens, flowers, shrubbery, flower and vegetable seeds and plants, and sod. These products may be grown under cover greenhouse, frame, cloth house, lath house) or outdoors. 198 This example is based on Comptroller s Letter No L (June 10, 2009).

72 Texas Franchise Tax Page 61 The auditor will determine that 0181 better describes Greenbelt s revenue because of the second and third sentence of the description in 5261: These establishments primarily sell products purchased from others, but may sell some plants which they grow themselves. Establishments primarily engaged in growing tress (except Christmas trees), shrubs, other plants, seeds, and bulbs are classified in Agriculture, Major Group 01 Since Greenbelt does not primarily sell products purchased from others, the auditor classifies its revenue under 0181, a non-wholesale or retail activity. Since Greenbelt therefore has no revenue from retail or wholesale activities, the auditor concludes that Greenbelt does not qualify for the.5% rate. Even if Greenbelt could be classified as a retailer or wholesaler, it would still not qualify for the.5% rate because of the manufacturer exclusion, described below. However, if Greenbelt resold plants that unaffiliated entities grew, and its revenue from the sale of products purchased from others exceed the revenue from sales of plants it grew itself, Greenbelt would qualify for the.5% rate. Example 2 Conglomerate Co. reports as a combined group. It has two members: Junk Food Emporium, Inc. (a retailer of snack foods) and FitBody, Inc. (a personal-training service provider). In 2012, Junk Food Emporium generates $2 million in revenue. FitBody generates $1 million. Does Conglomerate Co. qualify for the.5% rate in 2012?

73 Page 62 Texas Franchise Tax Example 3 Department Store, Inc. is a taxable entity. Historically, the company earns its money through retail activities, but recently its finance department has been dabbling in the stock market. In 2012, Department Store s total revenue from retail activities was $10 million. However, a stock gamble paid off that year, and the company also reported in 2007 a $25 million capital gain. Does Department Store, Inc. qualify for the.5% rate in 2012? Comment: Are the NAICS codes irrelevant? Several of the Comptroller s tax forms request the reporting entity s North American Industry Classification System (NAICS) code. This system was adopted by the United States government to replace the 1987 SIC system. 199 The Texas Legislature likely decided to use the 1987 SIC system because it better described the groups of industries that the Legislature felt deserved the.5% rate. For instance, the NAICS excludes restaurants and bars from the retail trade category, but these businesses qualify for the.5% rate under the 1987 SIC codes. It remains unclear, however, why the Comptroller requests an entity s NAICS code when the code apparently has no bearing on the entity s classification for franchise tax purposes. The line item on the form will likely lead to confusion. Retailer/Contractors. 200 Retailer/contractors sell items such as flooring, windows, doors, plumbing items, and appliances out of retail stores and offer the installation of these items in customers homes. The Comptroller treats the sale of items without installation as retail activity. However, when a retailer/contractor sells an item with installation, the Comptroller does not allow the taxpayer to separate the revenue from the sale of the item from the installation revenue to determine whether the taxpayer is primarily engaged in retail trade See Development of NAICS, U.S. Census Bureau, available at (Dec. 31, 2001). Tax Policy News (February 2011).

74 Texas Franchise Tax Page 63 According to the Comptroller, whether these retailer/contractors may use the ½% rate depends largely upon the types of items they sell and install. The Comptroller bases this position on the assumption that the sale and installation of items constitutes one inseparable activity. The Comptroller considers the sale and installation of structures and items that become integral parts of structures to be construction activity, not retail activity. These items include: Steel work on bridges or buildings; Elevators and escalators; Springer systems; Central air-conditioning and heating equipment; Communications equipment; and Insulation materials. Therefore, according to the Comptroller, taxable entities engaged primarily in selling and installing these items are not eligible for the ½% rate. However, the Comptroller considers the sale and installation of preassembled items to be retail activity. These items include appliances (refrigerators, dishwashers, clothes washers and dryers, stoves and ranges) and partitions for banks, stores, and restaurants. As a result, taxpayers primarily engaged in selling and installing these items qualify for the ½% rate. In a hearing, the Comptroller allowed a taxpayer who sold and installed prefabricated windows and doors to use the ½% rate. 201 The taxpayer sold windows and doors out of a public showroom and online. It arranged for independent contractors to deliver and install the windows and doors its customers purchased. Tax Rate Hearings. Several taxpayers brought challenges to audit assessments imposing the revised franchise tax at the 1% rate rather than the ½% rate used on their reports. All of these taxpayers brought their challenges in administrative hearings rather than in court. All of these taxpayers lost. All of these taxpayers received decisions signed by the Comptroller. 201 Comptroller Hearing Nos. 103,624 & 103,625 (Sept. 29, 2011).

75 Page 64 Texas Franchise Tax Internet Domain Name Seller. The taxpayer was denied use of the ½% rate since it sold intangible assets (internet domain names) which didn t qualify as a good under the statute. 202 Auto Repair/Parts Business. The taxpayer was denied use of the ½% rate even though it derived more than half of its revenues from the sale of auto parts. The Comptroller prevailed by reclassifying the revenue arising from the sale of installed parts in industry group 753. Industry group 753 applies to Establishments primarily engaged in both selling and installing such automotive parts as transmissions, mufflers, brake linings, and glass. 203 Pending Litigation. A case currently pending in Travis County District Court addresses the application of the half-percent rate for retailers and wholesalers to an auto repair business. The case raises the following issues: (1) Whether an autorepair business that earns over 50% of its revenue from the sale of parts qualifies for the ½% rate for retailers and wholesalers; (2) Whether the constitutional provisions regarding the ½% rate for retailers and wholesalers are arbitrary and capricious and unconstitutionally vague; and (3) Whether the statutory provisions regarding the ½% rate violate the constitutional guarantee of equal and uniform taxation Legislation. The 2013 Legislature amended the definition of retail trade to include industry group 753, effective for reports filed after January 1, Comptroller Hearing Decision 103, 824 (Apr. 7, 2011) Comptroller Hearing Decision 103,786 (May 10, 2011) Service King Paint & Body, LLC, successor to Alamo Body & Paint, Inc. v. Combs, No. D-1-GN Martens, Todd, Leonard & Taylor represents the plaintiff. Texas Tax Code (12)(C) (as amended by HB 500, 83 nd Legislature, Regular Sess. 2013).

76 Texas Franchise Tax Page 65 Meat Sellers. The Comptroller did not allow a taxpayer who sold meat products to restaurants to use the ½% rate. 206 The Comptroller denied the lower rate because more than half of its revenue came from selling products it produced. The meat seller cut some of the meat it sold into smaller portions before selling it to its customers. The Comptroller found that the meat seller produced the meat it cut into smaller portions because cutting the meat caused a physical change to the meat and increased its value by more than 10 percent. Manufacturer Exclusion. Less than half of the taxable entity s revenue from activities in retail or wholesale trade must come from the sale of products either the taxable entity produces, or from products produced by an entity that is part of the same affiliated group. 207 This means a retailer or wholesaler must sell more of someone else s goods than it does of its own or of its affiliates. Important Note. The statute states that this requirement does not apply to restaurants and bars (specifically, activities described by Major Group 58 of the SIC Manual). 208 Example 1 Basket Sellers, Inc. and Basket Weavers, Inc. are in the same affiliated group. About 10% of the baskets that Sellers sells come from unrelated manufacturers; the remaining revenue is from the sale of baskets that Weavers manufactures. The two companies are not in the same combined group because they operate autonomously and are therefore not in a unitary business. Can either company use the.5% rate? Comptroller Hearing Nos. 104,871 & 104,872 (Sept. 12, 2011). Texas Tax Code (c)(2). Texas Tax Code (c-1).

77 Page 66 Texas Franchise Tax Example Apex Electronics, USA and Apex-China are two corporations owned 100% by the same holding company. Apex Electronics, USA is headquartered in Dallas and sells televisions over the internet. All of the televisions that Apex Electronics, USA sells are manufactured by Apex-China. Although Apex Electronics, USA and Apex-China are in the same affiliated group, they cannot file as a combined group because Apex-China is beyond the water s edge. This is because over 80% of its property and payroll is located outside of the United States. Even though 100% of the revenue of Apex Electronics, USA is described by an SIC code in the 5000 s, and even though it doesn t manufacture its product itself, it still will not qualify for the.5% rate. This is because over 50% of its revenue from retail activities comes from the sale of products produced by Apex-China, an entity that belongs to the same affiliated group that Apex Electronics, USA belongs to. It does not matter that the two entities are not in the same combined group due to the water s edge requirement. 209 This example is based on an article in Tax Policy News (March 2010).

78 Texas Franchise Tax Page 67 Example Same as Example 2, except now the Apex Holding company owns only 40% of Apex-China. Apex Electronics, USA will now qualify for the.5% rate, even if Apex-China manufacturers the televisions to Apex Electronics, USA s specifications. This is because the entities are now not in the same affiliated group, despite that the Apex holding company owns 40% of Apex-China. However, remember that Apex Electronics, USA is not considered the producer of goods for purposes of the Cost of Goods Sold deduction in either Example 2 or Example 3. In both cases, Apex Electronics, USA s cost of goods sold deduction is limited to acquisition, storage, and handling costs. Apex Electronics, USA is not permitted to deduct as a cost of goods sold any research, experimental, engineering, and design activity costs, because the Comptroller has determined that these are production costs, and Apex Electronics, USA is not the producer. If Apex-China incurs these costs, it may deduct them as a cost of goods sold if it has a Texas franchise tax filing obligation. 210 This example is based on an article in Tax Policy News (Oct. 2009).

79 Page 68 Texas Franchise Tax Example 4 Matchmakers, Inc. is in the business of making strike-anywhere matches. It sells its matches exclusively through outlets in shopping malls. Because this business plan was not particularly profitable, the company also began selling candles in its match stores. The candles are produced by various unaffiliated companies. Approximately 75% of Matchmakers revenue comes from its candle sales; the remaining 25% is from the sale of matches. Can Matchmakers use the.5% rate? Modified Goods 10% Rule. According to a Comptroller rule, a taxpayer is not considered to have produced an item if modifications the taxpayer makes to an item do not increase the item s sales price by 10 percent or more. 211 However, the Comptroller s Tax Policy personnel appear to maintain that the inverse of this rule is also true: A taxpayer is the producer of an item if modifications the taxpayer makes to an item increase the item s sales price by 10 percent or more. 211 Comptroller Rule 3.584(d)(3)(B)

80 Texas Franchise Tax Page 69 Example A taxable entity is a retailer in the business of selling baseball caps that are embroidered at the shop to a customer s specifications. The entity purchases the baseball caps from a manufacturer and sells them, without embroidery, for $10 each. An embroidered cap sells for $18. The entity is considered to be the producer of the embroidered caps since the modifications made to them increases the sales price by 80 percent. If the sale of the embroidered caps accounts for 50 percent or more of the entity s total revenue, the entity would not be eligible for the 0.5 percent tax rate because 50 percent or more of the entity s total revenue comes from the sale of products it produces. Example 2 A used car dealer buys a used car that could be sold at retail for $3,000, then does repair work on the car that increases its value to $4,000. The Comptroller may consider the car an item that the used-car dealer produced because the repair work increases the used car s sales price by 10 percent or more. 213 Utility-Provider Exclusion. The taxable entity cannot sell retail or wholesale utilities and qualify for the half-percent rate. This includes telecommunications, electricity, and gas. 214 Important Note. It appears that even an immaterial amount of revenue from the sale of utilities could prevent a retailer or a wholesaler from qualifying for the half-percent rate. By implication, taxpayers may argue that the utility-provider exclusion only disqualifies a retailer or wholesaler from the ½% rate when the revenues derived from the sale of utilities exceeds 5% of total revenues This example is quoted verbatim from Tax Policy News (Jan. 2010). This answer was given by Comptroller Tax Policy personnel in a Franchise Tax Filing Update 2010 Webinar (Apr. 20, 2010). Texas Tax Code (c)(3). See Texas Tax Code (j)(2). Eff Jan. 1, 2014.

81 Page 70 Texas Franchise Tax Example Burgertime, Inc. is a large restaurant chain that qualifies as a retailer. The Manufacturer Exclusion does not apply because Burgertime is a restaurant. All of Burgertime s stores are networked with headquarters via fiber-optic lines. Because the network often has excess capacity, Burgertime sells its excess bandwidth for an immaterial amount of revenue. The Comptroller may claim that Burgertime will not qualify for the half-percent rate because it violates the Utility-Provider Exclusion. The Comptroller would have to determine that bandwidth is a utility, and that there is no implied exception to the rule for de minimus sales. Combined Groups & Utility Provider Exception. A taxable affiliate that provides electric utilities may not join in the filing of a combined report if the utility provider s revenue from selling electricity is less than 5% of the combined group s revenue and if the utility provider would otherwise cause the entire combined group to fail the utility provider test. Example A, B, C & U are affiliated entities engaged in a unitary business. A, B & C sell products at retail. For report year 2014, their total revenues equal $100 million. U sells electricity. For report year 2014, U generated revenues of $2 million from selling electricity. In the absence of the exception, U would be required to join in the filing of a combined report and in doing so, the entire combined group of A, B, C & U would not be eligible for the retailer s rate (1/2%) due to the inclusion of member U in the combined group. The exception avoids this result by requiring U to file a separate report from the combined group of the remaining members A, B & C. Important Note. The utility-provider exception for combined group members only applies to an affiliate that sells electricity. The language of the statute does not extend to providers of natural gas or telecommunications services. Questionable Policy for Lower Tax Rate. The pat answer for the justification of a lower rate for retailers and wholesalers is that they already operate on low margins. Low margin therefore low tax rate.

82 Texas Franchise Tax Page 71 If you think about it, this really makes no sense. Retailers and wholesalers have a low margin because their total revenue is only slightly more than their cost of goods sold. Since cost of goods sold is deductible in determining the tax, retailers and wholesalers already have a huge tax break. Example Assume we have two Texas corporations, both with identical revenues of $10 million and net income of $1 million. The retailer has COGS of $7million. Its G&A costs total $2 million. The rental company has no COGS. Its G&A totals $9 million, of which compensation comprises $3 million: Retailer Rental Revenue $10,000,000. $10,000,000. COGS/Comp (7,000,000) (3,000,000) Margin 3,000,000. 7,000,000. times tax rate 0.50% 1.00% Tax $ 15,000. $ 70,000. Which of these two companies should be entitled to a lower franchise tax rate? Temporary Credit on Taxable Margin 216 Eligible Entities. A taxable entity can take the credit only if it was subject to the old franchise tax as of May 1, Combined groups can take the credit for each member entity that was subject to the franchise tax as of May 1, Election on First Report. A taxable entity notifies the Comptroller of its intent to claim the credit by making the election on the first revised franchise tax report due on or after January 1, Calculation. For each of the entity s first 20 privilege periods, the credit is equal to the amount of loss carryforwards as computed under the previous franchise tax rules, multiplied by 2.25% for the first 10 privilege periods and by 7.75% for the next 10 periods, and then multiplied by 4.5%. 216 Texas Tax Code

83 Page 72 Texas Franchise Tax Example ABC, Inc. was subject to the old franchise tax on May 1, It filed its last report under the old franchise tax on May 15, That report generated a business loss carryforward of $1,000,000. On its 2008 report, and all subsequent reports through 2017, ABC may claim a temporary credit of $1, on each report. 217 For its reports from 2018 through September 1, 2027, ABC may claim a temporary credit of $3, on each report. 218 Non-Refundable Credit. The amount of credit claimed or any amount of credit carried forward cannot exceed the amount of franchise tax due each year. However, unused portions of the credit can be carried forward for future years, if no tax is due because the amount is less than $1,000 no credit is used. 219 Combined Group Calculation. A combined group may claim the credit for each member entity that was subject to the old franchise tax on May 1, Example A limited liability partnership owns 60% of a corporation that was subject to the old franchise tax on May 1, The corporation reported a $1 million loss carry forward on its May 2007 report. On its 2008 report, the combined group will be allowed to claim a temporary credit of $1,012.50, even though the corporation is only owned 60% by another member of the combined group. If there was another corporation in the combined group that also reported a $1 million loss carry forward on its May 2007 report, the combined group would be allowed to claim a temporary credit of $2, in $1,000,000 multiplied by 2.25% multiplied by 4.5% percent. $1,000,000 multiplied by 7.75% multiplied by 4.5% percent. Comptroller Rule (g). $1, plus $1,

84 Texas Franchise Tax Page 73 Combined Group Change. A taxable entity loses the right to claim the credit if the entity changes combined groups after June 30, The credit is lost to the old combined group and to the taxable entity that generated the credit. 221 The business loss carry forward does not follow the member to a separately filed report or to another combined group. 222 Partial Year. There is no proration of the credit or business loss carry forward for a partial year. 223 Merged Members. If a member merges into another member of the group, that member s business loss carry forward will remain with the group. 224 Dissolved or Terminating Members. Members that dissolve or terminate are treated just like any other member that leaves the group. The business loss carryover of that member is no longer available. 225 Adding New Members. If a combined group adds a new member, the credits of the existing members remain intact, but no credit is allowed for the new member Comptroller Rule 3.594(c)(3). Comptroller Rule 3.594(c)(3). Comptroller Rule 3.594(c)(3). Comptroller Rule 3.594(c)(3). Comptroller Rule 3.594(c)(3). Comptroller Rule 3.594(c)(3).

85 Page 74 Texas Franchise Tax Example Corporations A, B, C and D are members of a combined group. They have the following business loss carry forwards: Corp. A $ 2,000,000 Corp. B $ 2,000,000 Corp. C $ 2,000,000 Corp. D $ 4,000,000 During 2008, the combined group tax before the credit is $9,000. How much is the combined group s credit for 2008? How much is the credit carryover to 2009? Answer: Assume Corp. D leaves the combined group on June 30, How much credit is available for the combined group to claim on its 2009 franchise tax report? Answer:

86 Texas Franchise Tax Page 75 Non-Transferable. An entity may make only one election to take a temporary credit. Neither the election nor the credit may be conveyed, assigned or transferred to another entity. 227 This is true even in relation to a transaction in which another entity purchases the taxable entity. 228 Business Incentive Credits & Special Deductions Existing Credit Carryovers. The revised franchise tax statute repealed the existing Business Incentive Credits. However, taxpayers with unused business incentive credits may take them against the revised franchise tax. 229 They expire if not used by December 31, Research & Development Credit. Taxable entities performing qualified research are entitled to claim either a sales tax exemption for the qualifying equipment they purchase or a franchise tax credit based upon the incremental research expenditures they incur. Beginning January 1, 2014, taxpayers may claim a franchise tax credit equal to 5% of the difference between the qualified research expenses incurred during the current accounting period (e.g., incurred 2013 for the 2014 report) and 50% of the average amount of qualified research expenses for the three prior periods (eg. 2010, 2011 & 2012). 231 If the taxpayer hasn t incurred qualified research expenses during the three prior periods, the credit is 2.5% of the qualified research expenses incurred during the current accounting period. 232 If the taxpayer contracts with at least one public or private higher education institution to perform qualified research in Texas, the credit increases to 6.25% and 3.125%, respectively Texas Tax Code (a). Texas Tax Code (d). H.B. 3, 18 S.B. 1, 82 nd Legislative (2011), Special Session, Session Texas Tax Code (a). Eff. Jan 1, Texas Tax Code (c). Eff. Jan 1, Texas Tax Code (b) &(d). Eff. Jan 1, 2014.

87 Page 76 Texas Franchise Tax Qualified Research expenses are those incurred in Texas 234 and as defined in IRC The research & development credits carryover and expire if not used by December 31, Historic Structure Rehabilitation Credit. Beginning January 1, 2015, taxable entities that rehabilitate certified historic structures may claim a credit equal to 25% of their qualifying costs. In order to qualify, a taxpayer must meet several conditions: (1) the structure must be certified by the appropriate organization, (2) the structure is placed into service after September 1, 2013, (3) the taxpayer has an ownership interest in the structure after rehabilitation and after it s placed into service and (4) the total qualifying costs exceeds $5, The credit is transferable, assignable and may be carried forward for up to 5 years. 238 Solar Energy Devices. Taxpayers may deduct certain solar energy device costs. A solar energy device is a system or series of mechanisms designed primarily to provide heating or cooling or to produce electrical or mechanical power by collecting and transferring solar-generated energy. This also includes costs of operating mechanical or chemical devices capable of storing solar-generated energy for use in heating, cooling or producing power. Deduction from Margin. The deduction is subtracted from the apportioned margin of the taxable entity. 10% of Amortized Cost. The entity may deduct 10% of the amortized cost of the solar energy device if the taxable entity acquires the solar energy device for heating, cooling or producing power and uses the device in Texas. Amortization. The entity must amortize the device for at least 60 months in equal amounts or in conformity with federal depreciation schedules. The amortization must begin on the month the solar energy device is Texas Tax Code (4) Eff. Jan 1, Texas Tax Code (3). Eff. Jan 1, Texas Tax Code Eff. Jan 1, Texas Tax Code Eff. Jan 1, Texas Tax Code (a). Eff. Jan 1, 2014.

88 Texas Franchise Tax Page 77 placed in Texas and cover only the period that the device is used in this state. Clean Coal Projects. Taxpayers may deduct certain costs of equipment used in clean coal projects. A clean coal project means: The installation of one or more components of the coal-based integrated sequestration and hydrogen research project to be built in partnership with the United States Department of Energy, commonly referred to as the FutureGen project. The term includes the construction or modification of a facility for electric generation, industrial production, or the production of steam as a byproduct of coal gasification to the extent that the facility installs one or more components of the FutureGen project. 239 Deduction from Margin. The deduction is subtracted from the apportioned margin of the taxable entity. 10% of Amortized Cost. The entity may deduct 10% of the amortized cost of the equipment used in a clean coal project if the taxable entity acquires the equipment for generating electricity, producing process steam or industrial production and uses the equipment in Texas. Amortization. The entity must amortize the device for at least 60 months in equal monthly amounts. The amortization must begin on the month the clean coal device is placed in Texas and cover only the period that the device is used in this state. Clean Energy Projects. Beginning in September of 2013, the Comptroller can issue a franchise tax credit to qualified taxable entities that have constructed a new electric generating facility that complies with certain clean energy requirements. Once earned, the credit can be used to offset the tax associated with the revenue that was generated by the clean plant See Texas Water Code Texas Gov t Code (added by HB 469, 81st Reg. Sess. 2009).

89 Page 78 Texas Franchise Tax Main Office Relocation Costs. A business entity may deduct from its apportioned margin the relocation costs it incurred in relocating the business s main office or other principal place of business to Texas from another state. 241 Relocation costs means the costs of relocating computers and peripherals, other business supplies, furniture, and inventory; and any other relocation costs that are allowed as deductions for federal income tax. 242 The business must claim the relocation deduction on its first filed Texas franchise tax report. 243 On the Comptroller s request, the business must file proof of the deducted relocation costs with the Comptroller. 244 To qualify for the special deduction, the business: 1. must not have done business in Texas before relocating the main office or other principal place of business to Texas; and 2. cannot be a member of a combined group that has a member doing business in Texas on the date the business relocates its main office or principal place of business to Texas. 245 E-Z Tax Computation The E-Z Computation. The provision was enacted to simplify reporting for small and medium-sized businesses. 246 The E-Z Computation is only available for businesses with less than $10 million in total revenue. Choice. Businesses with no more than $10 million in revenue may elect to either compute taxable margin the regular way (revenues less compensation, cost of goods sold, or 30% of revenue; times the apportionment rate, times 1% or.5%) or to simply multiply total revenue by.575% Texas Tax Code (b). Eff. Sep 1, Texas Tax Code (a). Eff. Sep. 1, Texas Tax Code (c). Eff. Sep. 1, Texas Tax Code (d). Eff. Sep. 1, Texas Tax Code (b)(10 & (2). Eff. Sep. 1, Texas Tax Code Texas Tax Code

90 Texas Franchise Tax Page 79 Loss of Credits & Deductions. Businesses that make the E-Z election are not allowed to take any other credits or deductions. In effect, the E-Z Computation allows qualifying businesses the choice of giving up the cost of goods sold deduction or the compensation deduction and credits in exchange for an easier calculation method and a lower tax rate. Likely-Electing Taxpayer. We expect that very few wholesalers or retailers will elect to use the E-Z Computation for two reasons. First, their cost of goods sold deduction is likely to be relatively high, and it would not be an allowable deduction under the E-Z method. Second, wholesalers and retailers would be taxed at a greater rate under the E-Z method than under the Regular method (.575% and.5%, respectively.) However, for qualifying non-wholesale or retail businesses that would have been left with only the 30% deduction under the Regular method, the E-Z method will likely lead to a reduction in tax. The effective rate under the Regular method is.7% of revenues (Revenues multiplied by 70% multiplied by 1%). The effective rate under the E-Z method is only.575%. Parity in Constitutionality. If the Texas Supreme Court decides that the regular margin tax method is unconstitutional or invalid, then the E-Z method will also be unconstitutional or invalid, according to the terms of the statute. Annualized Revenue. If the accounting period is less than twelve (12) months, the taxable entity must annualize its revenue to determine whether it meets the $10 million threshold. 248 Small Entity Exemption Converted to a Deduction For reports due on or after January 1, 2014, the franchise tax calculation now incorporates the $1 million exemption as a $1 million deduction. An entity s taxable margin is now the lesser of (A) 70% of total revenue or total revenue less $1 million; or (B) total revenue less the greater of (1) $1 million, (2) COGS, or (3) compensation. 249 A taxable entity is not required to pay any franchise tax if the amount of tax computed for the taxable entity is less than $1, Tax Policy News (Mar. 2008). Texas Tax Code (a) eff. Jan 1, Texas Tax Code (d)(1).

91 Page 80 Texas Franchise Tax Example In 2014, A, B, and C are required to file as a combined group. A,B, & C s combined revenue equals $2,500,000. The group s COGS equals $700,000 and compensation equals $800,000. The group s taxable margin equals $1,500,000. Reporting. Taxable entities qualifying for the small entity exemption must file the No Tax Due Report, Form no as well as the applicable information report. Corporations and LLCs must file the Public Information Report, Form no All other taxable entities must file the Ownership Information Report, Form no Annualized Revenue Computation The E-Z computation presumes a full twelve (12) month accounting period. If the accounting period is other than twelve (12) months, the taxable entity must annualize its revenue to determine its qualification for the EZ method. 251 At the present time, we don t know if the Comptroller will require an annualization calculation for the $1 million deduction. Computation. The taxable entity annualizes its revenue by dividing its total revenue for the accounting period by number of days in the period and then multiplying the result by 365 days. 251 Tax Policy News (Mar. 2008).

92 Texas Franchise Tax Page 81 Example 1 ABC LP s 2012 franchise tax report is based upon margin generated during September 15, 2011 through December 31, During this period of 108 days, ABC LP generated revenue of $3,000,000. ABC LP s annualized revenue equals 365/108 times $3,000,000 equals $10,138,889. Does it qualify for the EZ rate? Answer: Exit Tax Texas law imposes the exit tax as an additional franchise tax. Texas law imposes the exit tax on entities that cease to be subject to the franchise tax. 252 Calculation. The additional tax is equal to the same rate that the entity normally pays on its regular annual reports. (generally 0.5% for retailers and wholesalers and 1% for other taxpayers). It is assessed on the entity s taxable margin for the period beginning on the day after the last day of the preceding accounting year for a regular annual report and ending on the date the taxable entity is no longer subject to the franchise tax. 253 Creates Double Tax. Because the revised franchise tax is a prepaid tax, this additional requirement can have harsh consequences. Essentially, a taxable entity may be forced to remit twice its normal tax liability on its final report Texas Tax Code (a). Texas Tax Code (b).

93 Page 82 Texas Franchise Tax Example Assume a corporation with a fiscal year ending on March 31is doing business in Texas as of January 1, The corporation files and pays its 2011 franchise tax on May 15, 2011 for the reporting year 1/1/11-12/31/11, based on its 3/31/10 fiscal year end. The corporation dissolves on 12/31/11. In order to avoid penalty and interest, the corporation must file and pay an additional tax on its taxable margin for the period from April 1, 2010 to December 31, 2011, a 21-month period, by February 29, Final Report. The Comptroller requires the exiting taxpayer to file a final report and pay the additional tax due within 60 days after the taxable entity becomes no longer subject to the franchise tax. The taxable entity must file an estimated tax report and payment before the Comptroller will give clearance (by way of a certificate of good standing) to dissolve, merge or withdraw. 254 Provided the proper amount is paid and an amended report, if needed, is filed within 60 days after the entity dissolves, merges or withdraws, no penalty or interest will be asserted by the Comptroller. Legal Challenges. Several corporations brought suit challenging constitutionality of this provision under the former Texas franchise tax. 255 Many of the cases have worked their way through the Texas court system and the taxpayers have lost. Exit Tax for Newly-Taxable, Disappearing Entities. The statute imposes the exit tax on taxable entities not subject to the old franchise tax that cease to be subject to the tax between June 30, 2007 and January 1, The exit tax is to be based on margin earned from the later of January 1, 2007 or the date the entity was subject to the tax This step is important to prevent any future liability for officers and directors. e.g., Universal Frozen Foods Co., v. Rylander, 78 S.W.3d 588 (Tex. App. -- Austin 2002, no pet.).

94 Texas Franchise Tax Page 83 Example CPA, LLP is owned equally by Charles, Paul and Allen, all of whom are CPAs. It is a calendar year entity and has provided public accounting services for many years. During 2007, its partners realize that the entity may soon be subject to the revised franchise tax and take steps to dissolve it. On September 30, 2007, the partners formally dissolve CPA, LLP. CPA, LLP must file a franchise tax report and pay tax on the margin it generated from January 1, 2007 through September 30, Passive Entity Exception. The statute does not require a taxable entity to pay the exit tax if it becomes no longer subject to the revised franchise tax because the entity qualifies as a passive entity. 256 A passive entity that ceases to do business in Texas or is no longer subject to the revised franchise tax must file a final report, but no tax would be due with the report. 257 Example Assume a limited partnership with a year end of December 31, 2011 is doing business in Texas as of January 1, The limited partnership files and pays its 2012 franchise tax on May 15, 2012 based on its 12/31/11 fiscal year end. The limited partnership ceases its active trade or business and qualifies as a passive entity during Since the limited partnership became a passive entity no longer subject to revised franchise tax, it isn t required to pay the additional tax on its taxable margin. Right to Transact Business in Texas. During 2013, the Comptroller is changing its procedures to allow persons to search online to determine whether a taxable entity has the right to transact business in Texas. Due to the complications of combined reporting, taxpayers were often designated as in bad standing due to technical reporting errors. This led to significant taxpayer problems in conducting routine business. To fix this problem, the Comptroller is changing its website to Texas Tax Code Comptroller Rule 3.592(d).

95 Page 84 Texas Franchise Tax reflect when an entity has the right to transact business in Texas as contrasted with when the entity is in good standing. 258 Certificate of Good Standing. Before a Texas entity terminates or a non-texas entity withdraws from business in Texas, the entity must obtain a certificate of good standing from the Comptroller. The entity must then provide this certificate to the Texas Secretary of State. 259 This step is important to prevent any future liability for officers or directors. The Comptroller requires the exiting entity to file an estimated final franchise tax report and pay the additional tax due within 60 days after the entity becomes no longer subject to the revised franchise tax before the Comptroller will issue a certificate of good standing. The Comptroller will assert no penalty or interest if the exiting entity pays the proper amount and files an amended franchise tax report, if necessary, within 60 days after the entity dissolves, merges, or withdraws from Texas. Payment & Reporting Requirements In General. Every taxable entity qualified to do business in Texas, doing business in Texas, or incorporated/organized in Texas on January 1 of a particular year must file a franchise tax report with the Comptroller of Public Accounts. The annual reports are initially due on May 15 of the report year. The tax payment accompanying the report pays for the privilege of doing business the entire report year period (period January 1 through December 31.) New entities and newlyqualified foreign entities operate under the special rules noted below. When No Reports are Required. The following entities are not required to file any type of franchise tax reports: Exempt Entities. Entities exempt under Texas Tax Code Chapter 171, Subchapter B that have requested and received exemption from the Comptroller s office do not have to file any reports, including the Public Information Report, Form no and the Ownership Information Report, Form no Tax Policy News (Apr. 2013). See Comptroller FAQs for Exemptions, Question and Answer No. 2 (May 19, 2010).

96 Texas Franchise Tax Page 85 Unregistered Passive Entities. Passive entities that have not registered with either the Texas Secretary of State s office or the Comptroller s office do not have to file any franchise tax reports until they no longer qualify as passive. 261 Unregistered Exempt General Partnerships. Exempt general partnerships that aren t registered with either the Texas Secretary of State s office or the Comptroller don t have to file franchise tax reports or ownership information reports. 262 General partnerships are exempt when they are directly and solely owned by natural persons. If an unregistered general partnership loses its exempt status, it should complete and file the Texas Business Questionnaire, Form AP- 224 (for Texas entities) or the Texas Nexus Questionnaire, Form AP-114 (for foreign entities). When to file No Tax Due Information Reports. Certain taxpayers must file the No Tax Due Information Report, Form no Registered Passive Entities. If the passive entity has notified the Texas Secretary of State s office or the Comptroller s office that it is doing business in Texas, then it must file the No Tax Due Information Report, Form no The filing deadline is the normal due date, including extensions, for the applicable form. 263 It isn t required to file the Public Information Report, Form no or the Ownership Information Report, Form no Registered Passive Entities must file the No Tax Due report (Form ) each year. 265 Previously, registered passive entities were only required to file the report for their initial year. The Comptroller made this change effective for reports due on or after January 1, Tax Policy News (Feb. 2008). Comptroller Rule 3.584(b). Tax Policy News (Feb. 2008). Tax Policy News (Feb. 2008). Tax Policy News, p. 1 (Apr. 2011) Tax Policy News, p. 1 (Apr. 2011)

97 Page 86 Texas Franchise Tax The $1 Million Deduction. Taxable entities generating revenue of less than $1 million owe no tax, but must file the No Tax Due Information Report, Form no The filing deadline is the normal due date, including extensions, for the applicable form. 267 They are also required to file the Public Information Report, Form no (for corporations or LLCs) or the Ownership Information Report, Form no (for other types of taxable entities) Tax Policy News (Feb. 2008) Texas Franchise Tax Information and Instructions, pages 10 & 22.

98 Texas Franchise Tax Page 87 Zero Texas Receipts. Taxable entities with no Texas receipts must file the No Tax Due Information Report, Form no The filing deadline is the normal due date, including extensions, for the applicable form. 269 If the entity has nexus with Texas, they are also required to file the Public Information Report, Form no (for corporations or LLCs) or the Ownership Information Report, Form no (for other types of taxable entities) Tax Policy News (Feb. 2008). Tax Policy News (Feb. 2008).

99 Page 88 Texas Franchise Tax Public Information Report. Corporations, LLCs, Banking Corporations, Savings & Loan Associations, and REITS that qualify as non-taxable under Texas Tax Code (c)(4) must file an annual public information report containing the following information: 271 The name of each corporation or LLC in which the entity filing the report owns 10% or greater interest, and the percentage owned. The name of each corporation or LLC that owns a 10% or greater interest in the entity filing the report. The name, title and mailing address of each person who is an officer, director or member and the expiration date of each person s term, if applicable. The name and address of the corporate agent. The address of the entity s principal office and principal place of business. 271 Texas Tax Code In this section, the statute still uses the term corporation rather than taxable entity.

100 Texas Franchise Tax Page 89 No Nexus Members. If the entity does not have a physical presence in Texas and is a member of a combined group, it does not have to file a Public Information Report Comptroller Webinar (Apr. 20, 2010)

101 Page 90 Texas Franchise Tax Ownership Information Report for Other Entities. Taxable entities other than corporations and LLCs must file Form no , Ownership Information Report. This includes Professional Associations, General Partnerships, Limited Partnerships, Limited Liability Partnerships, Trusts, Joint Ventures, and Business Associations. No Nexus Members. If the entity does not have a physical presence in Texas and is a member of a combined group, it does not have to file the Ownership Information Report.

102 Texas Franchise Tax Page 91 Information Reports for Non-Taxable Entity. The 2007 Act contains a provision that allows the Comptroller to require any entity to file an information report to verify that it is not subject to tax. 273 When to File Initial Franchise Tax Reports The filing rules vary depending upon when the new entity was formed. Only those entities formed before October 4, 2009 must file an initial report. Those formed on or after October 4, 2009 file regular reports. Here are the applicable rules: Formed On or After October 4, Entities formed on or after October 4, 2009 must file their first Texas franchise tax reports by May 15 of the calendar year following the year the entity became subject to the revised franchise tax. The new entity will file a regular annual report as its initial report. Generally, an entity s accounting year for its first franchise tax report begins on its date of formation and ends on the last day of its fiscal year. Therefore, entities that become subject to the new franchise tax between October 4, 2009 and December 31, 2009 would have filed an annual 2010 report on May 17, Entities that become subject to the new franchise tax during calendar year 2010, will have an annual report due on May 16, The first annual report is based on the accounting period beginning on the date the entity became subject to the new franchise tax and ending on the last accounting period ending date used for federal income tax reporting in the calendar year before the year the report is originally due. Example The first franchise tax report for an entity formed on October 15, 2009 with a fiscal year end of December 31 will be due on May 17, 2010 for the accounting period of October 15, 2009 through December 31, Texas Tax Code

103 Page 92 Texas Franchise Tax What if the end of a new entity s fiscal year is prior to its date of formation? The entity must still file its first Texas franchise tax report on May 15th of the calendar year following its year of formation. However, this report will be a no tax due report covering the day of formation only. The entity must then file a franchise tax report for the period from the day the entity became subject to the Texas revised franchise tax until the fiscal year end due on May 15 of the next year. Example An entity is formed on October 15, 2010 with a fiscal year end of August 31. It must file a no tax due report for the single day of October 15, The report is due on May 17, The following year, the entity will file an annual report based upon the accounting period from October 15, 2010 through August 31, The report will be due on May 16, The entity will then file a report for a full year due on May 15, Formed Before October 4, 2009: New taxable entities formed before October 4, 2009 must file initial franchise tax reports. A new taxable entity is one that is newly-formed. A newly-taxable entity is an existing entity that has become subject to the new franchise tax as a result statutory amendments to the revised franchise tax statute that subjects additional types of entities to the new tax. Example (New Taxable Entity) Smith & Jones formed S & J, LLP on July 1, S & J, LLP is a new taxable entity whose initial report will be originally due on September 27, Example (Newly-Taxable Entity) Davis & Williams formed D & W, LP on January 1, For 2008, D & W, LP is a newly-taxable entity (because LPs weren t subject to the old franchise tax). It should file an annual franchise tax report which will be originally due on May 15, Initial Report Filing & Payment Deadline. The initial report is due one (1) year and ninety (90) days after the entity is formed in Texas or after a foreign entity begins doing business in Texas.

104 Texas Franchise Tax Page 93 Combined Groups. In general, if a new taxable entity is a member of a combined group, it will include its data with the combined group s report for the corresponding annual period and will not report its data on a separate initial report. It must also file an initial report to tell the Comptroller the name of the reporting entity. If a member entity has an accounting period that begins before the combined group s accounting period, then the member entity must file an initial report for the stub period. 274 Entities Beginning and Ending in the Same Year. An entity that ceases to be subject to the franchise tax in the same year in which it became subject to the tax will file a final report 60 days after its ending date. It will not file an annual report. 275 Non-Texas Entities. Foreign entities that began doing business in Texas on or after October 4, 2009 should file their first Texas franchise tax reports as described above, substituting the date they began doing business in Texas for their date of formation. Combined Groups with New Entities. Combined groups file only annual reports regardless of whether the reporting entity or any or all of its members would have been required to file an initial or final report as a separate entity. If an entity was not a member of a combined group for the accounting period that would be covered by its initial report, the entity is required to file a separate report for the period that is outside the accounting period that the combined group will use Tax Policy News (Feb. 2009). Tax Policy News (Oct. 2009).

105 Page 94 Texas Franchise Tax Example Corporation A is not affiliated with any entity from January 1, 2008 through June 30, On July 1, 2008, Group X acquires Corporation A and holds them for three months, until September 30, Group X uses a March 31st year end. Group X sells Corporation A to Group Z on October 1, Group Z has adopted a calendar year end. Group A generated $250,000 in total revenue for the first six months of What 2009 Texas franchise tax reports are due? 1. Corporation A will file a separate report for the period January 1, 2008 through June 30, It doesn t meet the revenue threshold to qualify for filing a No Tax Due Report because it s annualized revenue exceeds the 2008 revenue threshold ($250,000 times 6/12 months equals $500,000). 2. Group X will file a combined report on May 15, 2009 based upon the accounting period April 1, 2007 through March 31, Group X will not include Corporation A in the 2009 tax report because Corporation A was not part of the group during that period. It will include Corporation A in its 2010 annual report for the period July 1, 2008 through September 30, Group Z will file a combined report on May 15, 2009 based upon the accounting period January 1, 2008 through December 31, 2008 and will include Corporation A s financial activity for the period October 1, 2008 through December 31, Comptroller Q & a 20 (Apr. 10, 2009).

106 Texas Franchise Tax Page 95 When to File Annual Franchise Tax Reports. Taxable entities are required to report and pay franchise tax on May 15th of each year based upon the business conducted by the taxable entity during the previous accounting year. Corporations & LLCs. Existing corporations and LLCs subject to the old franchise tax, compute margin based upon the accounting period that begins the day after the ending date on the previous franchise tax report. The accounting period ends on the same day as the most recent federal income tax accounting period that ends in the year before the year the report is originally due.

107 Page 96 Texas Franchise Tax

108 Texas Franchise Tax Page 97 Extensions In General-Due May 15th. Franchise tax reports for regular annual periods are due by May 15th of each year unless the corporation files by May 15th a request for extension of additional time. Extensions are routinely granted to August 15 th for EFT payment filers and to November 15 th for everyone else. Payment Required. In order to obtain an extension, the taxable entity must pay to the Comptroller not less than 90% of the amount of tax that will be reported as due, or 100% of the tax reported as due for the prior year. The prior year extension only applies if the prior year report was filed by May 15th of the current year (i.e. if a taxpayer intends to rely on the prior year exception for its 2008 report, it must have filed its 2007 report by May 15, 2008). If an entity was subject to the tax in the previous year, but paid no tax because it had zero tax due, it may still obtain an extension under the prior-year exception. 277 Combined groups won t qualify for the prior year extension unless either the combined group has lost a member or if the members of the group remain the same. 278 Informal guidance from the Comptroller suggests that the prior year extension will also be granted for combined groups with new members that were previously subject to the Texas franchise tax. 279 For taxpayers not required to remit tax by EFT, the extension will be granted to November 15th. No Estimated Tax Payments Required. Texas law has no provision for making estimated tax payments. Electronic Funds Transfer Taxpayers. The Comptroller requires some taxable entities to remit tax by electronic funds transfer. Texas law allows these entities to extend the due date for filing by electronic transfer to August 15th; so long as the entity remits with the extension request a payment equal to at least 90% of the tax shown due on the report filed on August 15th or 100% of the tax reported as due for the previous calendar year on the report due in the previous calendar year and filed on or before May 14th See Comptroller Letter No L (Sept. 30, 2008). Comptroller Rule 3.585(c)(3)(B). Comptroller s FAQs Extensions, No. 1.

109 Page 98 Texas Franchise Tax Additional Extension. For taxpayers required to pay by EFT, Texas law also permits an additional extension of time to file until November 15th if the entity requests it by August 15th and remits 100% of the taxes due on the report to be filed November 15th. The Comptroller will assess late payment penalties if the payment on August 15th exceeds ten percent of the total tax shown due on the form (i.e., the May 15th payment was less than 90% of the actual tax shown due). The Comptroller is allowed to waive the penalty if the amount paid on the May 15th and August 15th extensions equal at least 90% percent of the actual amount due on November 15th. Less Than $1,000 Due No Tax Payment Required. If a taxable entity completes the applicable franchise tax report and calculates a net tax amount due of less than $1,000 no tax payment needs to be made. Report Still Required. Although a taxable entity is not required to remit a tax of less than $1,000; 280 the entity must file the applicable franchise tax report and related information reports. 281 This is also necessary to start the running of the four-year statute of limitations and to prevent personal liability from arising to the entity s officers, directors, partners or members. Combined Reporting Reporting Entity. The combined group has a choice of which entity it may select as the reporting entity. Its choices are: Parent Entity. The parent entity may serve as the reporting entity if the parent entity is a member of the combined group. 282 Texas Entity. The member of the combined group that is subject to Texas taxing jurisdiction and has, for the first reporting period, the highest Texas receipts after eliminations Texas Tax Code (d)(1) Texas Franchise Tax Information and Instructions, page 3. Comptroller Rule 3.590(b)(5)(A). Comptroller Rule 3.590(b)(5).

110 Texas Franchise Tax Page 99 Accounting Periods for Combined Groups. A combined group determines the accounting period upon which its margin is calculated using these rules: The combined group uses the federal consolidated income tax accounting period if two or more of the combined group s members join in filing a federal consolidated income tax return. Otherwise, all members of the combined group must conform their accounting periods to that of the reporting member. Combined Reporting Filing Tips. In order to avoid processing errors and delays, the Comptroller s office makes the following suggestions: 284 Taxpayer Numbers. Use either the number provided by the Comptroller s office or the federal ID number. The Comptroller s website has a function called Taxable Entity Search. If affiliates don t have their own Comptroller number or federal ID number, leave the field blank. Use Correct Year Report Form. Do not mark up a prior year s form to use for the current year. The Comptroller s forms are bar-coded and if you mark up and file a prior year s form, you will create processing problems. Extension Requests. A combined group must complete both the Extension Request (Form ) and the Extension Affiliate List (Form ). The Extension Affiliate List states the entities that will be included in the combined group so that the Comptroller won t be looking for separate reports from them. Affiliate List/Affiliate Schedule. Include only those taxable entities that are affiliated (commonly owned by more than 50%) and are unitary. Tax Liability Issues Joint & Several Liability. Each member of a combined group is jointly and severally liable for the tax of the combined group. 285 Practical Application. This means that the Comptroller can seek to recover all of the tax from any member of the group Tax Policy News (Apr. 2009). Texas Tax Code

111 Page 100 Texas Franchise Tax Example A combined group fails to file a franchise tax report, and the Comptroller assesses taxes after an audit. There are three members of the combined group Company A, Company B, and Company C. The Comptroller calculates the tax by using the 30% standard deduction for the group. The Comptroller determines that Company a has revenue of $10 million, Company B has revenue of $9 million, and Company C has revenue of $1 million. The Comptroller assesses tax at the 1% rate for a total tax of $140,000. Company C is flush with cash. The Comptroller can attempt to collect the entire $140,000 from Company C, even though it only generated $7,000 of the tax. Or the Comptroller can collect the $140,000 in any combination of the three companies. Entity Forfeiture. This provision allows the comptroller to forfeit the certificate or registration of a taxable entity for the same reasons that it has used to forfeit a corporation s charter. Forfeiture of the entity s certificate or registration may occur when the entity has forfeited its corporate privileges for 120 days and has failed to pay the amounts necessary to revive the certificate or registration. 286 Consequences. If the entity s privileges are forfeited, each director or officer of the entity is liable for each debt of the entity that is created or incurred after the date of forfeiture. This period of personal liability continues through the date the entity privileges are revived, 287 but not for debts incurred thereafter. Exception. An officer or director is not liable for debts incurred over the officer or director s objection or without his or her knowledge (if he or she should have known about the debt after reasonable diligence) Texas Tax Code and Texas Tax Code Texas Tax Code (c)(1)&(2).

112 Texas Franchise Tax Page 101 Forfeiting Privileges. Entity s privileges may be forfeited in three instances: 1. The entity fails to file its franchise tax report within 45 days after the Comptroller sends notice of forfeiture, 2. The entity fails to pay its franchise tax and any penalty within 45 days after the Comptroller sends notice of forfeiture, or 3. The entity does not allow the Comptroller to examine its records when requested to do so. 289 Notice. The Comptroller must give notice of its intent to forfeit the privileges, but the notice has to be sent only to the entity s last known address. 290 Reviving Privileges. Entity privileges may be revived by paying the tax, penalty or interest due before the entity charter or certificate of authority is forfeited. 291 Revival Does Not Cure Interim Liability. Even if the entity privileges are revived, the liability for debts incurred during the interim period is not affected. 292 Because personal liability is severe and essentially penal in nature, the courts show a tendency to strictly construe the wording and interpretation of the statutes in favor of the officer or director. 293 Resigning Officers and Directors. In the case of the resignation of a director or officer, the resigning director or officer remains personally liable for sales tax incurred prior to the date of the resignation but not after the resignation date Texas Tax Code Texas Tax Code Texas Tax Code Texas Tax Code (d). See McKinney v. Anderson, 734 S.W.2d 173 (Tex. App.--Houston [1 Dist.] 1987).

113 Page 102 Texas Franchise Tax Notes

114 Texas Franchise Tax Page 103 Chapter III. Determining Revenue We begin the margin tax calculation by determining the entity s revenue. We start this determination by adding the amounts reportable on specific lines of the applicable federal income tax form of the reporting entity. Piggyback to Federal Forms The use of specific lines on federal income tax form allows Texas to incorporate, by reference, the entire body of federal tax law that determines the amounts reportable on the forms. The statute refers not only to specific federal income tax forms, but contemplates that other forms may exist, now or in the future, the reference to which will be necessary to determine revenue. 294 The statute then relegates to the Comptroller the duty of adopting rules to accomplish legislative intent in determining the appropriate forms and line numbers. 295 The federal rules exempt certain types of revenue. For example, interest earned on municipal bonds is tax-exempt. Exemptions such as these are implicitly incorporated in the margin tax system. After aggregating the lines of income from the federal return, we then make reductions for the exclusions provided by statute. The resulting amount is the revenue that the entity must report on the franchise tax form. Reportable vs. Reported. The statute requires taxpayers to calculate revenue based on the amount reportable as income on a certain line items to the extent the amount entered complies with federal income tax law. 296 Thus, it may not be what s actually reported on the specific lines numbers of the applicable forms; it s the amounts that should be reported according to the federal income tax laws. Effect. This means that if an entity s federal return is adjusted through audit or amendment, the franchise tax report must also be amended. This also prevents taxpayers from gaming the rules by manipulating federal reporting (for instance, by offsetting gross receipts by contractually-reimbursed expenses deductible for federal tax purposes but not deductible and not excludable for franchise tax purposes.) Texas Tax Code (a). Texas Tax Code (b). Texas Tax Code

115 Page 104 Texas Franchise Tax Issue: Often, the Comptroller still uses the word reported instead of reportable. For instance, the Comptroller has stated that if certain receipts are reported as revenue on the federal income tax form, they must be reported as revenue for the revised franchise tax. 297 This may mean the reported vs. reportable distinction can only harm, and not help, a taxpayer. Example 1 Ace Purchasing, LP acts as a purchasing agent for unrelated companies. Federal tax law allows Ace to report only its commissions as gross receipts, and report no cost of sales. However, on its federal return, Ace continues to include reimbursed costs in gross receipts, and then reduce taxable income with a cost of sales deduction. Ace s accountant realizes that Ace is not entitled to a cost of goods sold deduction under their franchise tax because it never takes ownership of the items purchased. She therefore includes only the commissions as revenue on the franchise tax report instead of electing a cost of goods sold deduction. If Ace is audited by the Comptroller, the auditor will likely conclude that Ace s revenue is understated by the amount of the reimbursed costs, because the reimbursed costs are reported as revenue on the federal income tax form. Ace should first amend its federal return to report gross receipts net of the reimbursed costs. Then the franchise tax report will agree to the amount reported as revenue on the federal tax return. 297 Comptroller Letter No L (Oct. 23, 2008).

116 Texas Franchise Tax Page 105 Example 2 Beta Trucking, Inc. is a transportation company that hires nonemployee contract haulers. For federal tax purposes, it is inappropriate to report Beta s gross receipts net of the amount Beta pays the contractors. Nevertheless, Beta s accountant is familiar with the franchise tax results of the previous example. Therefore, she improperly prepares Beta s federal tax return. The accountant feels comfortable with this because the change to the federal return does not change the amount of federal tax due. If Beta is audited by the Comptroller, the auditor will likely conclude that Beta s revenue is understated by the amount of the contract payments. This is because revenue should equal the amount reportable on certain line items on the federal tax return if the return had property complied with federal income tax law. The Applicable Internal Revenue Code. The Texas revised franchise tax is based on the Internal Revenue Code as it existed as of January 1, Therefore, entities should take care to remove from revenue any items that became taxable under the Internal Revenue Code after January 1, 2007, and include in revenue any items that the Internal Revenue Code excluded from taxation after January 1, Debt Cancellation. The American Recovery and Reinvestment Act of 2009 allows taxpayers to elect to defer recognition of income from the cancellation of certain debts. However, for Texas franchise tax purposes, entities who make this election for federal tax purposes must report this income on their franchise tax reports in the year they generated it because the Texas revised franchise tax doesn t incorporate these federal changes. 298 Federal Total Income We determine a taxable entity s revenue by referring to amounts reportable on specific lines of the federal income tax forms. IRS instructions accompany the federal forms and instruct taxpayers which specific accounts for income (a/k/a revenue in the franchise tax) and deductions are grouped and reported on the corresponding lines. 298 Comptroller s FAQs Revenue, No. 21.

117 Page 106 Texas Franchise Tax Corporations. Corporations use Form 1120, U.S. Corporation Income Tax Return to determine revenue before exclusions. Specifically, add the amounts shown on Lines 1c and 4 through 10 to determine revenue before exclusions: Gains & Losses. Note that the line references for capital gains (Line 8) and net gain or (loss) from Form 4797 (Line 9) represent revenue items that have been reduced by losses on other federal tax forms. Thus, by incorporating these line numbers, the revised franchise tax statute impliedly allows corporations to deduct losses from the sale of capital assets (at least to the extent of reported capital gains) and business assets (without limitation). Partnership Flow-through Income. Corporations report ordinary income from the trade or business of a partnership on Line 10, Other Income. However, ordinary losses from a partnership are not reported here. The instructions require corporations to report the ordinary losses arising from the trade or business from a partnership on Line 26 Other Deductions which is outside of the Lines used to determine revenue. 299 Partnerships. Partnerships use Form 1065, U.S. Return of Partnership Income to determine revenue before exclusions. Specifically, the statute directs taxpayers to add the amounts shown on Page 1, Line 1c, 4, 6 and 7; Schedule K, Lines 3a and 5 through 11, Form 8825, Line 17 and Form 1040, Schedule F, Lines 11, plus 2 or Line 45 to determine revenue before exclusions IRS Instructions to 2005 Form 1120, page 6. Texas Tax Code

118 Texas Franchise Tax Page 107 Note that unlike the federal income tax return for a regular corporation, the partnership income tax return divides the reporting of items of income (the federal equivalent of revenue ) between two forms: Form 1065 and Schedule K. The need for this split reporting arises from the varying federal income treatment of different types of income that flow-through from the partnership to other types of taxable entities. Form 1065, Page 1, Lines 1c 4, 6, and 7. The amounts reported on Page 1 represent income earned from a partnership s trade or business. Flow-Through Losses. Line 4 includes the flow-through income and losses from other partnerships. Note that a corporation owning a partnership interest may reduce revenue of an upper tier partnership by the flow-through loss of a lower tier partnership. The same corporation would not reduce revenue by the loss if it directly held the interest in the lower tier partnership.

119 Page 108 Texas Franchise Tax Example 1 C Corp. owns 50% of Upper LP. Upper LP owns 50% of Lower LP. Lower LP generates a loss of $2,000. Upper and Lower are passive entities. Upper LP reports its share of the loss ($1,000) on Line 4. Upper LP also earns $1,000. Upper LP s ordinary income (loss) is $-0-, of which, C Corp s share is $-0-. Example 2 C Corp owns 50% of Upper LP. C Corp. owns 25% of Lower LP. Lower LP generates a loss of $2,000. Upper and Lower are passive entities. Upper LP earns $1,000. C Corp s revenue includes its 50% share of the Upper LP income (50% times $1,000 equals $500), unreduced by the Lower LP loss. C Corp must report its share of the Lower LP on Line 26 of Form Schedule K. The amounts reported on Schedule K represent the flow-through of income arising from sources other than the taxable entity s ordinary trade or business: Under the federal income tax rules, a partnership computes its rental real estate income separately from its other financial activities. Partnerships compute rental real estate income using IRS Form 8825, as shown below.

120 Texas Franchise Tax Page 109 The resulting amount for gross rents from Line 17 is used as one of the starting points for determining revenue.

121 Page 110 Texas Franchise Tax Trusts. Trusts use Form 1041, U. S. Income Tax Return for Estates and Trusts to determine revenue before exclusions. Specifically, taxable trusts add the amounts shown on Lines 1, 2a, 3, 4, 7, and 8 from page 1 of Form 1041, Lines 3, 4, 32, and 37 of Form 1040, Schedule E, and Line 11, plus Line 2 or 45 of Form 1040, Schedule F to determine revenue before exclusions: Comptroller Rule 3.587(d)(4).

122 Texas Franchise Tax Page 111 S Corps & Other Entities. S Corporations determine revenue in a manner similar to partnerships. 302 They should add together the amounts on Lines 1c, 4, and 5 from page 1 of Form 1120S; amounts on Lines 3a and 4 through 10 on the Schedule K; and the amount on Line 17 of Form Flow-through Income. Unlike a regular Corporation, an S Corp reports on Line 5, Other Income, both income and losses from partnership interests. As a result, an S Corp with identical income and loss items as a C Corp may report less revenues for the revised franchise tax. Example C Corp earns $1,000. C Corp also receives a $600 ordinary net loss distribution from a 50% limited partnership interest in a passive entity. C Corp s revenues for the franchise tax total $1,000. Example S Corp earns $1,000. S Corp receives a $600 ordinary net loss distribution from a 50% limited partnership interest in a passive entity. S Corp s revenues for the franchise tax total $ Texas Tax Code (c)(3). Comptroller Rule 3.587(d)(2).

123 Page 112 Texas Franchise Tax LLCs Treated as Sole Proprietorships. LLCs that have elected to be treated as sole proprietorships need to refer to Line 3 from Form 1040, Schedule C; and, to the extent the amounts relate to income from the LLC, amounts from Line 17 from Form 4797; ordinary income and or loss from partnerships, S corporations, estates, and trusts from Form 1040, Schedule D; Line 11, plus lines 2 or 45, from Form 1040, Schedule F; and Line 6 from Form 1040, Schedule C. 304 The Applicable Internal Revenue Code. An entity must use the appropriate Internal Revenue Code and regulations in order to determine its revenue: Report Year Accounting Year Applicable IRC As of 1/1/ Subsequent Tax Code Amendments. Entities must remove from revenue items that become taxable as a result of changes to the Internal Revenue Code made after applicable IRC for the franchise tax report year. Likewise, entities must include in revenue items that become excluded as a result of changes to the Internal Revenue Code made after the applicable version of the IRC for the franchise tax report year Comptroller Rule 3.587(d)(5). Texas Tax Code (9).

124 Texas Franchise Tax Page 113 Note: This rule applies not only to the revenue calculation, but to all calculations that depend on federal tax reporting. Federal Gross Income Reporting The federal income tax rules or procedures for determining when taxpayers may net expenditures against gross receipts may significantly affect a taxable entity s franchise tax liability. Reimbursed Client Expenses. The United States Tax Court has held that federal gross income of a taxpayer engaged in a trade or business does not include reimbursements received for expenses incurred on behalf of a client or customer. 306 The IRS has recognized that netting of client or customer expenses against reimbursement income is a proper method of reporting. Its Farmer s Tax Guide, Publication 225, Chapter 4, states, in relevant part: Reimbursed Expenses. If an expense is reimbursed, either reduce the expense or report the reimbursement as income when received. IRS Publication 225, Farmers Tax Guide, Chapter 4. This rule applies so long as the taxpayer didn t deduct the expense in a prior year. Reimbursements of amounts previously deducted are included in gross income. 307 Expenses Incurred as Agent. Similarly, it appears to be long-standing federal income tax law that amounts received as the agent of another person are not included in gross income. 308 Comptroller Policy. The Comptroller has issued policy statements that recognize and apply these rules Gray v. Comm r., 10 T.C. 590 (1948), acq., C.B. 2. See Internal Revenue Code 111 and Utilities & Indus. Corp. v. Comm r., 41 T.C. 888 (1964), aff d sub nom. South Bay Corp. v. Comm r., 345 F.2d 698 (2d Cir. 1965); Rev. Rul , C.B. 21. See, Wayburn v. Comm r., 32 B.T.A. 813 (1935), nonacq., C.B. 71; Cochrane v. Comm r., 23 B.T.A. 202 (1931).

125 Page 114 Texas Franchise Tax Travel Agent Ruling. The first was a ruling issued to members of the travel agency industry. This is the complete text of the ruling:

126 Texas Franchise Tax Page 115 Tenant Improvements. The Comptroller s office has ruled that taxes and insurance paid by a tenant are includible income of the landlord, as the Comptroller interprets the Treasury Departments regulations. Question and Answer No. 10 for Revenue on the Comptroller s FAQs states: 10. If you reduce your property taxes and insurance expense for IRS reporting purposes for the amount of reimbursements received from tenants, can you also exclude these reimbursements from total revenue for Texas revised franchise tax purposes? CFR (c) states, As a general rule, if a lessee pays any of the expenses of his lessor such payments are additional rental income of the lessor... Total revenue for franchise tax reporting is specifically defined in Texas Tax Code and is tied to the amounts entered on specific lines from the federal return, to the extent the amount entered complies with federal income tax law, minus statutory exclusions. Based on the above IRS regulation, the reimbursement of expenses should be reported for federal tax purposes in gross rental income and not offset with the expenses. Therefore, for franchise tax reporting purposes the expense reimbursements are included in total revenue. (Updated 4/10/08) While this policy statement requires the landlord to include the reimbursed expenses in the calculation of revenue, its holding can be reconciled with the travel agent industry ruling. Third-party travel (eg. airfare) is a cost of the travel agent s customer whereas the taxes and insurance are the landlord s expenses. Reductions & Exclusions The Texas Legislature made numerous concessions and wrote many general and industry-specific exclusions into the law in order to gain the support to pass revised franchise tax statute. Note: Exclusions from revenue tend to benefit taxpayers more than if the excluded item was a component of the deductions for COGS or compensation. The reason is that the exclusions reduce total revenue, which serves as the benchmark for determining the small entity exemption, the discount and qualification for the E-Z computation.

127 Page 116 Texas Franchise Tax The following exclusions apply to all taxable entities: Bad Debt Expense. We reduce revenue by the amount of the bad debts that corresponds to items of gross receipts included for the current reporting period or a past reporting period. 309 No deduction is allowed unless it s also claimed on the applicable federal income tax return. 310 Issue: What is meant by corresponds to items of gross receipts included for a past reporting period? Does this mean that the bad debt must correspond to the write-off of a sale previously reported on a franchise tax report? Or under the old franchise tax? Or on a federal income tax return? Issue: Must the item relate to revenue the statute says gross receipts, not revenue. For corporations, we use the amount reported on Page 1, Line 15; for partnerships, Line 12. The IRS instructions to the forms state that the deduction equals the total debts that became worthless in whole or in part during the tax year. 311 The apparent basis for this rule is to prevent taxation on revenue that was never collected and to impose tax uniformly between accrual and cash basis taxpayers. Under the federal income tax rules, cash-basis taxpayers generally don t receive bad-debt deductions because the amounts weren t previously included in income. Example Bridal Shop, LLC that sells wedding dresses in the mall. Bridal Shop reports for federal income tax purposes using the accrual method of accounting. Betty Sue is engaged to Bob. She purchases a $1,000 wedding dress on credit from Bridal Shop. Later, Bob dumps her and she refuses to pay Bridal Shop for the dress. Since Bridal Shop previously included in revenue the sale of the wedding dress to Betty Sue, Bridal Shop will qualify for the bad debt exclusion Texas Tax Code (c)(1)(B)(i). Texas Tax Code (c)(1)(B)(i). IRS Instructions for Forms 1120 and 1120-A, p. 9.

128 Texas Franchise Tax Page 117 Financial Institutions. Many financial institutions reduce revenue by the amount of bad debts that arise in connection with unpaid loan principal. Since no sale was recorded (i.e., no amount is directly included in gross receipts for the loan principal) when the loan is made, it appears under the literal language of the statute that no reduction in revenue would be allowed when the loan principal becomes uncollectible, despite the fact that the financial institution suffers an economic loss. One possible solution may be for a bank to report the collection of loan principal and interest as revenue on the federal return. The bank would also need to report the tax basis of the loan principal as an offset to the revenue, so that just the net interest amount is reflected in federal gross income. Arguably, since gross margin is computed based on revenue reportable on specific lines of an entity s federal income tax return, including the gross loan proceeds would mean that any currently uncollectible loan principal would have been included in revenue in prior periods. Additionally, a bank may argue that the loan principal amount had been included in revenue as interest income in prior report periods. If the uncollectible loan principal could be traced (or reasonably allocated) to interest income previously included in federal gross revenue, then the requirements of the revised franchise tax statute may be met. Example 1 Big Bank, LLC is located in Texas and has been loaning money for over fifty years. Big Bank reports on a calendar year-end using the accrual method for federal income tax reporting. Big Bank s books reflect capital of ten million dollars; five million of which is contributed capital and five million of which comes from earnings (interest charged) on loans made over the past twenty years. Big Bank loans the full ten million dollars in capital on January 1, 2010, at a five percent rate of interest. During tax year 2010, Big Bank collects one million dollars in principal and five hundred thousand dollars in interest. Big Bank reports the $500,000 of interest as federal gross receipts. During tax year 2011, the loan becomes fully uncollectible and Big Bank collects no principal or interest. Big Bank reports a bad debt expense of nine million

129 Page 118 Texas Franchise Tax dollars on its federal tax return, Form It reports no interest income for Is Big Bank entitled to claim a bad debt exclusion against revenue during tax year 2011? If so, how much may it claim? Answer: Example 2 In 2012, Big Bank changes its federal accounting method for revenue. It begins to report the recovery of loan principal as revenue on Line 1a of its Form It reports a corresponding deduction for the tax basis of the loan principal recoveries on Line 2 Cost of Goods Sold, of Form In early 2012, Big Bank makes a short-term loan of its entire $10,000,000 in capital and receives full payment, plus interest by the end of the year. In 2013, Big Bank loans the $10,000,000 in capital to another taxpayer, who shortly defaults on the loan. May Big Bank exclude the $10,000,000 from revenue in 2013? Answer:

130 Texas Franchise Tax Page 119 Foreign Royalties. We reduce revenue to the extent it includes foreign royalties. 312 The exclusion isn t limited to the type of the underlying asset upon which the royalty is paid. Example D Corp. owns oil & gas royalties from properties located in the North Sea. D Corp. s revenue includes $1,000 of royalties from the North Sea properties. D Corp. is entitled to exclude the royalties from revenues. Note: Since a foreign royalty would be sourced as a non-texas receipt, this provision does not appear to significantly benefit taxpayers. 313 Sales Commissions. We exclude from revenue the amount of sales commissions accrued or paid to nonemployees. 314 Sales Commission means compensation paid to a licensed real estate broker, a licensed real estate sales person or a person acting as an agent selling products for another. Non-real estate commissions are only deductible if the commission is required to be reported on a Form Therefore, commissions paid to corporations cannot be excluded from revenue. 315 Licensed Real Estate Brokers & Sales Persons. The real estate broker or sales person must be licensed under Chapter 1101, Occupations Code. 316 This is the licensing statute for real estate brokers and real estate sales persons. A broker is a person who sells, purchases or leases real property for another for a commission. 317 Brokers may also list, appraise, and auction real property. A real estate sales person is associated with a licensed broker and assists the broker in performing the broker s duties Texas Tax Code (c)(1)(B)(ii). Note: Comptroller Rule 3.591(d)(5) provides that if an item is excluded from revenue, it not be included in either component of the apportionment factor. Texas Tax Code (g). Comptroller Letter No L (Oct. 16, 2008). Texas Tax Code (l)(1)(A). Texas Occ. Code (1)(A). Texas Occ. Code (7). may

131 Page 120 Texas Franchise Tax This exclusion also includes the payment or accrual of split-fee real estate commissions. 319 Note: The payment of commissions under this category will qualify for the exclusion even if the payment is made to an entity for which a Form 1099 is not required to be issued. Independent Representatives. Excludable commissions also include amounts paid to a sales representative by a principal where the commission is based on the amount of orders or sales of the principal s product, and that the principal is required to report on Form A principal is a person who manufactures, produces, imports, distributes, or acts as an independent agent for the distribution of a product for sale, uses a sales representative to solicit orders for the product, and compensates the sales representative wholly or partly by sales commission. 321 Issue: Must an entity make a payment to get the sales commission exclusion? What if an accrual-basis taxpayer accrues both a sale and a related commission? While the general rule doesn t state that the entity must actually make payment, the definition of sales commission requires it. Flow-through Funds Mandated by Law or Fiduciary Duty. We exclude from revenue the amount of funds that the taxpayer must distribute to others as a result of a fiduciary or statutory duty. These excluded funds include sales taxes and other so-called trust fund taxes that are included in revenue. 322 For sales tax, this provision appears to apply only when sales tax is included in the sales price of a contract and is booked as a direct component of the sales price. 323 The provision may also apply to the motor fuels taxes. Comptroller representatives have informally stated that they believe this exclusion applies only to taxes. However, the scope of the statutory language appears much broader. Two cases pending in Texas courts may help resolve the scope of this exclusion Texas Tax Code (l)(1)(A). Texas Tax Code (l)(1)(B). Texas Tax Code (l)(2) and Comptroller Rule 3.587(a)(11)(A). Texas Tax Code (f). cf. Texas Sales Tax Rule

132 Texas Franchise Tax Page 121 The first case, which is still pending, addresses whether this provision allows a freight broker that serves as a limited agent for its customers to exclude the customer payments it flows through to haulers. 324 The second case addressed whether this provision allows a taxpayer that owns working interests in oil and gas leases and sells a net profits interest to another entity to exclude the net profits distributions it makes. 325 The Texas statutes impose a duty on oil & gas operators that should be sufficient to qualify for this revenue exclusion. Specifically, Texas Natural Resources Code (a) requires operators to distribute to the non-operating interest holds their respective shares from the oil & gas leases. It states: The proceeds from the sale of oil or gas production from an oil or gas well located in [Texas] must be paid to each payee by payor on or before 120 days after the end of the month of first sale of production from the well. After that time, payments must be made to each payee on a timely basis according to the frequency of payment specified in a lease or other written agreement between the payee and payor. The Texas Natural Resources Code defines the terms payor and payee for the purposes of Texas Natural Resources Code (a) as follows: Payee means any person or persons legally entitled to payment from the proceeds derived from the sale of oil or gas from an oil or gas well located in this state. Payor means the party who undertakes to distribute oil and gas proceeds to the payee, whether as the purchaser of the production of oil or gas generating such proceeds or as operator of the well from which such production was obtained or as lessee under the lease on which royalty is due. The payor is the first purchaser of such production of oil or gas from an oil or gas well, unless the owner of the right to produce under an oil or gas lease or pooling order and the first purchaser have entered into arrangements providing that the proceeds derived from the sale of oil or gas are to be paid by the first purchaser to the owner of the right to produce who is thereby deemed to be the payor having the responsibility of paying those proceeds received from the first purchaser to the payee. Tex. Nat. Res. Code (1)-(2) Seltex, Inc. v. Combs, No. D-1-GN , Travis County District Court. Martens, Todd, Leonard & Taylor represents the plaintiff. BASA Resources, Inc. v. Combs, No. D-1-GN , Travis County District Court. Martens, Todd, Leonard & Taylor represents the plaintiff. Case settled in 2013.

133 Page 122 Texas Franchise Tax This statute creates a legal duty on the part of operators to distribute to the other interest holders their respective shares of the revenues generated from the sale of oil and gas from the lease. As a result, operators organized as taxable entities should be able to exclude the distributions to the non-operating interest holders. Example Oilfield Operator operates an oil & gas well in which it holds a 100% working interest and an 87.5% net revenue interest. Mr. Smith, the landowner, holds the remaining 12.5% net revenue interest. Oilfield Operator receives a net revenue check from the pipeline company of $10,000. Oilfield Operator pays Mr. Smith his share which equals $1,250. Oilfield Operator should be entitled to exclude the payment to Mr. Smith from total revenue. Note: Some Comptroller auditors take the position that oil & gas operators are not entitled to claim the exclusion, alleging that the revenue exclusion for statutory duties only arises in the context of sales tax. The Comptroller settled BASA Resources, Inc. v. Combs. Note: The recent appellate decision of Titan Transportation, LP v. Combs may shed light on the meaning of flow-through funds. 326 In Titan, the Third Court of Appeals rejected the Comptroller s argument that flow-through funds, as used in a different revenue exclusion, required the taxpayer to pay the other entity with the exact dollars that the taxpayer had received. The court declined to impose the Comptroller s overly formalistic segregate, wait, and trace requirement for flow-through funds. The Comptroller has filed a Petition for Review asking the Texas Supreme Court to review the Third Court of Appeals decision. The Supreme Court has not yet indicated whether it will review the case. Real Estate Industry Exclusion. Real estate industry businesses are allowed to exclude certain payments made to subcontractors. The revenue exclusion applies to payments to subcontractors 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 boundaries of real property Titan Transportation, LP v. Combs, No CV, 2014 WL Martens, Todd, Leonard & Taylor handled the trial and the appeal of this case. 327 Texas Tax Code (g)(3).

134 Texas Franchise Tax Page 123 Comptroller s Anti-Taxpayer Policy Overturned by Courts & Legislature. Prior to 2014, the statute stated: A taxable entity shall exclude from its total revenue... only the following flow-through funds that are mandated by contract to be distributed to other entities:... (3) 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. For 2014 and later years, the statute states: A taxable entity shall exclude from its total revenue... only the following flow-through funds that are mandated by contract or subcontract to be distributed to other entities:... (3) subcontracting payments made under a contract or subcontract entered into by the taxable entity to provide services, labor, or materials in connection with the actual or proposed design, construction, remodeling, remediation, or repair of improvements on real property or the location of the boundaries of real property. Note: The Comptroller interpreted the original statutory language to require that the general contractor s agreement with the owner state that the general contractor will subcontract out specific portions of the work. The Comptroller stated that a general statement that some of the work may be subcontracted out is insufficient. 328 During 2013, the Texas Legislature enacted HB 2766 which is intended to reverse the Comptroller s interpretation. Note: Oil and gas drillers and oilfield service providers may also qualify under this provision, since the Comptroller treats oil & gas wells as real property Comptroller Letter no L, Franchise Tax and the Construction Industry. Comptroller s Letter No L (Nov. 17, 2008)

135 Page 124 Texas Franchise Tax Titan Transportation Wins on Appeal. 330 On March 14, 2014, the Third Court of Appeals in Austin, Texas held that Titan Transportation was entitled to claim a revenue exclusion under the real property activities provision for the payments it made to independent contractor drivers. In doing so, the court rejected the Comptroller s position imposing conditions on taxpayers not found in the clear words of the statute. As a result of a desk audit, the Comptroller had denied Titan s claim for the revenue exclusion alleging: (1) Titan was not a construction company; (2) Titan s customer contracts did not reference its fee-splitting agreement with the independent haulers, and (3) Titan did not pay its independent haulers with the actual dollars that Titan received from its customers. The Third Court of Appeals rejected each of these arguments. First, the court explained that the real property service revenue exclusion is not limited to construction companies. The court stated that a taxpayer must simply have some reasonable nexus between the real property services delineated in the statute and the service, labor, or materials for which the subcontractors receive payment. Titan had the requisite nexus because its services (hauling and depositing aggregate on construction sites) were logically and reasonably connected with the construction of real property improvements. Second, the court held that Titan s independent hauler agreements satisfied the statute s mandated by contract language. Titan did not need a contract with its customer stating that a portion of the labor would be subcontracted out. Third, the court rejected the Comptroller s segregate, wait, and trace requirement for flow-through funds as overly-formalistic and inconsistent with the statute s plain language. Titan employed sufficient procedures to ensure that its independent haulers were paid from gross receipts attributable to the work they performed. The statute s flow-through requirement did not require Titan to pay its independent haulers with the actual dollars that Titan received from its customers. 330 No. D-1-GN

136 Texas Franchise Tax Page 125 The Comptroller has appealed Titan Transportation to the Texas Supreme Court. The Supreme Court has not yet indicated whether it will grant the Comptroller s Petition for Review. Note: Due the similarity in language of the revenue exclusion under Texas Tax Code (g)(3) and the COGS eligibility provision under Texas Tax Code (i), taxpayers should always review both provisions and assert alternative claims for both, where appropriate. Pending Litigation. Several cases currently pending in Travis County District Court address the scope of this revenue exclusion. 331 Allcat Claims Service, L.P. v. Combs, et al. 332 This case addresses: (1) Whether claims adjusters may exclude payments to independent contractor adjusters from revenue as real property subcontracting payments; and (2) in the alternative, whether claims adjusters may include payments to independent contractor adjusters in cost of goods sold. PEK, Inc. d/b/a Serviceline Transport v. Combs, et al. 333 This case addresses: (1) Whether an aggregate hauler may exclude payments to independent contractor drivers from revenue as real property subcontracting payments; (2) In the alternative, whether an aggregate hauler qualifies for the COGS deduction under section (i); (3) Whether the Comptroller properly apportioned gross receipts of an interstate transportation company; (4) Whether an aggregate hauler meets the definition of a qualified courier and logistics company ; and (5) Whether the Comptroller s interpretation of the provisions allowing deductions and exclusions for the real estate industry violates constitutional requirements of equal and uniform taxation Martens, Todd, Leonard & Taylor represents these plaintiffs. No. D-1-GN No. D-1-GN

137 Page 126 Texas Franchise Tax Tax Basis of Sold Securities. We exclude from revenue the tax basis of the securities or loans the taxable entity sells. 334 The exclusion also includes the tax basis attributable to securities underwritten by brokerage firms and others. 335 Securities. A security means one of the following: 336 Corporate stock. An interest in a widely-held or publicly-traded partnership. An interest in a widely-held or publicly-traded trust. A note, bond, debenture, or other evidence of a debt. Notional Principal Contracts for interest rates, currencies, equities or commodities. Derivatives. Hedge positions. Example A brokerage firm sells $1,000,000 worth of securities that cost $800,000. Under applicable accounting rules, the brokerage firm treats the $1,000,000 as gross revenues and reports the $800,000 as cost of sales. The $800,000 is not eligible for the cost of goods sold deduction because securities are not tangible personal property. In the absence of this revenue exclusion, the brokerage firm would owe the margin tax on the full $1,000,000. This exclusion allows the brokerage firm to exclude the $800,000 from revenue. Attorneys. Attorneys may exclude flow through funds mandated by contract, law, or fiduciary duty to be distributed to the claimant or others for damages, expenses, third-party claims, and co-counsel. 337 Attorneys may also exclude $500 per pro bono case. 338 We discuss the requirements for attorneys in Chapter VI. Industry Tax Preferences, below Texas Tax Code (g-2). Texas Tax Code (g)(3). Texas Tax Code Texas Tax Code (g-3). Texas Tax Code (g-3)(3).

138 Texas Franchise Tax Page 127 Pharmacy Cooperatives and Networks. Pharmacy Cooperatives may exclude rebates from wholesalers that are distributed to shareholders. 339 Pharmacy networks may exclude reimbursement for payments to pharmacies in the network. 340 Live Entertainment Event Promotion Companies. Qualified live entertainment event promotion companies may exclude from revenue payments made to certain categories of entertainers. 341 We discuss the requirements for Live Entertainment Event Promotion Companies in Chapter VI. Industry Tax Preferences, below. Destination Management Companies. Businesses that qualify as destination management companies may exclude from their total revenue payments they make to others for services, labor, or materials in connection with providing their destination management services. 342 We discuss the requirements for DMC s in Chapter VI. Industry Tax Preferences, below. Qualified Courier & Logistics Companies. These entities may exclude from revenue the payments they make to their subcontractors to perform delivery & logistics services. 343 Aggregate Haulers. For reports originally due before to 2014, aggregate haulers may rely on the Titan Transportation case to exclude from revenue the amounts paid to independent contractors. For reports originally due on or after January 1, 2014, aggregate haulers are entitled to exclude from revenue the amounts paid to independent contractors. 344 We discuss the requirements in Chapter VI. Industry Tax Preferences, below Texas Tax Code (g-4). Texas Tax Code (g-4). Eff. Jan 1, Texas Tax Code (g-5). Texas Tax Code (g-6). Texas Tax Code (g-7). Texas Tax Code (g-8). Eff. Jan. 1, 2014.

139 Page 128 Texas Franchise Tax Barite Haulers. Barite is the powered substance used to make drilling mud. For reports originally due before to 2014, barite haulers should be entitled to exclude from revenue the amounts paid to nonemployee agents under the Titan Transportation case. For reports originally due on or after January 1, 2014, barite haulers are entitled to exclude from revenue the amounts paid to nonemployee agents. 345 We discuss the requirements in Chapter VI. Industry Tax Preferences, below. Landman Services. Often companies that provide landman services subcontract work out to independent landmen to whom they issue IRS Forms For reports originally due on or after January 1, 2014, a business primarily engaged in performing landman services may exclude from revenue the subcontracting payments made to independent landmen who perform landman services on behalf of the business. 346 We discuss the requirements in Chapter VI. Industry Tax Preferences, below. Marine Transport Companies. 347 Waterway transport companies my exclude from revenue the direct costs of providing the transportation service. This provision applies to both intrastate and interstate transportation. The excluded direct costs are the equivalent of the COGS that an entity that sells goods would qualify to claim. We discuss the requirements in Chapter VI. Industry Tax Preferences, below. Registered Motor Carriers. A motor carrier registered under Chapter 643 of the Texas Transportation Code is entitled to exclude flow-through revenue derived from taxes and fees. 348 Crop Dusters. An agricultural aircraft operation 349 may exclude the cost of labor, equipment, fuel, and materials used to provide agricultural aircraft services. These services include spraying for pest control and fertilization Texas Tax Code (g-10). Eff. Jan. 1, Texas Tax Code (g-11). Eff. Jan. 1, Texas Tax Code (v). Eff. Jan. 1, Texas Tax Code (x). Eff. Jan. 1, C.F.R defines agricultural operations to include: (1) dispensing any economic poison, (2) dispensing any other substance intended for plant nourishment, soil treatment, propagation of plant life, or pest control, or (3) engaging in dispensing activities directly affecting agriculture, horticulture, or forest preservation, but not including the dispensing of live insects

140 Texas Franchise Tax Page 129 Professional Employer Organizations. PEOs may exclude from revenue the payments it receives from a client for wages, the related payroll taxes, employee benefits and workers compensation benefits for covered employees of the client. 350 We discuss the requirements in Chapter VI. Industry Tax Preferences, below. Affiliate Payments. An entity that is a member of an affiliated group may not exclude from revenue the payments made to other members for: Certain flow-through funds Sales commissions Tax basis of securities and loans sold, including underwritten securities Payments to subcontractors for real estate construction and remodeling Loan principal repayments received by lending institutions Distributor rebates from pharmacy wholesalers (for pharmacy cooperatives) Payments eligible for the attorney s exclusion 351 Note: The apparent basis for this rule is to prevent a taxable entity from benefiting from making excludable payments to uncombined affiliates who don t report in Texas Texas Tax Code (k). Eff. Sep. 1, Texas Tax Code (h).

141 Page 130 Texas Franchise Tax Example Mr. Smith owns ABC Architects Corp and NY Design Corp. ABC Architects is an architectural firm located in Texas. NY Design is a company that specializes in preparing certain complex CAD designs and is located entirely within the state of New York. ABC Architects occasionally subcontracts work to NY Design, but the companies are independent from one another. The companies therefore meet the affiliations test, but they don t file a combined report because they are not in a unitary business. If this rule wasn t in place, the two companies together could reduce the amount of franchise tax that ABC Architects had to pay. NY Design isn t required to file a Texas franchise tax report because it doesn t have a physical presence in Texas and would not be included in a combined group. It could therefore overcharge ABC Architects without increasing its Texas revised franchise tax. Without the rule, ABC Architects could artificially inflate its revenue exclusion for flow-through subcontracting payments. But under the affiliate payment exception, ABC Architects cannot exclude any of the subcontracting payments it makes to NY Design from its calculation of revenue, whether it inflated the payments or not. Interest & Dividends on Federal Obligations. We exclude from revenue the amounts of dividends and interest earned from investments in federal obligations. 352 Federal Obligations include: stocks and other direct obligations of, and obligations unconditionally guaranteed by, the United States government and United States government agencies; and direct obligations of a United States government-sponsored agency Texas Tax Code (m). Texas Tax Code (p)(1)(A) & (B).

142 Texas Franchise Tax Page 131 Obligations include bonds, debentures, securities, mortgage-backed securities, pass-through certificates or any other indebtedness by the issuing entity. 354 Obligations don t include: deposits, repurchase agreements, loans, leases, participation in a pool of loans, a loan collateralized by an obligation of a United States government agency, or a loan guaranteed by a United States government agency. 355 The term United States government includes any department or ministry, including a federal reserve bank. 356 The term does not include a state or local government, a commercial enterprise owned wholly or partly by the United States government, or a local governmental entity or commercial enterprise whose obligations are guaranteed by the United States government. 357 The term United States government agency includes the GNMA, Department of Veterans Affairs, the Federal Housing Administration, the Farmers Home Administration, the Export-Import Bank, the Overseas Private Investment Corporation, the Commodity Credit Corporation, and the Small Business Administration. 358 The term United States government-sponsored agency includes the Federal Home Loan Mortgage Corporation, the Federal National Mortgage Association, the Farm Credit system, the Federal Home Loan Bank system, and the Student Loan Marketing Association Texas Tax Code (p)(4). Texas Tax Code (p)(4). Texas Tax Code (p)(5). Texas Tax Code (p)(5). Texas Tax Code (p)(6). Texas Tax Code (p)(7).

143 Page 132 Texas Franchise Tax Foreign Dividends. We reduce revenue to the extent it includes foreign dividends. 360 This rule is consistent with the statute s goals of preventing double taxation. The statute imposes the franchise tax on margin earned in the United States and apportioned to Texas. It does not tax foreign margin. Example F Corp. declares a $100 dividend payable to D Corp. D Corp. records on its books a foreign dividend of $100. D Corp. may exclude the $100 foreign dividend from revenue. Foreign Gross-up Income. We reduce revenue to the extent it includes foreign gross-up income. 361 This type of revenue arises when a U.S. Corporation receives a dividend from a foreign corporation that has withheld foreign income taxes from the dividend payment. The Internal Revenue Code requires the corporation to include the withheld foreign tax as gross income in determining the federal taxable income when the corporation elects to claim the withheld foreign tax as a credit against its federal corporate income tax liability Texas Tax Code (c)(1)(B)(ii). Texas Tax Code (c)(1)(B)(ii). Internal Revenue Code 78.

144 Texas Franchise Tax Page 133 Example Same example as above, except D Corp. elects to claim a foreign tax credit. F Corp. declares a $100 dividend payable to D Corp. Pursuant to the tax laws of its country, F Corp. withholds $30 of foreign tax from the payment and & sends D Corp. $70. D Corp. records the $70 payment as dividend income. The Internal Revenue Code allows D Corp. a choice of how it may treat the $30 of withheld foreign taxes. D Corp. may deduct the foreign taxes or claim a credit for them. If D Corp. claims a foreign tax credit for the $30, the Internal Revenue Code requires that D Corp. include the $30 in its calculation of foreign dividends. In effect, the rule grosses-up the net dividend of $70 by $30, causing the corporation to report $100 in federal taxable income. Any amounts which may have been included in taxable income under IRC 78 from dividends received from foreign corporations by domestic corporations choosing the foreign tax credit are excluded from revenue. Controlled Foreign Corporation Income. The Internal Revenue Code requires that certain U.S. corporations include in federal taxable income their pro-rata share of income from controlled foreign corporations (CFCs). The IRC treats CFCs as like partnerships for federal income tax purposes. Any amounts included in taxable income under the CFC provisions (IRC ) are removed from revenue. Example D Corp. owns 80% of F Corp., a foreign subsidiary subject to Subpart F of the Internal Revenue Code. F Corp. earns $1,000 of income. The CFC rules require D Corp to report $800 of this income on its Form 1120.

145 Page 134 Texas Franchise Tax Flow-Through Income from Partnerships, and S-Corps. We reduce revenue by the amount of flow-through net distributive income presently included in revenue, if the net distributive income is from a taxable entity treated as a partnership or S-Corporation for federal tax purposes. 363 The apparent basis for this rule is to prevent the double taxation that would occur if the income were taxed both on the owner s return and on the flow-through entity s franchise tax report. Example S Corp. owns a 1% interest in MFG Ltd, a Texas limited partnership. Mr. and Mrs. Jones own the remaining 99% limited partnership interests. MFG Ltd. generates $100,000 of taxable margin and $10,000 of net taxable income. S Corp. s Form 1120S reports its 1% share of net taxable income ($100) on Line 5. S Corp. excludes the $100 from revenue. MFG Ltd pays the franchise tax on its $100,000 of taxable margin. Issue: The Comptroller has stated that there is no revenue exclusion for revenue received from the estate of a natural person, even if the revenue is reported on a K-1. This is because the estate is not treated as a partnership or S- Corporation Texas Tax Code (c)(1)(B)(iv). Comptroller Letter No L (July 31, 2008).

146 Texas Franchise Tax Page 135 Net Distributive Income is calculated by adding the amounts reflected in the following lines of the applicable Schedule K-1: Partnership - Schedule K-1: add 1, 2, 3, 4, 5, 6a, 7, 8, 9a, 10 & 11. Subtract from this total the amounts on lines 12, 13 and 16.

147 Page 136 Texas Franchise Tax Subchapter S Corporation - Schedule K-1: add 1, 2, 3, 4, 5a, 6, 7, 8a, 9 & 10. Subtract from this total the amounts on lines 11, 12 and 14. Issue: If the Form 1120S reports a flow-through loss from a partnership or S Corp, do we remove the loss under this rule? The answer is no if you read the statute literally.

148 Texas Franchise Tax Page 137 Example ABC Corp. is a holding company whose only asset is a 50% limited partnership interest in XYZ LP. XYZ LP does not qualify as a passive entity. During the year, XYZ LP reports ordinary income of $1,000,000 on its Schedule K-1 to ABC Corp. ABC Corp. initially includes the $1,000,000 in its calculation of revenue because the amount is reported on Line 10 of page 1 of Form Then, ABC Corp. excludes the entire $1,000,000 under the NDI revenue exclusion. As a result, ABC Corp. has no revenue and should file the No Tax Due Report, Form no Income from Disregarded Entities. We reduce revenue by the amount of net distributive income attributable to a disregarded entity presently included in revenue. 365 The apparent basis for this rule is to prevent the double taxation that would occur if the income were taxed both on the owner s return and on the flowthrough entity s franchise tax report. Issue: If the Form 1120S reports a loss from a disregarded entity, do we remove the loss under this rule? 365 Texas Tax Code (c)(2)(B)(iv).

149 Page 138 Texas Franchise Tax Schedule C - Special Deductions. Only corporations are allowed to remove the so-called special deductions from revenue. Special deductions are reported on Schedule C to the federal Form 1120: These are the federal dividends received deductions found in Internal Revenue Code sections They were enacted to prevent triple taxation of corporate income. This rule only applies to corporations; partnerships and trusts are not afforded this exclusion because the federal government does not perceive a risk of triple taxation at this level. Low-Producing Well Income. Taxable entities may exclude from total revenue the revenue generated from qualified low-producing oil and gas wells if it comes from oil and gas produced on certain dates. These wells are sometimes known as stripper wells.

150 Texas Franchise Tax Page 139 To qualify for the exemption, an oil well s production, as designated by the Texas Railroad Commission (or a similar out-of-state authority) must average less than 10 barrels a day over a 90-day period, and a gas well s production must average less than 250 MCF per day over a 90-day period. Revenue from qualified oil wells qualifies for the exclusion if it comes from oil produced on dates when the Comptroller certifies that the monthly average closing price of West Texas Intermediate crude oil is $40 per barrel. Revenue from qualified gas wells qualifies for the exclusion if it comes from gas produced on dates when the Comptroller certifies that the average closing price of gas reported on the New York Mercantile Exchange is below $5 per MMBTU. The Comptroller publishes these dates each month in the Texas Register. Generally, revenue from qualified gas wells has qualified for the exclusion due to the recent depression in natural gas prices, while revenue from qualified oil wells has not because of recent high oil prices. Consistency Requirements The revised franchise tax statute contains several provisions which require consistency in reporting in order to prevent double deductions or inconsistencies in the tax calculations. COGS & Compensation Consistency. Any amount that the rules exclude from revenue may not be included in the calculation of cost of goods sold or compensation. 366 The obvious purpose of this rule is to prevent a double deduction for the same amount. 366 Texas Tax Code (j).

151 Page 140 Texas Franchise Tax Example Real Estate Contractors LP is the general contractor in a project to remodel an office building. Real Estate Contractors LP contracts with Buddy Smith, a sole proprietor, to paint the building s interior walls. Real Estate Contractors LP makes a $100,000 payment to him for his services. Real Estate Contractors LP excludes the $100,000 payment from revenue, so it must not include it in its calculation of cost of goods sold or compensation. Apportionment Consistency. An item excluded from revenue may not be treated as either a Texas receipt or a receipt from everywhere in the apportionment factor. 367 Federal Consolidated Groups A corporation that is part of a federal consolidated group computes its revenue as though it had filed a separate return for federal income tax purposes. 368 This rule may lead to unintended and potentially harsh results. P Corp S Corp. Fed. Margin Revenue $1,000 $1,000 $2,000 $2,000 Cap G/L 1,000 (1,000) -0-1, Total: $2,000 $3, Comptroller Rule 3.591(d)(5) & (7). Texas Tax Code (d).

152 Texas Franchise Tax Page 141 Chapter IV. Cost of Goods Sold Deduction We traditionally think of a margin as a business s sales less its cost of goods sold. This deduction is loosely based upon this traditional notion. The purpose of the cost of goods sold deduction is to match revenue with the direct and indirect costs associated with acquiring and producing goods. In general, we re trying to determine when are costs capitalized and when are they deducted as incurred? The federal income tax rules require most businesses to capitalize these costs to inventory and deduct them when it sells the goods. Capitalization Election If an entity capitalizes cost of goods sold for federal tax purposes, the entity has the choice of either expensing the allowable franchise tax cost of goods sold as they are incurred, or may capitalize the costs and deduct them when the goods are sold. 369 If an entity chooses to capitalize, it may only capitalize costs allowed by the revised franchise tax statute that it also capitalized on its federal income tax return. If a cost is allowed by the franchise tax cost of goods sold rules but not capitalized for federal tax purposes, it should be included in cost of goods sold in the period incurred. 370 Example Quality Manufacturing incurs direct and indirect costs in connection with the production of washing machines for sale. In 2012, it produces 4,000 washing machines. It starts with no beginning inventory and sells 3,000 of its machines during During 2012 it purchases $600,000 in materials and pays its assembly workers $600,000. However, $200,000 of this payment was made to undocumented workers. For federal tax purposes, Quality has a cost of goods sold deduction of $900,000 and ending inventory valued at $300,000 ($1,200,000 of capitalized costs with 75% of inventory sold during the year and 25% remaining in ending inventory.) For revised franchise tax purposes, Quality Manufacturing may choose to deduct cost of goods sold as incurred or to capitalize the costs and deduct them as the washing machines are sold Texas Tax Code Comptroller s FAQs Cost of Goods Sold, No. 13.

153 Page 142 Texas Franchise Tax Deduct as Incurred Method. Under this method, Quality Manufacturing s cost of goods sold deduction would be $1 million ($600,000 materials plus $600,000 in labor less $200,000 paid to undocumented workers.) A taxpayer may select this method to provide greater deductions in earlier years or to simplify bookkeeping. Capitalized Method. Under this method, Quality Manufacturing s cost of goods sold deduction would be $750,000; and ending inventory would be valued at $250,000 for revised franchise tax purposes. ($1 million of deductible costs capitalized with 75% of inventory sold during the year and 25% remaining in ending inventory.) The taxpayer may elect this method to match the deduction to the year that the corresponding revenue is taxed. This would be particularly important if the deduction would not be fully utilized under the Deducted as Incurred Method (if it reduced taxable margin to below zero, for instance, or if the entity qualified for the small business discount for the earlier year.) Beginning Inventory for 2008 Reports. For an entity s first report due on or after January 1, 2008, it may include beginning inventory in its COGS calculation. While the Comptroller s rule provided that such beginning inventory could not be considered in the COGS calculation, 371 she subsequently reversed her position and issued a policy statement providing that taxpayers who elect to capitalize allowable expenses would be allowed to use a beginning inventory. 372 She later amended Rule accordingly. 373 Change in Method. The statute allows taxpayers to switch accounting methods for inventory from year-to-year. The provisions for changing methods are somewhat ambiguous and may lead to lost deductions. From Capitalized to Deduct as Incurred. If a taxpayer switches from the Capitalized Method to the Deduct as Incurred Method, no costs may be deducted if they were reported as ending inventory on a previous report, or if they were incurred before the beginning date of the accounting period on which the report is based See Comptroller Rule 3.588(c)(2)(A). See Tax Policy News (Jan. 2008). Comptroller Rule 3.588(c)(2)(A).

154 Texas Franchise Tax Page 143 From Deduct as Incurred to Capitalized. If a taxpayer switches from the Deduct as Incurred Method to the Capitalized Method, no cost may be capitalized if it was expensed on a previous report. Cash Method Taxpayers. Entities that are not required under the Internal Revenue Code to capitalize costs of goods sold and, in fact, do not capitalize them must use the Deduct as Incurred method. There is no accounting for beginning and ending inventories. For instance, service providers with less than $10 million in average annual gross receipts are permitted to use the cash method for federal income tax purposes. If they do so, they cannot capitalize costs for revised franchise tax purposes. Is the Entity Eligible to Deduct Cost of Goods Sold? Not all entities qualify for the cost of goods sold deduction. To be eligible an entity must own the goods it sells. Is the Entity the Owner? For most entities, we make this determination by considering the facts and circumstances surrounding the entities relationship with respect to the goods. The statute directs us to weigh the benefits and burdens of ownership that vest with the entity. 374 While the statute doesn t list the relevant factors, the courts have established them over the course of time: 375 Benefits Physical possession 376 Legal title 377 Control and dominion Texas Tax Code (i). See, e.g., Leeson v. Houston, 243 S.W. 485 (Tex. App. Houston 1922), See also First Heights Bank, FSB v. Gutierrez, 852 S.W.2d 596 (Tex.App.-Corpus Christi,1993) (stating that [i]ncidents of ownership include: legal title; possession; exercising control and dominion over property; enjoyment of rents and revenues from property; having the risk of loss or potential for gain with respect to property; and making payments for maintenance, property taxes and insurance. ). See id. See also Eastex Aviation, Inc. v. Sperry and Huchinson Co., 522 F.2d 1299, 1305 (5th Cir. 1975) (stating that dominion, which implies both title and possession is perfect control in the right of ownership. ). See id. See First Heights Bank, FSB v. Gutierrez, 852 S.W.2d 596 (Tex.App.-Corpus Christi,1993) (stating that [i]ncidents of ownership include: legal title; possession; exercising control and dominion over property; enjoyment of rents and revenues from property; having the risk of loss or potential for

155 Page 144 Texas Franchise Tax Use and enjoyment 379 Potential for gain 380 Right to sell the property 381 Right to assign the property 382 Right to receive rents, interest and other revenues 383 Burdens Depreciation, depletion, decline in value 384 Who bears risk of obsolescence 385 Who bears risk of loss 386 gain with respect to property; and making payments for maintenance, property taxes and insurance. ) See, e.g., Rusk v. Rusk, 5 S.W.3d 299 (Tex.App.-Houston [14 Dist.],1999)(stating that Ownership and possession of property also extends to the use and enjoyment of that property. ). See First Heights Bank, FSB v. Gutierrez, 852 S.W.2d 596 (Tex.App.-Corpus Christi,1993) (stating that [i]ncidents of ownership include: legal title; possession; exercising control and dominion over property; enjoyment of rents and revenues from property; having the risk of loss or potential for gain with respect to property; and making payments for maintenance, property taxes and insurance. ). See id. See, e.g., Seymour v. American Engine & Grinding Co., Not Reported in S.W.2d, 1996 WL (Tex.App.-Hous. (14 Dist.), 1996)(identifying the authority to assign the policy as one of the incidents of ownership of an insurance policy). See, e.g., Webb s Fabulous Pharmacies, Inc. v. Beckwith, 449 U.S> 155 (1980) (stating that the earnings of a fund are incidents of ownership of the fund itself and are property just as the fund itself is property. ). See also First Heights Bank, FSB v. Gutierrez, 852 S.W.2d 596 (Tex.App.-Corpus Christi,1993) (stating that [i]ncidents of ownership include: legal title; possession; exercising control and dominion over property; enjoyment of rents and revenues from property; having the risk of loss or potential for gain with respect to property; and making payments for maintenance, property taxes and insurance. ). See, e.g. A. Duda & Sons, Inc. v. U. S., 560 F.2d 669 (5th Cir ) (stating that the owner of mineral deposits, whether freehold or leasehold, shall within the limitations prescribed, secure through an aggregate of annual depletion and depreciation deductions the return of either (a) his capital invested in the property, or (b) the value of his property on the basic date, plus subsequent allowable capital additions.... ). cf. U.S. v. Cocke, 399 F.2d 433 (5th Cir. 1968) (discussing the various factors in whether a taxpayer is entitled to depreciate property, including ownership and economic interests). See, e.g., Eastex Aviation, Inc. v. Sperry and Huchinson Co., 522 F.2d 1299, 1305 (5th Cir. 1975) (considering risk of loss as another element of ownership.). See also First Heights Bank, FSB v.

156 Texas Franchise Tax Page 145 Who pays for insurance 387 Who pays the taxes 388 Who pays for maintenance costs 389 Who bears financial risk 390 Example 1 A broom manufacturer takes title to and possession of component parts (wood, straw, wire, etc.) when it receives them. It bears the risk of loss throughout manufacturing and maintains title and possession of the brooms in inventory until it sells them and delivers them to customers. The manufacturer maintains insurance on its plant and its inventory, including the work in process. The broom manufacturer bears the benefits and burdens of ownership and is the owner of the goods. Gutierrez, 852 S.W.2d 596 (Tex.App.-Corpus Christi,1993) (stating that [i]ncidents of ownership include: legal title; possession; exercising control and dominion over property; enjoyment of rents and revenues from property; having the risk of loss or potential for gain with respect to property; and making payments for maintenance, property taxes and insurance. ) See First Heights Bank, FSB v. Gutierrez, 852 S.W.2d 596 (Tex.App.-Corpus Christi,1993) (stating that [i]ncidents of ownership include: legal title; possession; exercising control and dominion over property; enjoyment of rents and revenues from property; having the risk of loss or potential for gain with respect to property; and making payments for maintenance, property taxes and insurance. ). See id. See id. See id.

157 Page 146 Texas Franchise Tax Real Estate Industry Service Providers Taxable entities that provide services to the real estate industry may qualify for the COGS deduction under a special provision that treats them as the owner of the labor and materials that they furnish to real estate projects. 391 The special provision applies to the following types of work: Construction. Improvement. Remodeling. Repair. Industrial Maintenance. Example 1 A general contractor hires a wiring subcontractor to install wiring in a building the general contractor is construction. The real estate industry services provision treats the wiring subcontractor as the owner of the installation labor and wiring materials it furnishes to the building. As a result, the wiring contractor is eligible for the COGS deduction. Newpark Resources, Inc. s Victory Affirmed on Appeal. 392 In Combs v. Newpark Resources, Inc., the Third Court of Appeals held that Newpark an integrated oilfield services company and combined group for Texas franchise tax reporting purposes was entitled to include the expenses of its drilling mud waste disposal division ( NES ) in its COGS deduction. The Court rejected the Texas Comptroller s argument that eligibility for the COGS deduction must be made separately for each member of the group. Instead, the Court held that NES s eligibility to claim the deduction should be determined by examining Newpark s combined business. After determining that the COGS analysis applied at the combined group level, the Court then determined that NES s waste disposal service qualified for the COGS deduction as labor furnished to a project for the construction or improvement of real property under Texas Tax Code (i). The Court held so because NES s Texas Tax Code (i). Combs v. Newpark Resources, Inc., No CV, 2013 WL Martens, Todd, Leonard & Taylor handled the trial and the appeal of this case.

158 Texas Franchise Tax Page 147 transportation and disposal of drilling waste constituted labor furnished to a project for the construction and improvement of an oil and gas well (real property). The testimony at trial established that drilling mud waste removal was an essential and direct component of the drilling process. The Court did not reach Newpark s alternative argument that it could exclude from total revenue NES s flow-through payments to certain real property subcontractors (a component of NES s COGS deduction), which spurred Chief Justice Jones to author a concurring opinion. In his opinion, Chief Justice Jones agreed with the judgment affirming Newpark s trial court victory, but felt that the Court should have addressed Newpark s revenue exclusion argument before taking up the COGS deduction. The Comptroller filed a Motion for Rehearing, in which she urged the Third Court of Appeals to reconsider its decision and limit (i) to those who work on and effect a physical change to the real property. The Court denied the Motion for Rehearing. In Titan Transportation, LP v. Combs, 393 issued by the Third Court of Appeals shortly after the Newpark decision, the Court explicitly rejected the Comptroller s attempt to add a physical change requirement to the revenue exclusion found in Texas Tax Code (g)(3), which contains similar but not identical language to (i). The Comptroller s deadline to appeal the Newpark case to the Texas Supreme Court has expired. The opinion is now final. Other COGS Cases. Other recent cases address the COGS deduction for real estate industry service providers. CGGVeritas Services (U.S.), Inc. v. Combs, et al. 394 In CGGVeritas, the trial court found for the taxpayer and ordered a full refund of the franchise taxes paid under protest. CGG s petition alleged: (1) that CGG qualified under the real estate activities provision 395 to claim the COGS deduction for costs incurred in producing custom-ordered seismic recordings and images that it sold to oil & gas well drillers and producers; and (2) that CGG qualified under media definition of goods 396 to include the costs of 393 Titan Transportation, LP v. Combs, No CV, 2014 WL Martens, Todd, Leonard & Taylor handled the trial and the appeal of this case. 394 Cause No. D-1-GN Martens, Todd, Leonard & Taylor represents the Plaintiff. 395 Texas Tax Code (i), third sentence. 396 Texas Tax Code (a)(3)(A).

159 Page 148 Texas Franchise Tax its seismic data library in its COGS deduction. As of the date of these materials, the Comptroller s deadline to appeal the decision has not yet expired. Flint Energy Services, Inc. v. Combs, et al. 397 This case addressed: (1) Whether an oil and gas construction company may include per diem payments to employees working on projects away from their homes in cost of goods sold; and (2) Whether the Comptroller s interpretation of the cost of goods sold statute violates constitutional requirements of equal protection and equal and uniform taxation. This case was concluded with a judgment in the taxpayer s favor. The Comptroller subsequently amended the COGS rule to treat per diem payments as direct costs. Pending Litigation. Two other cases currently pending in Travis County District Court address the scope of this provision. 398 Allcat Claims Service, L.P. v. Combs, et al. 399 This case addresses: (1) Whether claims adjusters may exclude payments to independent contractor adjusters from revenue as real property subcontracting payments; and (2) in the alternative, whether claims adjusters may include payments to independent contractor adjusters in cost of goods sold. PEK, Inc. d/b/a Serviceline Transport v. Combs, et al. 400 This case addresses: (1) Whether an aggregate hauler may exclude payments to independent contractor drivers from revenue as real property subcontracting payments; (2) In the alternative, whether an aggregate hauler qualifies for the COGS deduction under section (i); (3) Whether the Comptroller properly apportioned gross receipts of an interstate transportation company; (4) Whether an aggregate hauler meets the definition of a qualified courier and logistics company ; and (5) Whether the Comptroller s interpretation of the provisions allowing deductions and exclusions for the real estate industry violates constitutional requirements of equal and uniform taxation No. D-1-GN Martens, Todd, Leonard & Taylor represents the Plaintiff. Martens, Todd, Leonard & Taylor represents these plaintiffs. No. D-1-GN No. D-1-GN

160 Texas Franchise Tax Page 149 Advance Hydrocarbon Corporation v. Combs, et al. 401 This case addresses whether an oilfield services provider qualifies for the COGS deduction under section (i). Pipeline Companies Taxable entities that provide services to the real estate industry may qualify for the COGS deduction under a special provision that treats them as the owner of the labor and materials that they furnish to real estate projects. 402 Since pipeline companies provide a service and generally don t sell goods, they did not qualify for the COGS deduction under the statute as it was originally written. For reports originally due on or after January 1, 2014, pipeline companies may subtract as a cost of goods sold its depreciation, operations, and maintenance costs allowed by the COGS section. 403 Qualification. In order to qualify for the COGS deduction, the pipeline company must: 1. own or lease and operate the pipeline that transports products for others. The COGS deduction authorized by this provision applies only to the product owned by others. Presumably, to the extent the pipeline company owns it own product, it would qualify for the COGS deduction as the owner of goods; and 2. be primarily engaged in gathering, storing, transporting, or processing crude oil, including finished petroleum products, natural gas, condensate, and natural gas liquids, except for a refinery installation that manufactures finished petroleum products from crude oil. 404 Processing means the physical or mechanical removal, separation, or treatment of crude oil, including finished petroleum products, natural gas, condensate, and natural gas liquids after those materials are produced from the earth. The term does not include the chemical or biological transformation of those materials Nos. D-1-GN and D-1-GN Texas Tax Code (i). Texas Tax Code (k-2). Eff. Jan. 1, Texas Tax Code (k-2). Eff. Jan. 1, Texas Tax Code (k-3). Eff. Jan. 1, 2014.

161 Page 150 Texas Franchise Tax Federal Government Contracts. As a general rule, businesses retain title and risk of loss of goods in production until the project is complete and the customer receives the goods. However, under most federal contracts, businesses furnishing goods to the federal government transfer ownership before they complete the work. Under the general ownership rules, federal government contractors would not own the goods and would thus be ineligible to deduct the related costs. In order to remedy this disparity, the statute treats federal government contractors as owners of the goods manufactured or acquired. 406 This treatment extends to subcontractors working on the project. 407 The rule applies even if the applicable Federal Acquisition Regulation requires title or risk of loss to transfer to the federal government before manufacturing or production is complete. 408 Oil & Gas Drillers. By policy, the Comptroller s office treats oil & gas drilling companies as eligible for the COGS deduction. 409 Contract Manufacturers. According to the Comptroller, only the producer of goods may deduct the production costs of those goods. The Comptroller recently stated that an entity isn t considered the producer of goods if the entity contracts with an unrelated third party to produce the goods to the entity s specifications. Therefore, the Comptroller would only permit the entity to deduct the costs of acquiring the goods, not the costs of producing them. 410 Example ABC Company sells circuit boards. ABC Company employs engineers, who design the circuit boards. It then sends the specifications to an unaffiliated Chinese company that manufactures the circuit boards. The Chinese company then ships the circuit boards back to ABC Company for sale. Based on the Comptroller s guidance, ABC Company may deduct the costs it paid to the Chinese company, the cost of shipping the finished circuit boards back to ABC Company, and the Texas Tax Code (i). Id. Texas Tax Code (i). See Comptroller FAQs for COGS, Question and Answer No. 17 (April 16, 2008). Tax Policy News (Oct. 2009).

162 Texas Franchise Tax Page 151 warehousing costs for the circuit boards. However, ABC Company may not deduct the salaries it paid to the engineers. If ABC Company manufactured the circuit boards in-house or the Chinese company was included in ABC Company s combined group, the company would have been able to deduct the engineers salaries and other costs of designing the circuit boards. Does the entity sell goods? Goods are real or tangible personal property sold in the ordinary course of business of a taxable entity. 411 An entity must sell goods in order to deduct cost of goods sold. Tangible Personal Property. Tangible personal property is personal property that can be seen weighed, measured, felt, or touched or that is perceptible to the senses in any other manner. Note. This differs from the sales tax definition of tangible personal property, which includes personal property that can be seen, weighed, measured, felt, or touched or that is perceptible to the senses in any other manner, and, for the purposes of [the sales and use tax], the term includes a computer program and a telephone prepaid calling card. It s unclear whether telephone prepaid calling cards would be considered goods. Animals, Crops and Timber. Animals, crops and timber are goods for purposes of excluding compensation paid to undocumented workers. 412 While crops and timber would generally fit the definition of real property, this distinction makes it unclear whether the Legislature intended them to be goods for general purposes. Media. Tangible personal property includes films, sound recordings, videotapes, books and other media intended to be mass-distributed in a form that will not be substantially altered. Live and prerecorded television and radio programs qualify as goods. 413 Film and television producers or broadcasters can capitalize or deduct cost of goods. Broadcasters and local media may deduct the costs for the right to Texas Tax Code (a)(1). Texas Tax Code (e)(14)(B). Texas Tax Code

163 Page 152 Texas Franchise Tax broadcast or to use the property. 414 Media property does not have to be distributed in a tangible form to be tangible personal property. 415 Example 1 A cable company acquires a sports broadcast from the NFL via satellite, and then distributes the program live to pay-per-view subscribers via its cable network. Even though the broadcast never existed in tangible form, it still qualifies as tangible personal property. Example 2 A novel would fit the revised franchise tax definition of tangible personal property. However, a market survey report created on a proprietary basis for a single client would not because it is not intended to be mass-distributed. Computer Programs. Tangible personal property also includes computer programs, as defined in the sales tax law. A computer program is a series of instructions that are coded for acceptance or use by a computer system and that are designed to permit the computer system to process data and provide results and information. The series of instructions may be contained in or on magnetic tapes, punched cards, printed instructions, or other tangible or electronic media. 416 Real Property. The statute includes real property in the definition of goods but doesn t define it. Black s Law Dictionary defines real property as land and anything growing on, attached to, or erected on it, excluding anything that may be severed without injury to the land. 417 Real Estate Developers: A real estate developer improves land, thereby increasing its value. A developer owning real property may include the associated costs of the land and improvements in its cost of goods sold Texas Tax Code Texas Tax Code Texas Tax Code Black s Law Dictionary, 8th Ed., West Group (2004), page Texas Tax Code (i) states A taxable entity may make a subtraction under this section in relation to the cost of goods sold only if that entity owns the goods. Texas Tax Code (a)(1) includes real property in the definition of goods.

164 Texas Franchise Tax Page 153 Not Goods Example 1 A homebuilding partnership holding legal title to a house under construction is the owner of the goods (real property). Example 2 A real estate developer improves raw land by constructing roads and installing utilities. The developer subdivides the developed land into lots and sells the lots at a gain. Intangible Property. Intangible items are not goods. 419 Intangible property includes trademarks, patents, accounts receivable, contract rights, stocks & bonds, partnership interests, and so forth. Issue. An entity owning royalties, patents, trademarks, or other intangible assets does not qualify as a nontaxable passive entity if one or more related entities use the intangible property in a trade or business. 420 Services. Services are not goods. 421 Therefore, service providers are ineligible to deduct the costs they incur in providing their services. However, providers of mixed transactions, such as an automotive repair shop or a veterinarian s office, can deduct as a cost of goods sold costs related to the tangible personal property sold as part of their services (car parts, dog food). 422 If the Entity is Eligible, What is the Amount? In general, the entity includes the following in cost of goods sold: All direct costs of acquiring or producing the goods; Indirect or administrative costs allocable to acquiring or producing the goods; and Certain other indirect costs Texas Tax Code (a)(3)(B). Texas Tax Code (d). Texas Tax Code (a)(3)(B). Comptroller Rule 3.588(c)(6).

165 Page 154 Texas Franchise Tax Direct Costs. Direct costs include the costs of acquiring, producing and processing goods. They also include certain other costs that one wouldn t usually consider direct acquisition and production costs, such as geological and geophysical costs, and research and development costs. 423 Acquisition Costs Inbound Transportation Costs. These are costs attributable to freight and other inbound delivery of items such as goods, component parts, and raw materials. The Comptroller s current position is that construction businesses may include the cost of transporting materials to the job site in cost of goods sold as inbound transportation costs, but may not include the cost of transporting equipment and laborers to the job site. It is unclear whether a court would rule that the revised franchise tax statute supports the Comptroller s position. Electricity Acquisition. This is the cost of acquiring electricity sold. Component Materials. These are costs for materials that are an integral part of the goods produced. Consumed Materials. These are materials consumed in the ordinary course of performing production activities. Production activities include construction, installation, manufacturing, development, mining, extraction, improvement, raising or growth. Mining and extraction pertain to natural resources. Raising and growth pertain to agricultural activities. Production Costs Labor Costs. The statute does not define direct labor costs. However, the Rule states that labor costs include payments for W-2 wages, Form 1099 wages, temporary labor, payroll taxes, and benefits. 424 Electricity Production. This is the cost to produce electricity sold. Inventory Processing Costs Storage Costs. This includes costs of carrying, storing or warehousing property. The Comptroller has issued a policy statement stating the cost of a store stocker s salary is includible as a component of COGS Texas Tax Code (c). Comptroller Rule 3.588(d)(1).

166 Texas Franchise Tax Page 155 Handling Costs. This includes costs attributable to processing, assembling and repackaging goods. Facilities and Equipment Costs Depreciation, Depletion and Amortization. Taxpayers may deduct these costs to the extent they re associated with and necessary for producing goods. The amount should equal the amount reported on the federal tax return for the accounting period for each item associated with the production of goods. This includes IRC 197 recovery costs of goodwill and certain other intangibles. 426 Taxpayers may elect under IRC 179 for federal tax purposes to deduct certain the cost of certain property as an expense instead of capitalizing and depreciating it. This property generally includes depreciable tangible personal property used in an active trade or business. IRC 179(b)(1) limits the dollar amount of the maximum deduction a taxpayer may take. For Texas revised franchise tax purposes, taxpayers may include in cost of goods sold the cost of any property used in producing goods that they deduct under IRC 179. However, the Texas revised franchise tax is tied to the Internal Revenue Code in effect as of January 1, Therefore, taxpayers may only include amounts deducted under IRC 179 up to the maximum deduction the Internal Revenue Code allowed as of January 1, Taxpayers may not take any subsequent increases in the maximum allowable IRC 179 into account for Texas revised franchise tax purposes. The maximum IRC 179 deduction allowed for Texas revised franchise tax purposes is $112,000 for franchise tax report year 2008, $115,000 for franchise tax report year 2009, $120,000 for franchise tax report year 2010, and $25,000 for franchise tax report year Issue. Federal Depreciation Consistency. The 2007 Act provides that depreciation, depletion, and amortization deducted or capitalized should be calculated consistent with the method used on the entity s federal income tax return. 428 The Act ties the franchise tax deduction to the amount actually reported on the federal return. This appears to be an error. For consistency with the See Comptroller FAQs for COGS, Question and Answer No. 9 (April 16, 2008). Texas Tax Code (c)(6), Comptroller Rule 3.588(d)(6). Texas Tax Code (9). Texas Tax Code

167 Page 156 Texas Franchise Tax revenue calculation, the Act should tie the franchise tax deduction to the amount that is reportable for federal income tax purposes. Issue. Bonus and 179 Depreciation. Remember that the revised franchise tax is based on the federal tax code as it existed as of January 1, This means depreciation for the cost of goods sold deduction will not include the bonus depreciation included in the Economic Stimulus Act of It also means that cost of goods sold depreciation includes 179 depreciation but only up to the amount allowed by the code as of January 1, $112,000 for the 2008 reports; $115,000 for the 2009 reports, $120,000 for the 2010 reports, and $25,000 for 2011 and beyond 430 Issue. Depreciation Under the Old Franchise Tax. Under the old franchise tax, sometimes 179 deductions were not permitted for franchise tax purposes in the year they were deducted for federal tax purposes. However, the previous franchise tax allowed taxpayers to deduct this excess depreciation in later years. There is no such rule for revised franchise tax purposes. Excess depreciation accrued under the old franchise tax is lost. The amount of depreciation is limited to the depreciation as reported under the federal tax code as of January , without further advisement. 431 Since goods includes real estate, would a contractor s back-hoe or cement truck qualify as depreciable equipment eligible for the deduction? Rental Expenses. This includes costs of renting or leasing equipment, facilities or real property directly used for the production of goods. 432 Repair and Maintenance. This includes the costs of repairing and maintaining equipment, facilities or real property used directly for the production of the goods Comptroller Letter No L (Oct. 9, 2008). Comptroller FAQs Cost of Goods Sold Nos. 18 & 24. Comptroller Letter No L (Oct. 17, 2008). Texas Tax Code (c)(7).

168 Texas Franchise Tax Page 157 Other Costs Research & Development. These are costs attributable to research, experimental, engineering and design activities directly related to the production of the goods. This includes all research or experimental expenditures described by IRC IRC 174 applies to research or experimental expenditures which are paid or incurred by a taxpayer during the taxable year in connection with a trade or business. Note. Research and development costs are not eligible for the sales tax manufacturing exemption because they are used in pre-production work prior to the first chemical or physical change to the product being manufactured for sale. However, research and development costs, including depreciation on R&D equipment, are includible in franchise tax cost of goods sold. Note. Research and development costs are incurred prior to the production or acquisition of goods. It appears inconsistent to allow research and development in cost of goods sold but to disallow post-production costs, such as selling expenses and rehandling costs. G&G Costs. This includes geological and geophysical costs incurred to identify and locate property that has the potential to produce minerals. The revised franchise tax likely allows G&G costs in cost of goods sold in order to promote the exploration of new energy sources. Note. G&G costs are capitalized for federal tax purposes and depleted unless a taxpayer elects to amortize them. Pollution Control, Intangible Drilling and Dry Holes. The statute includes pollution control equipment and intangible drilling and equipment rental associated with dry hole costs in the cost of renting or leasing equipment, facilities, or real property directly used for the production of the goods. 434 It also includes repairs and maintenance of pollution control devices in cost of goods sold Texas Tax Code (c)(9). Texas Tax Code (c)(7). Texas Tax Code (c)(8).

169 Page 158 Texas Franchise Tax Transaction Taxes. These are taxes paid in relation to acquiring or producing any material, or taxes paid in relation to services that are a direct cost of production. (e.g., sales and use tax, excise tax, or property tax on inventory) Indirect Costs. Taxable entities may subtract indirect or administrative overhead costs as costs of goods sold. The indirect costs must be allocable to the acquisition or production of goods. The Comptroller recently amended COGS Rule The rule amendments favor taxpayers and appear to be applied retroactively. Labor Costs. The amended rule allows taxpayers to treat all labor costs, except those classified as service costs, as 100% deductible for COGS. Labor costs include Form W-2 wages, Form 1099 payments for labor, temporary labor expenses, payroll taxes, pension contributions, and employee benefits expenses, including health insurance and per diem payments for travel to the extent these expenses are deductible under the federal income tax rules. 437 The COGS rule defines service costs as:... indirect and administrative overhead costs that can be identified specifically with a service department or function, or that directly benefit or are incurred by reason of a service department or function... The COGS rule goes on to define a service department to include: Security Services. This includes payments for providing security for the business. Costs allocable to production would include, for example, fees paid for security services to guard a facility where goods are being produced or stored in inventory. Legal Services. This includes the cost of the legal department. Costs allocable to production would include, for example, fees a manufacturing plant incurs for legal services in connection with environmental cleanup litigation The rule became final on June 5, Comptroller Rule 3.588(d)(1)(A).

170 Texas Franchise Tax Page 159 Data Processing Services. This includes the cost of the data processing department. Costs allocable to production would include, for example, fees incurred for data processing services for inventory maintenance and the allocable portion of accounts payable and payroll processing. Accounting Services. This includes accounts payable, disbursements and payroll. Costs allocable to production would include, for example, the cost of accounting services related to manufacturing or inventory operations, such as cost accounting,. Personnel. This includes the cost of the personnel department. Costs allocable to production would include, for example, the costs of recruiting, hiring, relocating, assigning and maintaining employee personnel records for employees involved in manufacturing operations. General Financial Planning Costs. Costs allocable to production would include, for example, financial planning costs incurred in connection with planning for manufacturing or inventory operations. General Financial Management Costs. Costs allocable to production would include, for example financial management costs incurred in connection with cost accounting for manufacturing or inventory operations. 4% Limitation. The COGS rule treats only the allocable portion of the service costs as indirect costs subject to the four percent (4%) limitation of the taxable entity s total indirect or administrative overhead costs, including all mixed service costs. Any costs specifically excluded from the cost of goods sold deduction may not be subtracted as an indirect cost Comptroller Rule 3.588(f)(3).

171 Page 160 Texas Franchise Tax Example P & S are affiliates that file a combined report. Both are eligible to take the COGS deduction. They incur the following overhead and administrative costs: P S C Excluded Costs 100, , ,000 Allocable, Indirect Costs 2, , ,000 Non-Allocable, Indirect Costs 100, , ,000 Deductible Indirect Costs 2,000 8,000 10,000 This example illustrates two issues with the 4% indirect cost limitation: Q. Does the 4% limitation include the costs excluded under Texas Tax Code (e), such as interest, selling costs, and advertising? By Rule, the Comptroller says no: if a cost is excluded from the COGS deduction it may not be included in the overhead base against which the 4% limit is applied. 439 Q. Does a combined group calculate the 4% limitation on a separate company basis or on a combined basis? Comptroller Rule 3.590(d)(2)(A)(i) requires combining entities to compute cost of goods sold as if the member was an individual taxable entity. 439 Comptroller Rule 3.588(f)(2).

172 Texas Franchise Tax Page 161 Combined Group Overhead Limitation Calculation. In Newpark Resources, Inc. v. Combs, 440 a taxpayer recently won a case that involved combined reporting issues. 441 One of the grounds the suit raised was whether a combined group should calculate its 4% limitation for indirect costs based upon the total indirect administrative costs incurred by all members of the group. Although the Third Court of Appeals opinion did not expressly address indirect costs, it did confirm that COGS should be calculated as a combined group and that the members should not be viewed in isolation. Other Costs. The revised franchise tax also allows entities to include other costs in cost of goods sold if they are incurred in relation to the taxable entity s goods: 442 Production Costs Utilities. This likely includes electricity, gas, water and other utilities. The Tax Code doesn t specify how to determine if utilities are directly used in the production of goods. However, the sales tax rules for manufacturers purchasing tax-exempt electricity may provide guidance. Under the sales tax rules, natural gas or electricity used to operate production machinery and for lighting, cooling and heating in the manufacturing area are considered exempt uses. Gas and electricity used to operate, lighting, cooling and heating in manufacturing support areas are considered taxable uses. Manufacturing support areas include, but are not limited to, storage, engineering, office and accounting areas, research and development and break room, eating and restroom facilities. Utilities used in an area open to the public for purposes of marketing a product ready for sale are considered taxable uses. Utilities used to operate other nonproduction machinery or equipment are taxable. Quality Control. This includes the costs of replacing defective components pursuant to standard warranty policies, costs of inspections Combs v. Newpark Resources, Inc., No CV, 2013 WL Combs v. Newpark Resources, Inc., No CV, 2013 WL Martens, Todd, Leonard & Taylor handled the trial and the appeal of this case. Texas Tax Code (d).

173 Page 162 Texas Franchise Tax directly allocable to the production of goods, and costs of repairing and maintaining goods held for sale. 443 Costs Incurred Outside Production Pre-Production Direct Costs. If property is held for future production, preproduction direct costs are includible in cost of goods sold to the extent they re allocable to the property. This includes the cost of purchasing the goods, storing the goods and handling the goods. Post-Production Direct Costs. This includes storage, handling and other direct post-production costs allocable to the property. Cost of Waste Spoilage and Abandonment. This includes costs of rework labor, reclamation and scrap. Deterioration. This includes diminution of quality, character or value of the goods held in inventory. Obsolescence. This is the cost of declining usefulness of goods held in inventory because they have become outmoded or outdated. Administrative Costs Facilities Insurance. Cost of goods sold includes the cost of insurance on a plant or facility, machinery, equipment or materials used in the production of the goods. Inventory Insurance. We also include the cost of insurance on produced goods held in inventory. Licensing and Franchise Costs. These are costs and fees incurred in securing the contractual right to use a trademark, corporate plan, manufacturing procedure, special recipe or similar right directly associated with the goods produced. (e.g., the license and secret recipe to produce Coca-Cola ) 443 Texas Tax Code (d)(9).

174 Texas Franchise Tax Page 163 Partnership Contributions. A taxable entity may include in cost of goods sold a contribution to a partnership in which the taxable entity owns an interest. The contribution must be used to fund activities, the costs of which would otherwise be treated as cost of goods sold of the partnership. The partnership contributions are only included in cost of goods sold if they relate to goods the partnership distributes to the taxable entity as goods-in-kind in the ordinary course of production activities (rather selling them). Example A clothing manufacturer (Fine Fashions) owns an interest in a partnership that buys and sells fabric (Fine Fabrics). Fine Fashions contributes funds to Fine Fabrics for purchasing fabric to be used in its clothing production. Fine Fabrics uses the funds to purchase the fabric and distributes the fabric to Fine Fashions as an in-kind distribution in lieu of making a cash distribution to Fine Fashions. What Costs are Not Included? The revised franchise tax appears to exclude most pre-production, post-production and non-production costs. However, there are several inconsistencies in the statute. The following items are specifically excluded from cost of goods sold for purposes of calculating the Texas revised franchise tax: Pre-Production Costs Bidding Costs. Costs incurred in the solicitation of contracts are not deductible. This is true regardless of whether the contracts are ultimately awarded to the taxable entity. Post-Production Costs Selling Costs. Marketing, employee sales commissions, and other costs of selling goods (including employee expenses incurred in connection with sales of goods) are not deductible. Note. Display items are probably not a component of cost of goods sold. Advertising Costs. Costs incurred to attract public attention to a product or business are not deductible.

175 Page 164 Texas Franchise Tax Distribution Costs. Outbound transportation costs and other distribution costs are not deductible. The labor of the wait staff of a restaurant is not a component of COGS. 444 Rehandling Costs. Costs associated with restocking returned items and preparing them for sale are not deductible. Non-Production Costs Non-Production Rental Costs. Costs of renting or leasing equipment, facilities or real property are not deductible if they are not used for the production of goods. Idle Facility Expenses. Expenses incurred due to maintenance shutdowns or other idle facility time are not includible in cost of goods sold. Strike Expenses. Costs associated with hiring employees to replace striking personnel are not includible in cost of goods sold. However, the wages of replacement personnel, the costs of security and the legal fees associated with settling strikes are includible if they can be allocated to the goods being produced. Administrative Costs Interest. Interest on debt incurred or continued during the production period to finance the production of goods is not deductible. Exception. Lending institutions that offer loans to the public may include interest expense in cost of goods sold. Income Taxes. Local, state, federal, and foreign income taxes are not includible in cost of goods sold. This includes franchise taxes a taxable entity pays based on its income. Officers Compensation. Payments to officers are not deductible as cost of goods sold. As of mid-2009, the Comptroller has not defined who is considered an officer. 444 See Comptroller FAQs for COGS, Question and Answer No. 10 (April 16, 2008).

176 Texas Franchise Tax Page 165 Government Facilities. The costs of operating certain federal government facilities are not includible in cost of goods sold. This includes the costs of operating facilities located on property owned or leased by the federal government and managed or operated primarily to house members of the armed forces of the United States. These aren t includible in cost of goods sold because the income reported for federal purposes from those facilities isn t included in the determination of revenue. 445 Undocumented Workers. Compensation paid to undocumented workers to produce goods is not includible in cost of goods sold. Undocumented workers are persons who are not lawfully entitled to be present and employed in the United States. This may significantly affect large farms and ranches organized as taxable entities. Note that the production of goods includes the breeding and raising livestock or other animals, the growing and harvesting of crops, and the severance of timber from realty. In these circumstances, payments to undocumented migrant farm workers would not be a component of cost of goods sold. Comptroller Interpretations Applied to Industries Oil and Gas Working Interest Owners. The Comptroller has stated that oil and gas working interest owners may include the following expenses in cost of goods sold: 446 Lease operating expenses (the costs of operating the well); Severance taxes; Depreciation on well equipment; Intangible drilling costs; In-bound transportation costs; and Depletion See Texas Tax Code (e)(13) and (q). Letter from Martha Preston (Aug. 31, 2010).

177 Page 166 Texas Franchise Tax Depletion, as reported on the federal income tax return, is allowed as COGS to the extent associated with, and necessary for, the production of goods under Texas Tax Code Section (c)(6). A pass-through entity may include as COGS the depletion costs incurred and reported to its owners for federal tax purposes. The owners of a pass-through entity, however, may not include the depletion reported to them as COGS. The Comptroller intends to amend Rule 3.588(d)(6) to reflect this policy. 447 Cost of goods sold also includes property taxes specifically allocable to the land area of the well and to the well equipment in cost of goods sold, subject to the 4% limitation for indirect and administrative overhead costs. Cost of goods sold does not include distribution costs, including out-bound transportation. According to the Comptroller, whether a taxable entity may include transportation costs in cost of goods sold depends upon the terms of the producer s contract with its customers. If the producer sells the product at the well-head, then the costs to transport it are distribution costs, which the taxable entity may not include in cost of goods sold. If the producer sells the product after it is processed, then the transportation costs up to the point of processing are includible in cost of goods sold. Real Estate Industry. Real estate industry contractors may claim a COGS deduction for the labor, materials and other costs furnished to a project for the construction, improvement, remodeling, remediation, repair, or industrial maintenance of real property. 448 Retailers/Wholesalers. 449 Generally, retailers and wholesalers may deduct all direct costs of acquiring and producing the goods they sell. Typically, they may deduct the costs incurred from the acquisition of the goods through the point they put the goods on display for sale. However, retailers and wholesalers may not deduct selling costs, which generally consist of costs the business incurs once it displays the goods for sale Comptroller Letter No L (Nov. 1, 2010). Texas Tax Code (g). Tax Policy News (January 2011).

178 Texas Franchise Tax Page 167 As a result, the Comptroller s policy prevents retailers or wholesalers from deducting the costs associated with the store area visited by consumers to purchase goods. This includes the rental of the retail space, cost or depreciation of the display counters, utilities, retail clerk salaries and so forth. The Comptroller only allows the costs associated with the back room where inventory is kept and in which customers are not allowed. 450 According to the Comptroller, the costs retailers and wholesalers may deduct as cost of goods sold include: The purchase price of the goods; Repackaging costs; Inbound transportation costs; and Storage costs, but not rental of storage space. The Comptroller has stated that retailers and wholesalers may not deduct the following costs as cost of goods sold: Selling costs; Distribution costs (including outbound transportation); Advertising costs; Rehandling costs; and Officers compensation. 450 Comptroller Frequently Asked Question no.9.

179 Page 168 Texas Franchise Tax Example 1 A company operates several retail clothing stores throughout Texas. It also owns a distribution center that supplies the retail stores with clothing the company acquires. The company may include the following costs in cost of goods sold: The cost of acquiring the clothing; Compensation and related expenses (travel, etc.) for purchasing agents; The cost of transporting the clothing to the distribution center; Depreciation of the distribution center; Depreciation on equipment used in the distribution center; Distribution center utility costs; The cost of transporting the clothing from the distribution center to the retail stores; and The cost of utilities for the storage area only at the retail stores. The company may not include the following costs in cost of goods sold: Rent paid to shopping centers for retail stores; Utility costs for the retail store display areas; Display racks and display shelving; Compensation paid to sales managers and sales personnel; The cost of cash registers; Credit card company fees; Shopping bags; and Tissue.

180 Texas Franchise Tax Page 169 Example 2 A company operates several grocery stores throughout Texas, and also rents a distribution center in Austin. The company may include the following costs in cost of goods sold: The cost of acquiring the groceries it sells; Compensation and related expenses (travel, etc.) for purchasing agents; The cost of transporting groceries to the distribution center; Depreciation on distribution center equipment; Distribution center utility costs; The cost of transporting groceries from the distribution center to the grocery stores; and Compensation paid to grocery store stockers. The company may not include the following costs in cost of goods sold: Distribution center rent; Grocery store rent; Refrigerated display cases; Grocery display shelving; Compensation paid to cashiers and baggers; The cost of cash registers; Credit card company fees; and Grocery bags. Software. Companies that sell or manufacture software may deduct cost of goods sold because the Comptroller considers software a good Comptroller Letter No L (Aug. 1, 2011).

181 Page 170 Texas Franchise Tax Auto Repair. According to the Comptroller, auto repair businesses may include the cost of parts they sell as part of their repair service in cost of goods sold. However, the Comptroller says that auto repair businesses may not include repair labor costs in cost of goods sold. The Comptroller provides the following examples illustrating her interpretation of the cost of goods sold statute as applied to auto repair businesses: Example 1 An entity provides general automotive repair services as described in Industry Number 75238, General Automotive Repair Shops, of the SIC Manual. If this entity chooses to deduct COGS in determining its margin, only the allowable costs related to tangible personal property can be included in the deduction. The labor costs for the repair services cannot be included in the COGS deduction. Example 2 An entity sells auto parts from a retail establishment and also provides automotive repair services such as oil changes, tire rotations, wheel alignments, etc. The COGS deduction for this entity includes the allowable costs as specified in Texas Tax Code Section for the retail sales and also for the sale of any parts (tangible personal property) included in the automotive repair services. The labor costs for the automotive repair services, however, cannot be included in the COGS deduction. Example 3 A car dealership sells new automobiles and also provides automotive repair services. The COGS deduction for this entity includes the allowable costs as specified in Texas Tax Code Section for the retail sale of automobiles and also for the sale of any parts (tangible personal property) included in the automotive repair services. The labor costs for the automotive repair services, however, cannot be included in the COGS deduction.

182 Texas Franchise Tax Page 171 Restaurants and Bars. 452 The Comptroller provides the following examples of costs restaurants and bars may include in cost of goods sold: Costs of acquiring food; Costs of equipment (such as refrigerators, ovens, stoves, pots, pans, etc.) used to store and prepare food, including depreciation of this equipment; Compensation to food preparers, including Form W-2 wages, Form 1099 wages, temporary labor wages, payroll taxes, and employee benefits; Rent allocable to the kitchen (food production area) only; Cleaning and janitorial costs allocated to the kitchen and food storage area; Insurance allocable to the kitchen; Utilities allocable to the kitchen and food storage area; and Franchise fees directly associated with the goods produced. According to the Comptroller, a restaurant or bar may only deduct costs of supervising food preparers and property taxes allocable to the kitchen as indirect or administrative overhead costs, subject to the 4% cap. 452 Tax Policy Newsletter (October 2010).

183 Page 172 Texas Franchise Tax The Comptroller says that restaurants and bars may not deduct the following costs: Rent allocable to the dining area and other non-production areas; Dining area furniture; Dishes, silverware, and linens; Utilities allocable to the dining area; Cleaning and janitorial costs allocated to the dining area; Compensation to hosts, wait staff, and busboys (including the cost of any uniforms provided); Credit card commissions/fees; Mixed beverage gross receipts tax; Advertising; and Officers compensation. Restaurants and bars may not include mixed beverage taxes they pay in cost of goods sold because the Comptroller says they are not paid in relation to acquiring or producing the restaurant or bar s goods. 453 Cattle Feed Lots. If the cattle feeder owns the cattle, the Comptroller allows it to claim the COGS deduction, which includes all of the direct feed and labor costs of raising the cattle. The direct costs typically include: labor, cattle & related insurance, feed, medicine, storage of the feed/grain, and the following costs relating to production equipment: depreciation, maintenance, repair, utilities, insurance. The Comptroller will not allow a depreciation deduction on the barn for the cattle. If the cattle feeder doesn t own the cattle, the Comptroller will treat it as providing a mixed service. The Comptroller will allow a COGS deduction only for the cost of the feed and medicine, but no deduction for any of the other costs stated above. If the feed lot operator both owns cattle and feeds cattle belonging to others, the feed lot operator must allocate the costs based upon the relative number of cattle it owned during the period upon which the revised franchise tax is based Tax Policy Newsletter (December 2011).

184 Texas Franchise Tax Page 173 Special Industry Provisions Lending Institutions. A lending institution that elects to deduct cost of goods sold may include interest expense in its computation of cost of goods. Rental Companies. In general, rental companies are unable to deduct cost of goods sold. For sales tax purposes, a rental of tangible personal property is included in the definition of a taxable sale. However, the revised franchise tax treats rental companies as having no inventory. This may be harsh because rental companies don t incur significant compensation expenses. They spend most of their money buying the equipment they lease. There is a limited exception for taxable entities that rent or lease certain types of vehicles or equipment. These entities may include in cost of goods sold the expenses incurred in connection with the vehicles or equipment. The following types of rental companies qualify for this exception: Motor vehicle rental companies that remit motor vehicle gross rental receipts tax, or a motor vehicle leasing company. 455 Heavy construction equipment rental or leasing companies. Railcar rolling stock rental or leasing companies. For further discussion of the effects of the revised franchise tax on various entities see Chapter VI Industry Tax Preferences. Unitary Tax Effects on Cost of Goods Sold Unitary businesses required to file a combined report calculate cost of goods under the following rule: First, each member of the combined group computes its cost of goods sold as though it filed a separate federal income tax return. 456 Next, the costs of goods sold for each entity (computed in step #1) are added together to arrive at a preliminary total cost of goods sold Tax Policy Newsletter, p. 1-3 (March 2011). Comptroller Rule 3.588(c)(9) and Comptroller Letter No L (Oct. 28, 2008). Texas Tax Code (c)(1) Texas Tax Code (c)(2)

185 Page 174 Texas Franchise Tax Finally, the group subtracts from the amount computed in step #2 the cost of goods sold arising from a payment from one member of the combined group to another member of the combined group where a corresponding amount was included in another affiliates revenue. 458 Example Four entities form a combined group- a butcher, a baker, a candlestick maker, and a restaurant. They have common ownership and management. The butcher buys meat for resale and provides its finest cuts to the restaurant. The baker sells bread and rolls to the public and to the restaurant. The candlestick maker sells candles over the Internet and furnishes candles to the restaurant for use on its tables. The butcher, baker and candlestick maker sell to the restaurant at cost plus a 10% markup. The combined group elects to deduct as costs are incurred. 458 Texas Tax Code (c)(3)

186 Texas Franchise Tax Page 175 Step #1: The butcher incurs the following costs: Meat purchased for sale to customers $ 5,000 Meat purchased for sale to restaurant 1,500 Other cost of goods sold 3,500 Total Cost of Goods Sold $ 10,000 The baker incurs the following costs: Ingredients for bread sold to customers $ 3,500 Ingredients for bread sold to restaurant 1,000 Other cost of goods sold 5,000 Total Cost of Goods Sold $ 9,500 The candlestick maker incurs the following costs: Wax & wicks for candles sold to customers $ 1,200 Wax & wicks for candles sold to restaurant 800 Other cost of goods sold 4,000 Total Cost of Goods Sold $ 6,000 The restaurant incurs the following costs: Meat purchased from butcher $ 1,650 Bread purchased from baker 1,100 Candles purchased from candlestick maker 880 Other cost of goods sold 16,370 Total Cost of Goods Sold $ 20,000

187 Page 176 Texas Franchise Tax Step #2: The total cost of goods sold for the group is: Butcher $ 10,000 Baker 9,500 Candlestick maker 6,000 Restaurant 20,000 Total Group Cost of Goods Sold $ 45,500 Step #3: The combined group subtracts the payments made from the restaurant to the other businesses because they were included in the businesses revenue: Total Group Cost of Goods Sold $ 45,500 Less: Payments to butcher ( 1,650) Less: Payments to baker ( 1,100) Less: Payments to candlestick maker ( 880) Combined Cost of Goods Sold $ 41,870 Exception for Affiliated Group Payments. Payments made by one member of an affiliated group to another member of the group that is not a member of the combined group may be subtracted as a cost of goods sold only if it is a transaction made at arm s length. 459 The revised franchise tax defines arm s length as the standard of conduct under which entities that are not related parties and that have substantially equal bargaining power, each acting in its own interest, would negotiate or carry out a particular transaction Texas Tax Code (l). Texas Tax Code (m).

188 Texas Franchise Tax Page 177 The Tax Code considers parties to be related if a single entity or group directly or indirectly owns or controls more than 50% of the other. This includes entities treated as pass-through entities or disregarded entities for federal tax purposes, even if one or more of the entities aren t subject to the Texas revised franchise tax. 461 Example Assume the same facts as the example above, except the candlestick maker is not part of the combined group. Instead, the candlestick maker is an affiliated entity. The restaurant owns and controls an interest in the candlestick maker s business. For purposes of this example, the candlestick maker is an out-of-state business without nexus in Texas and is not subject to the Texas revised franchise tax. The restaurant may only include its payments to the candlestick maker in cost of goods sold if the price that the restaurant pays for the candles is comparable to the price that the restaurant would pay in the open marketplace. This rule is designed to prevent abuses between related entities. Otherwise the restaurant could divert revenues and avoid tax by paying the candlestick maker a higher than average price for the candles. This is particularly true when the related entity is a nontaxable entity, such as a sole proprietorship, operating in Texas. 461 Texas Tax Code (n)

189 Page 178 Texas Franchise Tax Federal Tax Effects on Cost of Goods Sold The federal tax laws and regulations affect a taxable entity s accounting for inventory and cost of goods sold. They also affect an entity s recordkeeping requirements for the Texas revised franchise tax. The statute states that if a taxpayer elects to capitalize cost of goods sold, it must capitalize each cost allowed under this section that it capitalized on its federal income tax return. 462 Several sections of the Internal Revenue Code must therefore be considered if cost of goods sold is capitalized. IRC 471 establishes the general rules for taking inventories and accounting for shrinkage. IRC 263A requires businesses to capitalize certain expenses and include them in inventory rather than deducting them when they are incurred. IRC 460 provides special rules for long-term contracts. If a cost is allowed by the franchise tax cost of goods sold rules but not capitalized for federal tax purposes, it should be included in cost of goods sold in the period incurred. Example Quality Manufacturing incurs direct and indirect costs in connection with the production of washing machines for sale. During 2012, it produces 4,000 washing machines. It starts with no beginning inventory and sells 3,000 of its machines during It incurs these costs during 2012: 462 Texas Tax Code (g).

190 Texas Franchise Tax Page 179 Direct Costs Materials $ 100,000 Inbound transportation costs 10,000 Manufacturing labor costs 100,000 Equip repair labor (undoc. EEs) 50,000 Equipment depreciation 40,000 Plant Manager (also an officer) 200,000 Indirect Costs Security costs (1/2 allocable) $ 100,000 Personnel costs (1/2 allocable) 120,000 Accounting costs (1/3 allocable) 150,000 Interest Expense 200,000 Other Service Costs (non-allocable) 430,000 Indirect costs total $ 1,000,000

191 Page 180 Texas Franchise Tax For federal tax purposes, Quality Manufacturing calculates its COGS as follows: Materials $ 100,000 Inbound transportation costs 10,000 Manufacturing labor costs 100,000 Equip repair labor (undoc. EEs) 50,000 Equipment depreciation 40,000 Plant Manager (also an officer) 200,000 Security costs (1/2 allocable) 50,000 Personnel costs (1/2 allocable) 60,000 Accounting costs (1/3 allocable) 50,000 Interest Expense 200,000 Total $ 860,000 Beginning Inventory $ 0 Capitalized Costs 860,000 Ending Inventory 215,000 COGS $ 645,000

192 Texas Franchise Tax Page 181 For revised franchise tax purposes, Quality Manufacturing calculates its COGS as follows if it uses the Capitalized Method: Materials $ 100,000 Inbound transportation costs 10,000 Manufacturing labor costs 100,000 Equip repair labor (undoc. EEs) 0 Equipment depreciation 40,000 Plant Manager (also an officer) 0 Indirect costs 32,000 Interest Expense 0 Total $ 282,000 Beginning Inventory $ 0 Capitalized Costs 282,000 Ending Inventory 70,500 COGS $ 211,500 Recordkeeping Changes. While cost of goods under the revised franchise tax is conceptually similar to cost of goods sold for federal income tax and GAAP, there are many important differences. Therefore, taxpayers should have modified their accounting systems beginning January 1, 2007 to track the items they will need in order to compute costs of goods sold for the Texas revised franchise tax. Essentially, the revised franchise tax will force companies to have two sets of books to track inventory. Moreover, taxpayers will need to establish timekeeping systems in order to track direct labor costs and indirect personnel costs related to the acquisition or production of goods.

193 Page 182 Texas Franchise Tax Example Annual Election Software developers are considered producers of goods. Therefore software development companies will need to track and document the direct labor costs associated with development activities. In order to do so, they ll need to keep time records to support the labor costs attributable to development activities. Businesses may choose to deduct either cost of goods sold, compensation or the alternate deduction (30% of revenue). It s a year by year choice. A business is not bound in later years by earlier choices. As a result, each year a taxable entity will calculate all three deductions and choose the largest. Form of Election. The election to use COGS, Compensation or the alternate deduction (30% of revenue) is made by filing the franchise tax report and using the selected method. 463 Election-Switching Policy Reversal. The Comptroller recently reversed her prior policy on election changes. The Comptroller now says that taxpayers may amend their Texas franchise tax reports to switch to the cost of goods sold or compensation deductions at any time within the statute of limitations. 464 Previously, the Comptroller said that taxpayers could not file amended reports to change their election after the due date of the report. 465 Many taxpayers believe the Comptroller s prior policy conflicted with the Texas Tax Code and the Comptroller s own tax forms and instructions See Comptroller FAQs for COGS, Question and Answer No. 11 (April 16, 2008). Texas Comptroller of Public Accounts, Important Information Concerning Cost of Goods Sold (COGS) and Compensation Deduction Elections available at See, e.g., Comptroller Hearing No. 105,037 (Nov. 15, 2011).

194 Texas Franchise Tax Page 183 Cases Challenge Comptroller Election Policy. Two cases filed in Travis County District Court before the Comptroller s policy change concern whether taxpayers who initially file using the E-Z computation form may elect the cost of goods sold deduction. 466 The Comptroller s policy reversal came shortly before the August 20, 2012 jury trial scheduled in one of these cases. District Court Allows Election Change. In the first case to be tried in the Travis County District Courts, the taxpayer prevailed in proving it qualified as a temporary employment service, rather than as a professional engineering firm as alleged by the Comptroller. In her order, the trial judge ruled that the taxpayer was entitled to claim the compensation deduction for the wages and benefits of the unassigned workers. The taxpayer had previously claimed the COGS deduction. 467 The district court decided this case prior to the Comptroller s policy change. Is this still relevant after the Comp reversed her election switching policy?? Comptroller Allows Election Change by Certain Combined Entities. The Comptroller interprets the Texas Tax Code to allow certain taxpayers to calculate margin under a different method than originally filed. This policy applies to taxpayers who originally filed separate reports in error and later filed a combined report. The Comptroller will allow the combined group to choose any method (COGS or Compensation) so long as one member of the group had previously filed a separate report electing that method. 468 Example Company A and Company B are affiliated. They file separate reports in which Company A calculates its margin based upon the COGS method and Company B files using the Compensation method. Later, and after the due dates for the reports have lapsed, the Comptroller forces the two companies to file a combined report. The Comptroller will allow the combined entity to elect to calculate Bigham Bros., Inc. v. Combs, No. D-1-GN Martens, Todd & Leonard represented the plaintiff. Sunbelt Custom Mineral, LLC v. Combs, No. D-1-GN Martens, Todd & Leonard represented the plaintiff. Taylor & Hill v. Combs, No. D-1-GN , 53rd District Court, Travis County, Texas, July 7, James Martens and Lacy Leonard with Martens, Todd, Leonard & Taylor tried this case. Comptroller Letter No L (Aug 9, 2011).

195 Page 184 Texas Franchise Tax its margin based upon either the COGS or Compensation method. (Note that EZ and the 30% minimum deduction are always available). The rationale for this policy is that the combined group is a distinct taxpayer from its members and is therefore making its reporting election for the first time on the late-filed combined report Id.

196 Texas Franchise Tax Page 185 Chapter V. Determining Compensation Compared with the cost of goods sold deduction, the compensation deduction looks relatively simple. There are a few twists to look out for, however. Overview The compensation deduction consists of two elements. 470 They are: The wages and cash compensation paid to certain individuals. 471 This amount also includes net distributive income paid to partners or owners, and stock awards and stock options deducted for federal income tax purposes. This amount is capped to a certain amount of wages and cash compensation per individual. The wage and cash compensation caps are: 2008 $300, $300, $320, $320, $330, $330,000 The cost of all benefits provided to certain individuals. 472 This amount is uncapped. Compensated Individuals The statute allows deductions for the wages and cash compensation and benefits only when they are paid to certain classes of individuals: Employees Officers Owners Partners Directors Comptroller Rule 3.589(c). Texas Tax Code (b)(1). Texas Tax Code (b)(2).

197 Page 186 Texas Franchise Tax Planning Tip. Because the compensation deduction is limited only to the short list of individuals above, an entity planning to take the compensation deduction should make its employment decisions carefully. In particular the revised franchise tax treats compensation differently in certain circumstances: Contract Labor Non Deductible. Payments made to independent contractors reportable on Form 1099 cannot be deducted as compensation. This is true even for amounts that do not have to be reported on a Form 1099 due to the IRS minimum reporting requirements. 473 Temporary Workers and Covered Employees Deductible. Oftentimes, companies choose to hire temporary workers or use a professional employer organization in order to reduce the administrative burden of keeping up with payroll and personnel administrative duties. Temporary workers are the employees of the temporary agency. Legally, a covered worker is the co-employee of both the professional employer organization and the client. Normally, a client would not receive the compensation deduction for a temporary worker or a covered worker, because they are not the employee of the client. However, in both cases, the statute takes the true relationship into consideration, and allows the client to deduct payments made to the temporary help agency or professional employer organization for wages and cash compensation, payroll taxes and benefits as if the workers were actually employees of the company. 474 However, the client may not deduct any other amounts paid to the temporary agency or the professional employer organization. 475 A Comptroller Rule explicitly states that a client cannot deduct any administrative fee or other costs that it was charged Comptroller Rule 3.589(d)(1). Texas Tax Code (e). Texas Tax Code (e)(2) & (3). Comptroller Rule 3.589(f)(3).

198 Texas Franchise Tax Page 187 Issue. If a taxpayer is only allowed to deduct the amount of wages and cash compensation and benefits that the temp agency or professional employer organization paid, how is the taxpayer supposed to know what this amount is? The Legislature considered this problem, and requires the temporary help agency or professional employer organization to disclose the necessary information on either an invoice or on a form to be designed by the Comptroller. In the first case to be tried in the Travis County District Courts, the taxpayer prevailed in proving it qualified as a Temporary Employment Service, rather than as a professional engineering firm as alleged by the Comptroller. In her order, the trial judge ruled that the taxpayer was entitled to claim the compensation deduction for the wages and benefits of the unassigned workers. The taxpayer had previously claimed the COGS deduction. 477 The POE/Temporary Help Services Company Report. The form... designed by the Comptroller is the Staff Leasing Services Company Report (Form ), available on the Comptroller s website. 478 We ve reproduced a copy of the form and instructions in Chapter V on pages 147 and 148. The form is completed by the professional employer organization, not the taxpayer. The taxpayer, however, must request the form from the professional employer organization, and also provide the beginning and ending dates of its accounting period. Once the professional employer organization receives the request, it should respond by February 28 or the thirtieth day from the date of the request, whichever is later. However, there is currently no statutory or regulatory penalty for a professional employer organization that ignores these deadlines, or simply chooses not to issue the form at all Taylor & Hill v. Combs, Cause no. D-1-GN , 53rd District Court, Travis County, Texas, July 7, James Martens and Lacy Leonard with Martens, Seay & Todd tried this case. See

199 Page 188 Texas Franchise Tax For each assigned employee, two amounts must be reported: The amount the professional employer organization paid the assigned employee in wages and cash compensation, as defined by the revised franchise tax statute, without regard to the compensation cap. This amount will be used by the client company to compute the wages and cash compensation portion of the compensation deduction. 2. The amount the client company paid the professional employer organization for the assigned or covered employee. This amount will include wages, the employer s share of employment taxes, benefits (whether or not deductible for federal income tax purposes), and the administrative fee. This amount will not be used by the client to compute its compensation deduction. This amount might be used to calculate the cost of goods sold deduction, if the assigned or covered employee is to be included as direct labor or in the indirect cost pool. Additionally, the professional employer organization should report a single amount equal to the total amount the client paid for benefits that the professional employer organization paid to the assigned employees, as long as the benefits are deductible for federal income tax purposes. This amount will be used by the client to compute the benefits portion of the compensation deduction Form and Instructions (rev. January 2008). 480 Id.

200 Texas Franchise Tax Page 189 Example 1 The law firm of Schiester & Schiester pays a temporary employment service $35,000 a year for its receptionist. The temporary employment service pays the receptionist $25,000 a year, and also must pay its share of the payroll taxes (approx. $1,900 a year). The remaining $8,100 covers the $1,200 per year health insurance the temporary employment service provides the receptionist, and the service s overhead and profit. What amounts should the temporary employment service report on the Staff Leasing Services Company form? What amounts should be included in the law firm s compensation calculation? How much will the temporary employment service report as revenue related to this employee? How much will it include in the compensation deduction calculation?

201 Page 190 Texas Franchise Tax

202 Texas Franchise Tax Page 191

203 Page 192 Texas Franchise Tax Independent Contractors Not Deductible. Often, businesses attempt to classify workers as independent contractors instead of employees for a variety of reasons. It may be less expensive to hire an independent contractor because the company does not have to pay for unemployment or workers compensation insurance for the contractor. Also, the company is not responsible for withholding payroll taxes from the contractor, so the paperwork burden is lighter. Liability risks may be reduced, as well. There are also many good reasons to classify workers as employees, not the least of which is the serious federal tax consequences that may result if the worker was misclassified as an independent contractor. In calculating the compensation deduction for the revised franchise tax, compensation paid to an independent contractor is not deductible. This is because independent contractors are not employees, or any other type of qualified recipient as listed on page 185. A Comptroller Rule also explicitly excludes from compensation payments made to independent contractors on Forms Depending on the other factors involved, this change in the law may be enough to convince some companies to reclassify their workers as employees. 481 Comptroller Rule 3.589(d)(1).

204 Texas Franchise Tax Page 193 Example Bill s Trucking Broker, Inc. (BTB) receives payments from companies that need to ship goods via truck. It has no truckers as employees; instead, it uses a network of independent-contractor truckers to ship its customers goods. All of BTB s shipments stay within Texas borders. It chose, in prior years, to report for federal income tax purposes as its gross receipts the entire amount of payment it receives from its customers. When pays its independent contractors, it properly reports the payment via Form Its only employee is Bill, the president, who earns a salary of $100,000. In 2011, BTB received $50 million from its customers. It paid $40 million to its independent contractors and $8 million in fuel, leaving $2 million to cover overhead (including Bill s Salary) and profit. How much revised franchise tax must BTB pay in 2012? Exception: Real Estate Industry Contractors Excludable. Note that real estate contractors may exclude from revenue the funds they pay to subcontractors. This includes flow-through funds for subcontracting payments made under a contract or subcontract entered into by the taxable entity to provide services, labor, or materials in connection with the actual or proposed design, construction, remodeling, remediation or repair of improvements on real property or the location of the boundaries of real property Texas Tax Code (g).

205 Page 194 Texas Franchise Tax Fees Paid to Management Company Deductible. Some companies hire management companies to manage a portion of their trade or business. If the management company qualifies, then the managed company (client) is permitted to deduct the payments it makes to the management company for wages and cash compensation paid to the management company s employees as though the client had paid the amounts directly to the management company s employees. This provision is based upon Texas s law of principal/agent. The management company acts as the agent for its client, the principal. Issue. Can benefits be shifted from management companies to managed entities? Before the Comptroller issued the rules, many practitioners assumed that a managed entity could deduct both reimbursed wages and cash compensation and reimbursed benefits paid to the management company. The statute states that the managed company could include in its deduction reimbursements made to the management company for wages and compensation. 483 Although the statute uses the word compensation instead of benefits, the Legislature chose not to use the phrase wages and cash compensation. If it did, this would clearly exclude benefits. But because benefits are part of what the statute considers to be deductible as compensation, it is arguable that the Legislature intended for managed companies to deduct reimbursed benefits along with wages. This also seems to correspond with the general structure of the deduction, since there is no obvious reason to differentiate between reimbursed wages and reimbursed benefits. However, the Comptroller s rule strongly suggests that managed companies will not be permitted to deduct reimbursed benefits. The rule clearly states that a managed entity may subtract wages and cash compensation that are reimbursed to the management company. 484 Wages and cash compensation is a defined term that does not include benefits. 485 Since the Comptroller s interpretation of the statute does not appear to comply with the intent of the Legislature, this matter may one day be resolved by the courts Texas Tax Code (g). Comptroller Rule 3.589(g)(2). Comptroller Rule 3.589(b)(9).

206 Texas Franchise Tax Page 195 Issue. There does not appear to be a requirement that the management company actually pay the wages and compensation to its employees in order for the managed company to take the deduction. The only requirement is for the managed company to reimburse the management company for the wages and compensation. 486 There is no rule that requires the management company to disclose to the managed company the amount it paid to its employees, like the rule for staff leasing services companies. 487 This suggests that it is the classification of the reimbursement on the invoice that controls, not the characterization of the payment to the employees. Although it s likely that the Comptroller may take a contrary view, the vague language of the statute and rule may create planning opportunities. Qualifications as Management Company. To qualify as a management company, an entity must: 1. Be organized as a state law corporation, limited liability company, or other limited liability entity, and; 2. Conduct all or part of the active trade or business of a managed entity in exchange for: a. a management fee; and b. reimbursement of specified costs incurred in the conduct of the active trade or business of the managed entity. 488 Comptroller Policy: Entire Business Rule. By policy, the Comptroller states that a management company must conduct either conduct all of an entity s active trade or business or all operations for a distinct revenue-producing component of an entity. 489 A company that only provides shipping or accounting services to another company isn t a management company, according to the Comptroller. 490 The Comptroller has apparently adopted this rule in order to limit management companies to only entities that manage real estate like hotels and resorts Texas Tax Code (g); Comptroller Rule 3.589(g)(2). Texas Tax Code (Requiring a client company of a staff leasing services company to rely on information provided by the leasing company when computing cost of goods sold or compensation). Texas Tax Code (11). Comptroller Rule 3.589(b)(3) Tax Policy News (Aug. 2009).

207 Page 196 Texas Franchise Tax Management Fee Requirement. In exchange for its services, a management company receives a management fee. The management company also receives reimbursement of specified costs it incurs in connection with managing the business. The reimbursed costs generally include employee compensation. Management companies formed as taxable entities may exclude these reimbursements from total revenue so long as they actually receive a management fee for their services. Affiliated Management Companies. In many cases, a management company will be affiliated with a managed company, and also be in the same unitary business. Therefore, you should anticipate that related management companies and managed companies may be required to report as a combined group. In this case, the payments between the entities will be eliminated. However, if the companies are unaffiliated or not in the same unitary business, this section of the statute may allow the managed company additional deductions. Example 1 Old McDonald had a farm. He owns and operates the farm via a taxable entity, McDonaldCo. He contracts with his brother Ronald to manage the farm. Ronald hires some farm hands as employees. The employment agreement is between Ronald, as an individual, and the farm hands, and does not mention Old McDonald or McDonaldCo. At the end of the year, Ronald sends McDonaldCo an invoice with the following line items: Management Fee: $ 500 Wages of Farm Hands: 1,000 Out-of-pocket Expenses: 300 Total $ 1,800 Which entity is allowed to deduct the ranch hand wages?

208 Texas Franchise Tax Page 197 Example 2 The next year, Ronald s attorney tells him that for liability reasons, he should incorporate. So Ronald forms RonaldCo, a Texas corporation. Ronald assigns the management contract to RonaldCo. At the end of the year, RonaldCo sends the same invoice, as shown above. Now which entity is allowed to deduct the farm hand wages? Example 3 Old McDonald buys 100% of RonaldCo from Ronald. Old McDonald now owns 100% of both RonaldCo and McDonaldCo. What are the revised franchise tax consequences?

209 Page 198 Texas Franchise Tax Example 4 The facts are the same as Example 2, above, except RonaldCo issues an invoice that is unitemized. At the end of the year, RonaldCo sends an invoice that merely states: Management Charge: $1,800 Will McDonaldCo still get to include some or all of this charge in the compensation deduction? Note: Since some of the terms in the definition of management company are vague, as Example 4 suggests, this topic will likely be litigated. Another issue regarding the definition of management company is whether the Comptroller will, in certain circumstances, prevent taxpayers from deducting reimbursed wages and compensation because the management company does not conduct all or part of the active trade or business of the managed company. 491 The Comptroller s Office was asked to clarify this portion of the definition of a management company, but it refused to do so, stating that what an active trade or business is must be determined on a case by case basis Texas Tax Code (11). 32 TexReg

210 Texas Franchise Tax Page 199 Example Bob owns 100% of Investments, LP and Service, Inc. Investments would have a substantial compensation deduction, but it qualifies as a passive entity and therefore does not need to take one. Investments employs a full-time bookkeeper. Service is a taxable entity that takes the compensation deduction. Service and Investments enter into a management contract under which the bookkeeper provides bookkeeping services for Service. Bob sets up a management contract between the two entities. By doing so, Investments seeks to shift its compensation deduction to the company that needs it. Will this strategy work? What issues may arise? Wages and Cash Compensation The deduction for wages and cash compensation paid to a qualified individual is a sum of the individual s Medicare wages and tips reported on the Form W-2, net distributive income, and the value of stock awards and stock options. This deduction is capped at a certain amount per individual ($330,000 for the 2012 and 2013 report years). No deduction can be taken for wages and cash compensation paid to undocumented workers.

211 Page 200 Texas Franchise Tax Wages and Tips. The starting point to determine wages and cash compensation is the company s Federal Forms W-2: The base amount of wages and cash compensation for each employee is Box 5, Medicare Wages and Tips. 493 Generally, the types of compensation included will be the same as the amount of wages, tips, and other compensation reported in Box A non-exhaustive list of items to include is: Wages, bonuses, and tips Non-cash payments, including taxable fringe benefits Certain payments for non-job-related education expenses Employer s payment of employee s share of taxes Texas Tax Code (a). In a few unusual situations, the type of wages subject to Medicare tax can differ from the amount subject to income tax withholding. For a helpful chart of these differences, see Section 15 of IRS Circular E, Employer s Tax Guide. IRS Instructions for Form W-2, p. 9.

212 Texas Franchise Tax Page 201 The Medicare wages and tips box will also include the employee s elective deferrals to a 401(k) plan and other qualified cash or deferred compensation arrangements. The Medicare wages and tips box is likely used instead of the Wages, tips, and other compensation box (Box 1) because Box 1 does not include the compensation the employee elected to contribute to the deferred compensation plan. Note that the employer s share of employment taxes is not deductible, either as wages and cash compensation or benefits. 496 Net Distributive Income. The revised franchise tax has made allowances for service businesses such as law firms and accounting firms that compensate their partner-employees in whole or in part through partnership distributions. Therefore, Wages and Cash Compensation also includes net distributive income if the income meets two requirements: First, the direct recipient of the income must be a natural person, which is defined as a human being or the estate of a human being not a purely legal entity, like a corporation, LLC, partnership or trust. 497 Second, net distributive income is only includable as wages and cash compensation for three types of entities, depending on their federal tax classification: 1. Taxable entities treated as partnerships for federal income tax purposes; LLCs and corporations treated as S corporations for federal income tax purposes, and LLCs electing to be treated as sole proprietorships for federal income tax purposes Comptroller Rule 3.589(d)(3). 497 Comptroller Rule 3.589(b)(4) Texas Tax Code (a)(1). Texas Tax Code (a)(2). Texas Tax Code (a)(4).

213 Page 202 Texas Franchise Tax Example 1 A large limited partnership elects to sell its common units on a public exchange and therefore elects to be treated as a corporation for federal tax purposes. It will not be allowed to include any net distributive income in wages and cash compensation because it is not treated as a partnership, S corporation, or sole proprietorship for federal tax purposes. Example 2 Four CPAs form a limited liability partnership that is treated as a partnership for federal tax purposes. Each CPA directly owns his or her LLP interest. Subject to the $300,000 per person cap, the LLP s entire net distributive income is includable in wages and cash compensation.

214 Texas Franchise Tax Page 203 Example 3 Four doctors form a limited partnership each owning an equal share. The LP is treated as a partnership for federal tax purposes. Three of the doctors directly own their LP interest. The fourth owns hers through a wholly-owned professional association. May the LP include the net distributive income from all the partners in wages and cash compensation? Example 4 Same as Example 3, except now all of the doctors own their share of the LP each through her own wholly-owned professional association. How much net distributive income is included as wages and cash compensation?

215 Page 204 Texas Franchise Tax Definition. What is net distributive income? Nowhere in the statute is the term net distributive income defined. It is also undefined by the Internal Revenue Code or Regulations. The Comptroller s Rules, however, define it to be 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. 501 The Comptroller has informally stated that net distributive income per individual arises from the following items on the K-1 for a partnership or an S corporation: 502 Add: Ordinary business income (loss) Net rental real estate income (loss) Other net rental income (loss) Guaranteed payments (partnerships only) Interest income Ordinary dividends Royalties Net short-term capital gain (loss) Net long-term capital gain (loss) Net section 1231 gain (loss) Other income (loss) Subtract: Section 179 deduction Other deductions Foreign transactions, total foreign taxes paid Comptroller Rule 3.589(b)(5). See Comptroller FAQs for Compensation, Question and Answer No. 10 ( April 23, 2008).

216 Texas Franchise Tax Page 205 Note. Since partners cannot be employees of their own partnership, 503 a taxable entity should have no W-2 compensation paid to a partner included in the wages and cash compensation calculation. However, if an entity does issue a W-2 and a K-1 to the same individual, wages and cash compensation equals the sum of the two amounts (subject to the compensation cap) Rev. Rul Comptroller FAQs Compensation No. 12

217 Page 206 Texas Franchise Tax Does net distributive income have to be paid to the individual before it is deductible as compensation? The statute is ambiguous. The Comptroller attempted to clarify the issue via Rule 3.589, but was not completely successful. The Rule defines wages and cash compensation as including net distributive income, regardless of whether cash or property pertaining to such income is actually distributed. 505 The Comptroller added this phrase to address concerns from the State Bar of Texas that a deduction for net distributive income may not match the related revenue (or may be lost entirely) if it is only deductible when actually distributed. The Comptroller s Rule adopts the State Bar s proposed corrective language word-for-word. 506 Therefore, it is clear that the Comptroller intends for net distributive income to be part of the wages and cash compensation calculation when it is reportable, regardless of whether it is actually distributed. However, the Rule does not correct the ambiguity in the statute. Both the Rule and the statute state that the compensation deduction includes, among other items, all wages and cash compensation paid by a taxable entity to its officers, directors, owners, partners and employees. 507 It s possible, then, for unpaid net distributive income to be considered wages and cash compensation, but remain non-deductible as compensation because it was not wages and cash compensation that was paid. The Comptroller has provided informal guidance that explicitly states that undistributed net distributive income is included in the compensation calculation. 508 However, until the statute and rule are amended, it s possible that the Comptroller could decide to disallow undistributed net distributive income. Net Distributive Losses. In late 2008, the Comptroller amended its Rule on Compensation to state that wages and compensation included net distributive income, regardless of whether it is a positive or negative amount. Therefore, if an entity has a net distributive loss, it may be forced to reduce its compensation by the loss Comptroller Rule 3.589(b)(9)(B) Comments to the Texas Comptroller s Draft Margin Tax Rules, Tax Section of the Texas Bar, State and Local Tax Committee, II.I.2, pg. 38. Texas Tax Code (b); Comptroller Rule 3.589(c) (emphasis added). See Comptroller FAQs for Compensation, Question and Answer No.7 (April 23, 2008).

218 Texas Franchise Tax Page 207 if the entity otherwise meets the requirements to include net distributive income in the wages and cash compensation calculation. 509 Stock Awards and Stock Options. Wages and cash compensation also includes stock awards and stock options given to employees, directors, or owners, but only if they were deducted for federal income tax purposes. This will generally include nonstatutory compensatory options. However, the compensation from employerprovided nonstatutory stock options has likely already been included in Box 5 of from W-2, 510 and cannot be included in wages and cash compensation twice. 511 Therefore, this part of the compensation calculation will rarely be used. It will primarily be used for stock options issued as compensation to nonemployee directors. The Compensation Cap. For franchise tax due in 2008 and 2009, a taxable entity may not include more than $300,000 for any person for wages and cash compensation. 512 For reports due after January 1, 2010, and every even year after 2010, the cap amount will be adjusted by formula for inflation. 513 The cap amount is $320,000 for 2010 and 2011 and $330,000 for 2012 and Issue. The statute states that the cap is $300,000 per 12-month period on which margin is based. 514 For instance, if an entity s 2008 report is based on a six-month accounting period, the cap would be $150,000, not $300,000. Planning Tip. Remember that the cap only applies to the wages and cash compensation amount, not to benefits. Therefore, if a highly paid individual is up against the cap, consider the tax savings achieved by shifting the individual s compensation to benefits instead of an item categorized as wages and cash compensation. For small businesses with owner-employees up against the cap, a Simplified Employee Pension plan (SEP) may be appropriate. Planning Tip. Be sure that all family members are appropriately compensated for their efforts and the wage payments aren t all paid to one family member Comptroller Rule 3.589(b)(9)(B). IRS Publication 525, Taxable and Nontaxable Income. 511 Comptroller Rule 3.589(b)(9)(C) Texas Tax Code (c). Texas Tax Code (b). Texas Tax Code (c).

219 Page 208 Texas Franchise Tax Example 1 Husband and Wife are both employees of the family business. Husband receives total wages and cash compensation of $500,000. Wife receives total wages and cash compensation of $100,000. All $100,000 of Wife s compensation is deductible, but only $330,000 of Husband s compensation is deductible. Total compensation is $600,000, but the deduction is $430,000. Example 2 The same as 1, except Husband and Wife both are paid $330,000 each. Total compensation is still $660,000, but now the entire $660,000 is deductible. Example 3 A-B, LP is a limited partnership with two limited partners (Mr. A and Mr. B), each with a 49% share of the partnership. Both Mr. A and Mr. B live in Oklahoma with their spouses. In 2012, A-B, LP had no employees and net distributive income of $2 million: $1 million allocated to each limited partner. Without planning, the cap will prevent the LP from deducting more than $660,000 in otherwise deductible in wages and cash compensation. Mr. A and Mr. B should consider adding Mrs. A and Mrs. B as limited partners. By adding two more natural-person partners that can receive net distributive income, the LP can double its compensation deduction from $660,000 to $1,320,000. Comment. What if Mr. A and Mr. B were residents of Texas or another community property state instead of Oklahoma, and what if the interests in the partnership were the community property of the a and B families? It would appear then that each of the spouses would be entitled to their own compensation cap, since they both are natural persons receiving the income. No guidance on this issue has been provided by the Comptroller. Until guidance is provided, it may be best for the partnership to issue a K-1 to each of the family members (50% each), so that is it clear to the Comptroller that two individuals own each interest. Planning Tip. Consider allocating wage and salary payments over multiple years when payment of a large bonus would cause the entity to exceed the cap.

220 Texas Franchise Tax Page 209 The Combined Group Cap. The per-person cap on wages and cash compensation applies to the combined group as a whole, and not individual taxable entities within the combined group. 515 In other words, a combined group cannot avoid the compensation cap by paying an individual from multiple members of the combined group. Example Bob is sole owner and president of two S corporations, Big Bucks, Inc. and Little Bucks, Inc. Both companies are members in the same combined group. He receives compensation of $250,000 from Big Bucks, Inc. and compensation of $200,000 from Little Bucks, Inc. Without the combined cap, the combined group would be allowed to deduct $450,000 of compensation paid to Bob, despite the $330,000 per person cap. This is because each member of the combined group would have been allowed to calculate its revenue and deductions without regard to other members in the combined group. However, the cap applies to the combined group, not to individual members of the combined group. Therefore the combined group as a whole will only be able to deduct $330,000 paid to Bob in this particular period. Wages Paid to Undocumented Workers. A taxable entity may not include wages or cash compensation paid to an undocumented worker. an undocumented worker is defined by the statute as a person who is not lawfully entitled to be present and employed in the United States. 516 Note that there is no good faith rule in effect; an employer would lose the deduction even if they believed the worker was legally employed. Several business groups requested that the Comptroller change the definition to refer to a person who is employed in violation of the employment eligibility laws of the United States to partially remedy this. The Comptroller refused to do so, because the recommendation would be contrary to the statute Texas Tax Code (c). Texas Tax Code (c-1); Comptroller Rule 3.589(b)(8). 32 TexReg

221 Page 210 Texas Franchise Tax However, benefits provided to undocumented workers appear to remain deductible. This may be an oversight which the Legislature will eventually fix, or it may have been intentional. The oversight remained law even though the Legislature could have revised it in 2007 or 2009, and the Comptroller s Rule only excludes from compensation wages or cash compensation paid to undocumented workers. 518 Remember that the section on the cost of goods sold deduction also includes a prohibition on wages paid to undocumented workers. The statute specifically excludes from cost of goods sold any compensation paid to an undocumented worker used for the production of goods. 519 Wages Paid for the Operation of Facility located on Federal Land. A taxable entity also cannot deduct wages or cash compensation paid to an employee whose primary employment is directly associated with the operation of a facility that is located on property owned or leased by the federal government and managed or operated primarily to house members of the armed forces of the United States. 520 Note that revenue directly derived from the operation of these facilities is also exempt from inclusion, so the intent is to entirely remove from the margin calculation the business activities related to these facilities. 521 Except that it appears that these entities are permitted to deduct benefits paid to these employees. While it s unlikely that this was the Legislature s intent, a literal reading of the statute and Comptroller s Rule allow it. Benefits In addition to wages and cash compensation, the statute also allows an entity to deduct benefits as compensation. Benefits are entirely separate from the wages and cash compensation calculation (and therefore do not fall under the compensation cap) but still must be provided to one of the eligible classes: officers, directors, owners, partners, or employees Comptroller Rule 3.589(d)(5). Texas Tax Code (e)(14). Texas Tax Code (h). Texas Tax Code (q). Texas Tax Code (b)(2).

222 Texas Franchise Tax Page 211 Benefits Undefined? Neither the statute nor the Comptroller s Rules define benefit. The Comptroller has interpreted that the statute lists three requirements for a benefit to be deductible: 1. The entity can only deduct benefits to the extent they are deductible for federal income tax purposes; 2. The benefits must actually be provided by the taxable entity; and 3. The amount deducted must actually benefit the recipient. 523 Although the statute doesn t define benefits, it does list four items that should be considered as benefits, as long as they are deductible for federal income tax purposes: Worker s compensation benefits Health care Employer contributions made to employee s health savings accounts Retirement The statute does not appear to limit benefits to only these items. The Comptroller states that certain items are not benefits: 524 Amounts included in the definition of wages and cash compensation. Discounts offered to an eligible class, but not available to other customers (i.e., an employee discount). Payroll taxes, including payments to state and federal unemployment compensation funds, and FICA payments. Working condition amounts provided so employees can perform their jobs. This category explicitly includes but is not limited to: An employee s use of a company car for business Job-related education provided to an employee Travel reimbursement Tex Reg ; Comptroller Rule 3.589(e). Comptroller Rule 3.589(e)(2).

223 Page 212 Texas Franchise Tax A state district court ruled that the working condition disallowance provision in Comptroller Rule 3.589(e)(2)(D) is invalid to the extent that it disallows deductions that are allowed for federal income tax purposes. 525 Pending Litigation. A recently-filed court case addresses the scope of benefits a taxpayer may include in its compensation deduction. The taxpayer, a law firm, argues that it may include certain expenses paid on its employees behalf, including parking expenses, attorney occupation tax, and continuing legal education expenses, in its compensation deduction. 526 Health Care Benefits Bonus. The Legislature wanted to encourage businesses to provide health benefits to their workers, so in 2007 it created a health care benefits bonus compensation deduction. Only certain qualifying small employers are permitted to take the bonus deduction. In the first twelve-month accounting period that the entity meets the following requirements, the entity can take the bonus deduction: 527 Small Employer. The entity must be a small employer. The statute references the Insurance Code to define small employer. A small employer is an entity that employs an average of at least two but not more than 50 eligible employees on business days during the preceding calendar year. A partnership is considered the employer of a partner. All Employees Covered. Health care benefits must be provided to all employees. No bonus deduction is available if only some employee classes get benefits. No Previous Benefits. In the calendar year previous to the beginning date of the reporting period in which the deduction is taken, no health care benefits can be provided to any employees. Subject to the Franchise Tax. The entity must be subject to the revised franchise tax Winstead PC v. Combs, District Court, 201 st District, No. D-1-GN (Mar. 18, 2013). No. D-1-GN , Travis County District Court (filed Jan. 19, 2012). Texas Tax Code (b-1).

224 Texas Franchise Tax Page 213 Amount of the Bonus. For the first twelve-month accounting period that the entity meets the four requirements, the entity can multiply the amount of health care benefits provided by 50%, and add this bonus amount to its compensation deduction. 528 In the second twelve-month period, the entity receives an additional 25% deduction for health care costs. 529 Example Mom & Pop, Inc. qualifies as a small employer. It is a calendar year filer. In 2006, the company did not provide health care benefits to any of its employees. On January 1, 2007, Mom & Pop, Inc. started a health care plan and began providing health care to all employees. It spent $10,000 on health care benefits in For the franchise tax report filed in 2008, Mom & Pop, Inc. will be allowed to include in its compensation deduction $15,000 of benefits ($10,000 plus 50% of $10,000). Mom and Pop, Inc. continue to provide benefits to all employees throughout In 2008, it again spent $10,000 on health care benefits. For the franchise tax report for 2009, Mom & Pop, Inc. will be allowed to include in its compensation deduction $12,500 of benefits ($10,000 plus 25% of $10,000). Comment: Does the employer merely have to offer health care to all employees, or does it have to provide health care to all employees? The statute says provide to all employees but what if some employees choose not to participate? Does the employer still qualify? Planning Tip. Due to ambiguities in the statute, it s best to start providing benefits as close to the beginning date of the reporting period as possible. Otherwise, the bonus deduction could be greatly reduced, or even unavailable Texas Tax Code (b-1)(1). Texas Tax Code (b-1)(2).

225 Page 214 Texas Franchise Tax Example Mom & Pop, Inc. still qualifies as a small employer, and still is a calendar year filer. Although it has never provided health-care benefits to its employees, it begins to do so on December 15, 2008, and continues to pay benefits through It pays $500 in benefits in 2008 and $10,000 in benefits in It s unclear how the Comptroller will interpret the statute, but one of the following treatments is likely. Neither is good news for the taxpayer: Wasted Bonus. Because 2008 is the first twelve-month period for which Mom & Pop, Inc. met the four requirements, the 50% bonus will be applied to the $500 paid in The 25% bonus will be applied to the $10,000 paid in If Mom & Pop, Inc. had waited until January 1, 2009 to provide benefits, the 50% bonus, not the 25% bonus, would have applied to the $10,000 paid in No Bonus Allowed. Because the statute is poorly worded, the Comptroller could interpret it in such a way that would completely disallow the bonus deduction. Because Mom & Pop, Inc. did not provide benefits to all employees for all of the twelve-month report period ending December 31, 2008, the Comptroller could determine that the requirements were not met for 2008, and no bonus is allowed. Mom & Pop, Inc. would also not qualify for the bonus in 2009 because they paid benefits to its employees in the calendar year 2008, the calendar year previous to the beginning date of the reporting period.

226 Texas Franchise Tax Page 215 Compensation Paid to Individuals Serving on Active Duty The statute provides a special deduction for entities that have paid compensation to individuals serving on active duty as members of the armed forces. 530 An entity is allowed to deduct compensation paid to these individuals even if it elects to deduct cost of goods sold. Also, if an entity takes the compensation deduction, it appears that it can deduct the compensation paid to these individuals twice: once under the compensation deduction, and once under the additional deduction. Note that no deduction is allowed if the entity chooses the 30% of total revenue deduction or the E-Z method. Compensation paid to these individuals is computed under the rules for the compensation deduction, so the amount includes both wages and cash compensation subject to the cap, and benefits. The Comptroller has implemented the special deduction by requiring taxpayers to add the compensation amount to both the Cost of Goods Sold Other line item (Line 13) and the Compensation Other line item (Line 17). 531 Issue. The statute clearly allows a deduction for benefits paid to individuals serving on active duty. However, the Comptroller s instructions for the tax forms limit the deduction to only the wages and cash compensation portion of the compensation deduction. 532 The Comptroller s Rules do not even mention the deduction. Are benefits paid to individuals serving on active duty included in the additional deduction? Planning Tip. Although this deduction was almost certainly meant to cover wages paid to employees on active duty, it also appears to cover net distributive income paid to owners and partners serving on active duty, up to the $300,000 cap. Certain Restrictions. There are two restrictions on this deduction: 1. The compensation is limited to the amount paid to the individual during the period the individual is serving on active duty. 2. The compensation can only be deducted if the individual is a resident of Texas at the time he or she is ordered to active duty Texas Tax Code (a)(1)(B)(iii) Texas Franchise Tax Report Information and Instructions, Form No (Rev.5-08/3). Id.

227 Page 216 Texas Franchise Tax Cost of Training Replacement. The cost of training replacements for the individual on active duty is also deductible in addition to the compensation and cost of goods sold deductions. Cost of training is not defined by the statute. It is unclear if the deduction amount is limited to out-of-pocket training costs paid to third parties, or if it is sufficiently broad to include the compensation paid during the training period to the replacement individual, a portion of the compensation of the other employees responsible for training him or her, and an allocable share of overhead and other indirect costs of training.

228 Texas Franchise Tax Page 217 Chapter VI. Industry Tax Preferences The revised franchise tax provides generous tax benefits to many industries ironically, primarily to those that also stood to gain the most from the property tax reductions. Moreover, even in the absence of special industry tax breaks, the revised franchise tax affects different industries in vastly different ways. These industry preferences go far beyond the obvious rate differences between retailers and wholesalers and taxpayers in other industries. This chapter discusses the favorable and unfavorable effects of the revised franchise tax on various industries. Who Did the Franchise Tax Hit Particularly Hard? The service industry bears the biggest burden of the change in tax, and particularly the professions that the former franchise tax did not reach because they were organized as partnerships. This group includes attorneys, architects, doctors, and CPAs, many of whom practice as LLPs. The medical profession has already been granted large exemptions. Notwithstanding, the former Comptroller has claimed that the Legislature didn t do enough for the doctors who will likely pass on the costs of the new tax to their patients during a time when medical fees are already very high. 533 The tax will be particularly punishing to the transportation and rental industries. These types of businesses have significant costs, such as interest and depreciation, that won t be deductible either as compensation or cost of goods sold. Industries that rely heavily on independent contractors, like the trucking industry, will also suffer greatly unless the Legislature changes the law. Are Any Industries Better Off? Certain industries will likely receive a net decrease in total Texas tax when combined with the significant property tax decreases that the Legislature passed at the same time it passed the new business tax. Oil and gas production companies will do particularly well. They are capital-intensive businesses, so they will benefit significantly from the property tax reduction. The Legislature structured the passive entity definition in such a way that oil and gas businesses are more likely to qualify for instance, royalty interests and nonoperating working interests in mineral rights are passive activities. 533 See, e.g., Strayhorn Says Perry s Income Tax Plan & Plan to Tax Health Care does not include Perry s Broken Promises to Doctors, available online at:

229 Page 218 Texas Franchise Tax Manufacturers will likely fare better than service companies because of the broad cost of goods sold deduction. Moreover, the fifty percent (50%) cut in the tax rate for wholesalers and retailers is a very significant tax break, particularly since these companies will also likely choose the cost of goods sold deduction. The Legislature justified the lower rate because wholesalers and retailers tend to operate on very low margins. However, they re also able to take more deductions than other companies. Moreover, many other types of companies also operate on low margins, and are ineligible for both the rate break and the cost of goods sold deduction. It s possible that eventually this disparate treatment may be determined to be unconstitutional as a violation of equal protection and due process. Vertically-Integrated Conglomerates. Will a vertically-integrated conglomerate qualify as a retailer? Vertically-integrated conglomerates are united through a hierarchy and share common owner(s). Usually each member of the hierarchy produces a different product or service, and the products combine to satisfy a common need.

230 Texas Franchise Tax Page 219 Example A vertically-integrated oil conglomerate owns various related entities that operate different levels of the supply chain for producing gasoline. One entity owns the wells that extract the crude oil from the earth. Another entity owns pipelines which transport the oil to the refinery. Once the refinery has processed the crude oil and prepared the gasoline for sale, the refiner transports the gasoline to a related gas station company that sells the gasoline to the public. If the gas stations also sell products of other entities, do they qualify as retailers?

231 Page 220 Texas Franchise Tax The Texas Tax Code requires combined groups to report and pay franchise tax on a single, combined report. A group of affiliated taxable entities is a combined group if it is engaged in a unitary business. The Tax Code considers various factors in determining whether a unitary business exists. These factors include whether the activities of the group members are steps in a vertically structured enterprise or process. 534 Presuming that the businesses in our vertically integrated oil company are required to file a combined report, the issue is whether the combined group will qualify for the half-percent rate. The franchise tax rate of half-percent applies where a business is engaged predominately in retail or wholesale activities. A business fails the test if at least half of its revenues come from sales of products it produces. If the entity that owns the gas stations were not part of the combined group, it would qualify as a retailer as long as less than half of its revenues came from products it or others in its affiliated group produced. However, if the entity owning the gas stations is part of a combined group, it appears that the entity would be required to consider the manufacturing and production activities of the combined group in determining whether the group predominately generates its revenues from retail or wholesale sales of products the group does not produce. Crude Oil Trading and Balancing. Sometimes one company owns crude oil or gas in a location where another company needs it. For example, Sandbox Oil owns crude oil located on the Gulf coast, but it needs it in the Panhandle. Cowboy Oil owns crude oil in the Panhandle, but needs it on the Gulf coast. The two companies may exchange the products instead of shipping the actual product across the state. Taxable entities engaging in trading or balancing are literally selling product other than that which the vertically-integrated company created. May they consider the revenues derived from trading and balancing increase their percentages of revenues from sales of products produced by others? 534 Texas Tax Code (17)(a)(ii).

232 Texas Franchise Tax Page 221 Specific Industry Provisions Attorneys Attorneys providing legal services through taxable entities may exclude certain revenue from their total revenue in calculating taxable margin. Flow-Through Funds. Taxable entities, such as LLPs, may exclude from total revenue the following flow-through funds that a claimant s attorney is mandated by law or by contract to distribute to the claimant or to other entities on the claimant s behalf: Damages due to the claimant. 535 Funds subject to a lien or other contractual obligation arising out of the representation (this does not include fees owed to the attorney) 536 Funds subject to a subrogation interest or other third-party contractual claim 537 Payments to contractors. 538 Reimbursed Expenses. To the extent otherwise included in revenue, reimbursements of expenses the attorneys incur in prosecuting a client s matter are excluded from total revenue as long as they are specific to the client s matter and are not general operating expenses. Important Note. The statute and the applicable rule appear to limit the benefit of this exclusion to the claimant s attorney and not to defendants attorneys. 539 Revenue Consistency Requirement. Attorneys may exclude from revenue certain flow-through funds or reimbursement of expenses only if otherwise included in revenue Texas Tax Code (g-3)(1)(A). Texas Tax Code (g-3)(1)(B). Texas Tax Code (g-3)(1)(C). These are fees paid to an attorney in the matter who is not a member, partner, shareholder or employee of the taxable entity. See Texas Tax Code (g-3)(1)(D). Texas Tax Code (g-3)(1) and Comptroller Rule 3.587(e)(5). Texas Tax Code

233 Page 222 Texas Franchise Tax Flat Deduction for Pro-Bono Cases. Attorneys may deduct from revenue a flat $500 per pro-bono services case instead of $500 of out-of-pocket expenses. This is really a statutory exemption not exclusion since the $500 was not included in revenue to begin with. Moreover, attorneys don t have to actually pay this amount to get the exemption. 541 Banks and Savings & Loans Banking Corporations. The revised franchise tax defines a banking corporation as each state, national, domestic, or foreign bank except for bank holding companies. 542 A bank holding company is generally any company which has control over any bank. 543 Banking corporations are taxable entities subject to the Texas revised franchise tax. 544 Delaware Sandwich. Under the former franchise tax regime, financial institutions would often structure their operations using a strategy labeled the Delaware Sandwich. Under this structure, a bank would form an intermediate holding company between the parent holding company and the operating bank. The intermediate holding company would be incorporated outside of Texas. The operating bank would remit its equity as dividends to the intermediate holding company. The intermediate holding company would, in turn, remit the dividends as dividends to the holding company parent. All entities would be combined for computing the franchise tax, so the structure will no longer reduce/avoid franchise tax. Exclusion of Certain Interest from Apportionment Factor. The Texas Tax Code apportions margin based upon the ratio of Texas gross receipts to gross receipts from everywhere. In general, the Texas Tax Code apportions bank dividends and interest according to the location of payor rule Texas Tax Code Texas Tax Code (3). Section 2, Bank Holding Company Act of 1956 (12 U.S.C. Section 1841). Texas Tax Code

234 Texas Franchise Tax Page 223 The law provides exclusions for federal interest and for certain interest received from a correspondent bank located in Texas. A correspondent bank relationship exists where a bank has exposure to another insured depository institution but the two entities are not commonly-controlled. 545 Banking corporations exclude from the numerator of the bank s apportionment factor any interest earned on federal funds and securities sold under certain repurchase agreements with correspondent banks. The repurchase agreement must be for funds held in Texas in a correspondent bank that is domiciled in this state. 546 Generally, this is interest earned on excess cash deposited into a correspondent bank overnight. The excess cash is returned to the supplying bank prior to 8 a.m. the following morning. This exclusion appears to create a substantial tax benefit to financial institutions since the interest earned on funds held in a correspondent bank located in Texas would otherwise be included in the numerator of the apportionment factor. However, in apportioning margin, receipts excluded from total revenue by a taxable entity may not be included in either the receipts of the taxable entity from its business done in this state (the numerator) or the receipts of the taxable entity from its entire business (the denominator). 547 Since interest from federal obligations is excluded in computing total revenue, 548 the interest would be excluded from both the numerator and the denominator. It is doubtful that the Legislature intended a double exclusion for interest earned on federal funds in correspondent banks. Issue: The provision does not state whether the term domicile refers to the bank s commercial domicile or legal domicile See 12 C.F.R Texas Tax Code (d). Correspondent has the meaning assigned by 12 C.F.R. Section 206.2(c). Texas Tax Code (a). Texas Tax Code (m).

235 Page 224 Texas Franchise Tax Savings and Loan Associations. The revised franchise tax further defines savings and loan association to include any savings & loan association or savings bank, regardless whether its organized under Texas laws, another state s laws, federal U.S. law or another country s laws. Savings and loans are taxable entities subject to the Texas margin tax. 549 Construction Industry The revised franchise tax treats general contractors that build, maintain or repair real estate as producers of goods. The general contractors hire subcontractors to perform various parts of the work, such as cabinet construction, electrical wiring, plumbing, low-voltage wiring, floor installation, fixture installation, painting, and other tasks. Real Estate Industry Revenue Exclusion and Cost of Goods Sold Deduction. The revised franchise tax provides a revenue exclusion and cost of goods sold deduction for some real estate industry businesses. Revenue Exclusion. The revenue exclusion applies to payments to subcontractors 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 boundaries of real property. 550 Prior to 2014, the statute stated: A taxable entity shall exclude from its total revenue... only the following flow-through funds that are mandated by contract to be distributed to other entities:... (3) 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 Texas Tax Code (g)(3).

236 Texas Franchise Tax Page 225 For 2014 and later years, the statute states: A taxable entity shall exclude from its total revenue... only the following flow-through funds that are mandated by contract or subcontract to be distributed to other entities:... (3) subcontracting payments made under a contract or subcontract entered into by the taxable entity to provide services, labor, or materials in connection with the actual or proposed design, construction, remodeling, remediation, or repair of improvements on real property or the location of the boundaries of real property. Note: The Comptroller interprets this section to require that the general contractor s agreement with the owner state that the general contractor will subcontract out specific portions of the work. The Comptroller states that a general statement that some of the work may be subcontracted out is insufficient. 551 During 2013, the Texas Legislature enacted HB 2766 which is intended to reverse the Comptroller s interpretation. Cost of Goods Sold Deduction. Similarly, these real estate industry businesses may include in cost of goods sold the labor and materials they furnish to projects for the construction, improvement, remodeling, repair, or industrial maintenance of real property. The statute states:... A taxable entity furnishing labor or materials to a project for the construction, improvement, remodeling, repair, or industrial maintenance (as the term maintenance is defined in 34 T.A.C. Section 3.357) of real property is considered to be an owner of that labor or materials and may include the costs, as allowed by this section, in the computation of cost of goods sold. 552 Comptroller Limitations. The Comptroller generally limits the revenue exclusion to payments to subcontractors performing construction work or designing improvements to real property. The Comptroller limits the cost of goods sold provision further. According the Comptroller, the provision applies only when the entity furnishing the labor or materials physically works on the property and makes a physical change to that property Comptroller Letter no L, Franchise Tax and the Construction Industry. Texas Tax Code (i). Comptroller Letter No L, Franchise Tax and the Construction Industry.

237 Page 226 Texas Franchise Tax The Comptroller s position is that the provision does not apply to engineers, architects, and other similar businesses because, unlike the revenue exclusion, the cost of goods sold provision does not expressly the actual or proposed design of improvements on real property. The statutory language and legislative intent may not support the Comptroller s limited interpretation of these provisions. Neither statutory provision expressly includes the limitations the Comptroller imposes. In fact, the language of both provisions appears fairly broad in scope. The revenue exclusion applies to payments in connection with the actual or proposed design, construction, remodeling, or repair of improvements on real property or the location of boundaries of real property (emphasis added). The phrase in connection with suggests that the revenue exclusion may apply to business activities connected to the improvement of real property other than construction and design. Similarly, the cost of goods sold provision applies to taxable entities furnishing labor or materials to a project for the construction, improvement, remodeling, repair, or industrial maintenance... of real property (emphasis added). Projects for the improvement of real property typically include a variety of activities other than those that cause a physical change to the property.

238 Texas Franchise Tax Page 227 Comptroller Examples. In the August 2010 edition of Tax Policy News, the Comptroller provided the following examples of her application of these provisions. It is unclear whether Texas courts would interpret these provisions in such a limited manner: Example 1 A general contractor is hired to construct a private residence. The general contractor s contract with his client states that he will subcontract out all electric, plumbing and HVAC work on the project. The general contractor, therefore, may exclude from revenue the subcontracting payments made to the electrician, plumber and HVAC technician. Once these particular subcontracting payments have been excluded from revenue, they may not be included in the determination of cost of goods sold. Payments made to subcontractors for work not specified in the contract and the costs of direct labor and materials may be included in the cost of goods sold deduction. Example 2 An architecture firm is hired to provide all of the design work for a construction project. The architecture firm s contract with the customer says that it will subcontract out the engineering work on this project. Based on this contractual provision, the architecture firm is allowed to exclude from revenue the amounts paid to an engineering firm for work on this project. The architecture firm, however, only produces the plans for the construction project. The architecture firm does not construct, improve, remodel or repair the property (physically work on the real property and effect a change to that property). As a result, the architecture firm is not eligible to take a cost of goods sold deduction for its services.

239 Page 228 Texas Franchise Tax Example 3 A general contractor is hired to construct a commercial building. The general contractor hires a transportation company to bring materials to the construction site and haul debris away from the site. The general contractor, who physically works on the real property and effects a change to that property, can include these trucking costs in the cost of goods sold deduction. The transportation company, however, is not allowed a cost of goods sold deduction. A transportation company is a service provider and does not sell tangible personal property in the ordinary course of business. Transporting materials to or from a construction site is not effecting a change to the real property and does not qualify for the COGS deduction. Also, the transportation company cannot subtract from revenue any subcontracting payments made to independent truckers. The exclusion from revenue for subcontracting payments is allowed only for entities that provide services, labor, or materials for the actual or proposed design, construction, remodeling or repair of improvements on real property or the location of the boundaries of real property. Supervisory Labor. The Comptroller s position is that construction businesses may fully include labor costs in cost of goods sold (i.e. treat as direct costs) except for labor costs attributable to service departments. Formerly, the Comptroller held that construction businesses must treat supervisory labor as an indirect cost subject to the 4% cap on indirect or administrative overhead costs. 554 Inbound Transportation Costs. The Comptroller s current position is that construction businesses may include the cost of transporting materials to the job site in cost of goods sold as inbound transportation costs, but may not include the cost of transporting equipment and laborers to the job site. It is unclear whether the revised franchise tax statutes support the Comptroller s position. 554 Comptroller Letter No L.

240 Texas Franchise Tax Page 229 Judicial Clarification. Two recent cases have provided clarification with respect to the revenue exclusion and cost of goods sold deduction for those in the construction industry. Titan Transportation v. Combs, et al. 555 On March 14, 2014, the Third Court of Appeals in Austin, Texas held that Titan Transportation was entitled to claim a revenue exclusion under the real property activities provision for the payments it made to independent contractor drivers. Titan hauled and deposited aggregate on construction sites. The Comptroller has appealed this decision to the Texas Supreme Court, who has not yet indicated whether it will hear the case. Combs v. Newpark Resources, Inc. In Newpark, the Third Court of Appeals held that Newpark an integrated oilfield services company and combined group for Texas franchise tax reporting purposes was entitled to include the expenses of its drilling mud waste disposal division ( NES ) in its COGS deduction. The Comptroller did not appeal this decision and the opinion is now final. CGGVeritas Services (U.S.), Inc. v. Combs, et al. 556 In CGGVeritas, the trial court found for the taxpayer and ordered a full refund of the franchise taxes paid under protest. CGG s petition alleged: (1) that CGG qualified under the real estate activities provision 557 to claim the COGS deduction for costs incurred in producing custom-ordered seismic recordings and images that it sold to oil & gas well drillers and producers; and (2) that CGG qualified under media definition of goods 558 to include the costs of its seismic data library in its COGS deduction. As of the date of these materials, the Comptroller s deadline to appeal the decision has not yet expired Titan Transportation, LP v. Combs, No CV, 2014 WL Martens, Todd, Leonard & Taylor handled the trial and the appeal of this case. Cause No. D-1-GN Martens, Todd, Leonard & Taylor represents the Plaintiff. Texas Tax Code (i), third sentence. Texas Tax Code (a)(3)(A).

241 Page 230 Texas Franchise Tax Pending Litigation. Several cases currently pending in Travis County District Court also address the scope of these provisions. 559 Allcat Claims Service, L.P. v. Combs, et al. 560 This case addresses: (1) Whether claims adjusters may exclude payments to independent contractor adjusters from revenue as real property subcontracting payments; and (2) in the alternative, whether claims adjusters may include payments to independent contractor adjusters in cost of goods sold. PEK, Inc. d/b/a Serviceline Transport v. Combs, et al. 561 This case addresses: (1) Whether an aggregate hauler may exclude payments to independent contractor drivers from revenue as real property subcontracting payments; (2) In the alternative, whether an aggregate hauler qualifies for the COGS deduction under section (i); (3) Whether the Comptroller properly apportioned gross receipts of an interstate transportation company; (4) Whether an aggregate hauler meets the definition of a qualified courier and logistics company ; and (5) Whether the Comptroller s interpretation of the provisions allowing deductions and exclusions for the real estate industry violates constitutional requirements of equal and uniform taxation. Seltex, Inc. v. Combs, et al. 562 This aggregate hauler performs freight broker services. This case will present the unique issue arising under Texas Tax Code (f) concerning flow-through payments under fiduciary relationships. Seltex serves as a limited agent for its customers. Texas law classifies agency relationships as fiduciary. Advance Hydrocarbon Corporation v. Combs, et al. 563 This case addresses whether an oilfield services provider qualifies for the COGS deduction under section (i) Martens, Todd, Leonard & Taylor represents these plaintiffs. No. D-1-GN No. D-1-GN No. D-1-GN Nos. D-1-GN and D-1-GN

242 Texas Franchise Tax Page 231 Compensation. General contractors deduct compensation only for their own employees and not the subcontractors employees. The subcontractors deduct the compensation expense for their own employees. The general contractors exclude their payments to subcontractors from their revenue. Example 1 A homebuilding partnership (real estate developer) holding legal title to a house under construction is the owner of the goods (real property). If the developer elects to deduct cost of goods sold, it may include its own qualifying costs of developing the property, but not payments to its subcontractors because it excludes them from revenue. If the developer elects to deduct compensation, it may include the costs of employing its own workers but may not include compensation expenses for contractors who work on the property.

243 Page 232 Texas Franchise Tax Example 2 A general contractor is the owner of the installation labor and materials it furnishes to real property even if the developer holds title to the real property. If the general contractor elects to deduct cost of goods sold, it may include its own qualifying costs of constructing the property, but excludes flow-through payments to subcontracts from both revenue and expenses. For example, if the general contractor hires a wiring contractor to install low voltage wiring in the building, the general contractor excludes the flow through payments for the subcontractor s work from both revenues and cost of goods sold. If the general contractor elects to deduct compensation, it may include the costs of employing its own workers but may not include compensation expenses for the wiring contractor or other contractors who work on the property. Example 3 The wiring subcontractor is the owner of the installation labor and wiring materials it furnishes to real property even if someone else holds title to the real property. If the subcontractor elects to deduct cost of goods sold, it s entitled to deduct its qualifying costs of constructing the property. If the subcontractor elects to deduct compensation, it s entitled to deduct the costs of its own workers. Tax Rate Issues. The Comptroller applies the Texas revised franchise tax rules to prevent businesses that sell and install items as real property from qualifying for the ½% retailer/wholesaler rate. 564 The Comptroller states that the following businesses which sell and install products are not eligible for the ½% rate: flooring, windows, carpet, sprinkler systems, elevators, central HVAC units, insulation materials, etc. The Comptroller does allow businesses that sell and install household appliances to qualify for the ½% rate. 564 Tax Policy Newsletter, p. 1-3 (Feb 2011).

244 Texas Franchise Tax Page 233 Crop Dusters An agricultural aircraft operation 565 may exclude the cost of labor, equipment, fuel, and materials used to provide agricultural aircraft services. These services include spraying for pest control and fertilization. Destination Management Companies Businesses that qualify as destination management companies may exclude from their total revenue payments they make to others for services, labor, or materials in connection with providing their destination management services. 566 To qualify as a destination management company ( DMC ), a business must meet the following requirements: The DMC must be formed as a corporation or limited liability company; 80 percent or more of the DMC s revenue must come from providing or arranging 6 of the 9 statutorily-listed destination management services. These services generally involve transportation management, shuttling services, airport meet & greet services, managing entertainers, coordinating tours, and event management and staffing; The DMC must have a permanent, non-residential office with three or more full-time employees; 80 percent of the DMC s client contracts must be for clients located outside Texas or where out-of-state program attendees; The DMC must maintain a general liability insurance policy with a limit of at least $1 million; The DMC, nor an affiliate, may not own equipment it uses to provide its services, such as limousines, lighting, dance floors, podiums, and catering equipment; The DMC may not provide wedding services; The business may not own a venue for which it provides its services; and C.F.R defines agricultural operations to include: (1) dispensing any economic poison, (2) dispensing any other substance intended for plant nourishment, soil treatment, propagation of plant life, or pest control, or (3) engaging in dispensing activities directly affecting agriculture, horticulture, or forest preservation, but not including the dispensing of live insects.. Texas Tax Code (g-6).

245 Page 234 Texas Franchise Tax The DMC, nor an affiliate, may prepare or serve beverages, meals, or other food products. 567 Lending Institutions The revised franchise tax defines lending institutions as entities that make loans and are regulated by certain governmental bodies. 568 These regulatory bodies include: the Federal Reserve Board, the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation, the Commodity Futures Trading Commission, the Office of Thrift Supervision, the Texas Department of Banking, the Office of Consumer Credit Commissioner, the Credit Union Department, or any comparable regulatory bodies; or are licensed by, registered with, or otherwise regulated by the Department of Savings and Mortgage handling; and brokers and dealers. 569 Brokers & Dealers. The 2007 Act adds brokers and dealers to the list of entities that qualify for the lending institution preferences. 570 Note. The definition of lending institutions includes more than banks and savings & loans. It includes entities such as finance companies and other types of lenders. Agricultural Lenders. Entities that make loans to unrelated parties solely for agricultural production may deduct interest expense as cost of goods sold. 571 Since these types of lenders do not make loans to the general public, but only a small niche, they wouldn t ordinarily qualify to take interest expense as a cost of goods sold deduction Texas Tax Code Texas Tax Code (10). Texas Tax Code (10) as amended by H.B. 3928, 80th Cong., Reg Sess 1 (Tx. 2007) (enacted) as effective January 1, Texas Tax Code (10) as amended by H.B. 3928, 80 th Cong., Reg Sess 1 (Tx. 2007) (enacted) as effective January 1, Comptroller Rule

246 Texas Franchise Tax Page 235 Auto Finance Companies. In 2008, the Comptroller clarified that motor vehicle sales financing companies qualify for the interest expense deduction as long as they are licensed through the Office of Consumer Credit Commissioner, as provided for under Chapter 348 of the Texas Finance Code. 572 Excluded Lenders. The statute excludes certain businesses, primarily pawn shops, from taking the interest expense deduction for lending institutions. This change was likely made because the interest expense deduction was meant primarily for entities that would not otherwise have a cost of goods sold deduction (like banks). Since pawn shops and other used-merchandise businesses would likely already take the cost of goods sold deduction, they are excluded from taking interest expense as an additional deduction. 573 Interest. Lending institutions that offer loans to the public and elect to deduct cost of goods sold may include interest expense in cost of goods sold. 574 Principal. Lending institutions may also exclude from total revenue the proceeds they receive from the principal repayment of loans. 575 Apportionment for Loans & Securities Treated As Inventory. The Comptroller s Rules state that for the 2008 and 2009 reports, if a loan or security is treated as inventory of the seller for federal income tax purposes, the gross proceeds of the sale of that loan or security are considered gross receipts, but for the 2010 reports and thereafter, gross proceeds for loans and securities treated as Securities Available for Sale or Trading Securities under Financial Accounting Standard No. 115 are also considered gross receipts Comptroller Letter No L (Sept. 24, 2008). Texas Tax Code Texas Tax Code (k). Texas Tax Code (g-1). Texas Tax Code (f-1), (as amended by HB 4611, 81st Reg. Sess. 2009); Comptroller s Rule 3.591(e)(16).

247 Page 236 Texas Franchise Tax However, a Comptroller Letter states that the Comptroller now views the new sections added by the Comptroller in 2009 as a clarification of existing law, and as a result, a lending institution will be allowed to use the gross proceeds from the sale of securities or loans treated as Securities Available for Sale or Trading Securities for all reports originally due on or after January 1, Marked-to-Market Gains. Internal Revenue Code 475 requires dealers in securities to elect the mark to market accounting method for securities held at year end. Mortgage companies, savings and loan institutions, and banks with large mortgage operations often are considered dealers in securities for their mortgages. The mortgages or mortgage pools could be considered securities and marked to market at year end, depending upon elections made by eligible taxpayers. Under the mark-to-market accounting method, the securities are valued at their fair market value as determined on the last business day of the year, regardless of whether the security is actually sold. Gain or loss is recognized for reporting purposes and basis in the securities is adjusted. The effects of the mark-to-market accounting method are purely timing. Gains recognized will accelerate the reporting of margin and losses recognized will defer the reporting of margin. Health Care Industry Health Care Providers. Health care providers organized as taxable entities may exclude certain revenues in computing their taxable margin. The revised franchise tax defines health care providers as taxable entities that provide health care services and participate in the Medicaid program, Medicare program, Children s Health Insurance Program, state workers compensation program, or TRICARE military health system. Health care providers eligible for the 100% exclusion include: Physicians Physicians assistants Nurse practitioners Clinics 577 Comptroller Letter No L (May 28, 2010).

248 Texas Franchise Tax Page 237 Combined Groups. The determination of whether an entity qualifies as a health care provider is made at the individual member level; it isn t made at the combined group level % Exclusion. Health care providers may exclude from total revenue any funds received under any plans under the following government programs: Medicaid Medicare Indigent Health Care and Treatment Act Children s Health Insurance Program Workers compensation fees for services provided under a workers compensation claim. TRICARE military health system fees for services provided to beneficiaries Payments received from health plan options that are part of the Medicare or Medicaid programs, such as, Medicare advantage plans, qualify for the exclusion 579 Limitation for Health Care Institutions. Health care institutions may exclude 50% of the revenues from each type of government program listed above and may deduct 50% of the actual cost of uncompensated care. 580 Health care institutions include: 581 Ambulatory (day surgery) surgical centers Licensed assisted living facilities Emergency medical service providers Home and community support services agencies Hospices (end-of-life care) Hospitals Hospital systems See Preamble to Comptroller Rule Comptroller Letter No L (Oct. 27, 2008). Texas Tax Code (o). Texas Tax Code (p)(2).

249 Page 238 Texas Franchise Tax Intermediate care facilities for the mentally retarded Home and community-based services waiver programs for the mentally retarded Birthing centers Nursing homes Licensed end-stage renal disease facilities Pharmacies No Reduction in Deductions. When excluding revenue from Medicare, Medicaid and the other programs listed above, no corresponding adjustment needs to be made to the deductions for COGS or Compensation for costs attributable to the excluded revenue. 582 Example A medical partnership keeps its Medicaid/Medicare records on an accrual basis, but reports its federal tax on a cash basis. It would be fairly easy to compute the amount of excluded funds via a ration, but more difficult to calculate the actual amount of Medicaid/Medicare cash reported for federal tax purposes. May the partnership calculate the exclusion with a ratio? No. The Comptroller s office says that the partnership is only entitled to exclude the payments that were included in revenue, so therefore the use of a ratio is not permitted. 583 Co-payments & Deductibles. The amounts received from patients or supplemental insurance for co-payments and deductibles under these government programs are excluded from revenue as well Tax Policy News (Feb. 2008). Comptroller Letter No L (Sept. 30, 2009). Comptroller Rule 3.587(b)(1)(G).

250 Texas Franchise Tax Page 239 Actual Cost of Uncompensated Care. Health care providers may also exclude from revenue the actual cost incurred for uncompensated care. The health care provider must maintain records of the uncompensated care. If the provider later receives payment for all or part of the care, the provider must adjust the amount excluded for the tax year in which the payment is received. Health care providers determine the amount of the actual costs of uncompensated care with the following formula: Operating Expenses * Uncompensated Care Ratio (Cost of Goods Sold plus total Payments) Reported on federal return) (any items previously excluded from revenue) * (Uncompensated Care Charges) (Partial Total Charges In this formula: Uncompensated Care Charges. The standard charges for health care services where the provider has received either partial payment or no payment at all. This amount does not include any charges covered by one of the government programs eligible for the 100% exclusion (listed above), services performed for a contracted or agreed upon rate with a private health care plan or individual, or services where payments received cover the cost of the care provided. 585 Standard charges must be comparable to the charges applied to services provided to all patients. 586 Partial Payments. Any amount received towards uncompensated care charges. 587 Total Charges. Charges for all health care services, including uncompensated care charges Comptroller Rule 3.587(b)(1)(C). Comptroller Rule 3.587(b)(1)(D). Comptroller Rule 3.587(b)(1)(E). Comptroller Rule 3.587(b)(1)(F).

251 Page 240 Texas Franchise Tax Required Reduction in Deductions. Health care providers that take a revenue exclusion for the actual cost of uncompensated care must also reduce their cost of goods sold or compensation deduction, otherwise costs these costs would be include in the calculation twice. The amount of the reduction to each deduction equals the deduction multiplied by the Uncompensated Care Ratio, described above. 589 Example Medical Clinic, LLP provides medical care to four patients. During 2012, it generates the following patient-care revenue: Standard Patient Receipts Medicare Insurance Total Charges Co- Pay Deductible Receipts Receipts Receipts Patient #1 $2,000 $20 $50 $230 $1,000 $1,300 Patient # Patient # Patient # Total $3,525 $50 $150 $230 $1,600 $2, Comptroller Rule 3.587(b)(1)(H).

252 Texas Franchise Tax Page 241 Also, during 2012, Medical Clinic, LLP incurs the following operating expenses: Salaries and wages $200 Guaranteed payments 300 Repairs and maintenance 20 Rent 225 Taxes and licenses 55 Interest 50 Depreciation 35 Retirement Plans 40 Employee Benefit Programs 60 Total Operating Expense $985

253 Page 242 Texas Franchise Tax What is the Cost of Uncompensated Care? Uncompensated care charges divided by total charges Uncompensated Care Ratio multiplied by operating expenses Cost of Uncompensated Care What is the adjustment to the Compensation Deduction? Compensation Included in Operating Expenses: Salaries and wages Guaranteed payments Retirement Plans Employee Benefit Programs Total multiplied by the Uncompensated Care Ratio Adjustment to Compensation Deduction

254 Texas Franchise Tax Page 243 What is the resulting Texas franchise tax calculation? Revenue Exclusions: Medicare Payments Total Revenue Compensation Employee Benefits Total Compensation Taxable Margin Tax Rate 1% Tax Due

255 Page 244 Texas Franchise Tax Revenue Consistency Requirement. A health care provider may exclude payments (Medicare, Medicaid, CHIP, workers comp, etc.) only if the payments are otherwise included in revenue. 590 Pharmacy Coops. Pharmacy cooperatives may claim a revenue exclusion for flowthrough funds from rebates from pharmacy wholesalers that are distributed to shareholders. 591 Vaccines. A taxable entity shall exclude from its total revenue the actual cost paid by the taxable entity for a vaccine. 592 Vaccine means a preparation or suspension of dead, live attenuated, or live fully virulent viruses or bacteria, or of antigenic proteins derived from them, used to prevent, ameliorate, or treat an infectious disease. 593 Insurance Companies Insurance companies that are authorized to engage in the insurance business in Texas are generally exempt from revised franchise tax. This is because insurance companies and title insurance agents are required to pay the annual insurance gross premiums tax. Caution. Insurance companies are subject to the revised franchise tax if, for any portion of a year, they are in violation of an order issued by the Texas Department of Insurance regarding unfair discriminatory premium rates. The order must be final after appeal or no longer subject to appeal. The list of exempt entities includes non-admitted insurance organizations that are required to pay gross premium receipts tax during a tax year. The non-admitted insurance organizations will be exempt from the revised franchise tax for the years in which they are required to pay gross premium receipts tax Texas Tax Code Texas Tax Code Texas Tax Code (u). Eff. Jan. 1, Texas Tax Code (p)(8). Eff. Jan. 1, 2014.

256 Texas Franchise Tax Page 245 The Comptroller s former position was that only insurance companies that paid the Texas gross premiums taxes qualified for this exemption. 594 The Texas Legislature amended the Texas revised franchise tax statute in 2013 to provide that the exemption applies when the nonadmitted insurance company is subject to an occupations tax, privilege tax or gross premiums tax in another state. 595 The legislative amendment adopts the position advanced by Atlantic Casualty Insurance Co. in its suit against the Comptroller. Settled Litigation. A surplus lines carrier recently settled its lawsuit challenging the Comptroller s position that only insurance companies that pay Texas gross premiums taxes qualify for the exemption. 596 Texas imposes a tax on gross premiums for surplus lines insurance, and surplus lines carriers typically pay gross premiums taxes to states in which they hold certificates of authority. Atlantic Casualty argued that the payment of a gross premiums to another state (besides Texas) was sufficient to invoke the franchise tax exemption. The revised franchise tax statute has now been amended to comport with the result sought by Atlantic Casualty s lawsuit Comptroller Letter No L (Sept. 30, 2011). Texas Tax Code Ann (a) eff. Jan. 1, 2014). Atlantic Casualty Insurance Company v. Combs, et al., No. D-1-GN Martens, Todd, Leonard & Taylor represented Atlantic Casualty.

257 Page 246 Texas Franchise Tax Live Entertainment Event Promotion Companies Qualified live entertainment event promotion companies may exclude from revenue payments made to certain categories of entertainers. 597 Qualified live entertainment event promotion companies. To qualify, the company must meet several conditions: 598 It must receive at least 50% of its annual revenues from arranging or providing its live event promotion services to three or more live events; It must employ at least 10 or more full-time employees; It must provide its services from a permanent location that is not a residence; It cannot provide services for weddings and carnivals; and It cannot be a movie theatre. Live Event Promotion Services. This includes promoting, coordinating, operating, managing live entertainment events and includes services relating to staff provided and scheduling and promoting the artists who perform or entertain at the event Texas Tax Code (g-5). Texas Tax Code (11-b). Texas Tax Code (10-b).

258 Texas Franchise Tax Page 247 Management Companies A management company is a firm that organizes, manages, and administers the business of another entity. In exchange for its services, a management company receives a management fee. The management company also receives reimbursement of specified costs it incurs in connection with managing the business. The reimbursed costs generally include employee compensation. Management companies formed as taxable entities exclude from total revenue reimbursements of specified costs incurred in its conduct of the active trade or business of a managed entity. 600 A management company will not qualify for this preferential treatment unless it actually receives a management fee for performing its services. 601 Management companies do not produce or sell goods. Therefore, they must elect between deducting 30% of revenue or their actual compensation costs. These costs include wages and cash compensation of up to a capped amount per employee per year, plus benefits. Management companies electing to deduct compensation may not deduct wages or cash compensation reimbursed by a managed entity. They may deduct only those wage and compensation payments that are not reimbursed (i.e., payments to their own administrative employees). Manufacturers Manufacturers do not qualify as being primarily engaged in retail or wholesale trade if 50% or more of their total revenues come from the sale of products they produce or manufacture. The 50% also includes total revenues from products produced by an entity that is part of a taxpayer s affiliated group. Exception. This requirement does not apply to eating and drinking places, such as restaurants, lunch counters and refreshment stands Texas Tax Code (m-1). Comptroller Rule 3.589(b)(3)(A). See Texas Tax Code (c-1) (referencing businesses classified as eating and drinking places under Office of Management and Budget s Standard Industrial Classification Manual Major Group 58: Division G).

259 Page 248 Texas Franchise Tax Manufacturers in Affiliated Groups. An affiliated group is a group of one or more entities in which a common owner holds a controlling interest. 603 Entities are not members of an affiliated group unless they commonly-owned. The revised franchise tax statute classifies entities as commonly-owned if they share common ownership of more than 50%. Example 1 Manufacturing Partnership is owned equally by A and B. It sells materials to A and B. A and B use the materials in manufacturing products. B also sells the materials to the general public. The manufacturing partnership is not considered to be an affiliate of either A or B. Example 2 A and B are commonly-owned entities. A manufactures products and sells them to B. B sells the products in the open market. B does not sell the products of anyone else. A and B are members of an affiliated group for revised franchise tax purposes and, if they are unitary, they must report as a combined group. A and B will not qualify for the half-percent rate because a is a manufacturer and B generates more than half of its revenues from sales of products the affiliated group manufacturers. A and B form a manufacturing partnership with outside third parties owning more than 50% of the partnership shares. The manufacturing partnership is not an affiliate of A or B. A sells all of the products it manufactures to the manufacturing partnership, which in turn sells the products to B. B sells the products in the open market. Although the law is unclear, A and B may argue that they are no longer members of a combined group. 603 Comptroller Rule 3.590(b)(1).

260 Texas Franchise Tax Page 249 Movie Theatres A movie theater that elects to subtract cost of goods sold may include cost relating to the acquisition, production, exhibition, or use of a film or motion picture, including expenses for the right to use the film or motion picture. 604 This 2013 provision is a clarification of existing law and does not create a substantive change. 605 Oil & Gas Industry The statute provided generous benefits to the oil and gas industry. The oil and gas industry has special provisions for qualifying under the passive entity exception. Oil and gas entities electing to deduct cost of goods sold may also benefit from special treatment for geological and geophysical costs, intangible drilling costs and others. And oil and gas entities will have benefited from the alleged reduction in property taxes. Passive Entity Treatment. Passive entities are exempt from revised franchise tax. An entity may qualify as passive if at least 90% of its income comes from passive sources. The passive sources include royalties, bonuses or delay rental income from mineral properties and income from other non-operating mineral interests. The test for determining a passive entity s status considers certain activities of affiliated group members. Specifically, the income a non-operator receives from mineral properties under a joint operating agreement is not passive income if the operator under the agreement is a member of the same affiliated group as the nonoperator receiving the income. Also, an entity is not passive if it conducts an active trade or business, such as manufacturing or wholesale or retail trade. However, owning a royalty interest or a non-operating working interest in mineral rights does not constitute the conduct of a trade or business for purposes of determining whether an entity is a passive entity Texas Tax Code (t). Eff. Sep. 1, Texas Tax Code (t). Eff. Sep. 1, 2013.

261 Page 250 Texas Franchise Tax Geological and Geophysical Costs. Cost of goods sold includes geological and geophysical costs (G&G) incurred to identify and locate property with the potential to produce minerals. Taxpayers exploring for minerals incur G&G costs in obtaining and accumulating data that will serve as the basis for acquiring and retaining mineral properties. Generally, the federal income tax laws require taxpayers to capitalize geological and geophysical costs and cost deplete them. Recent federal tax changes may affect this deduction for taxpayers in the oil and gas industry. For federal tax purposes, taxpayers may now amortize G&G costs incurred in connection with U.S. oil and gas exploration over 2 years. Even in the case of abandoned property, taxpayers may recover the basis of G&G costs over the 2-year amortization period. New Federal Tax Law. For amounts paid or incurred after May 17, 2006, the Tax Increase Prevention and Reconciliation Act of 2005 extends the 2-year amortization period for G&G costs to 5 years for certain major integrated oil companies. Similarly, in the case of abandoned property, basis is recovered over a 5 year amortization period. The 5-year amortization rule applies only to integrated oil companies that have an average daily worldwide production of crude oil of at least 500,000 barrels for the tax year, gross receipts in excess of $1 billion in the last tax year ending during calendar year 2005, and an ownership interest in a crude oil refiner of 15% or more. 606 This new law may have not only federal tax implications but also Texas franchise tax consequences for affected taxpayers. Intangible Drilling Costs. Cost of goods sold includes payments for intangible drilling costs or dry holes. For federal tax purposes, intangible drilling costs are generally not included in inventory and deducted through costs of goods sold. Federal income tax law allows taxpayers to choose whether to capitalize intangible drilling costs or deduct them. The same election applies to dry hole costs. Oil & Gas Drillers. By policy, the Comptroller s office treats oil & gas drilling companies as eligible for the COGS deduction See IRC 167(h)(5) as amended by Tax Increase Prevention and Reconciliation Act of See Comptroller FAQs for COGS, Question and Answer No. 17 (April 16, 2008).

262 Texas Franchise Tax Page 251 Oilfield Service Companies. Oilfield service companies are treated much like contractors in the construction industry, because the Comptroller considers oil and gas wells to be real property, and considers oilfield service providers to be engaged in the construction, improvement, remodeling, repair, or industrial maintenance of real property. The labor, materials, and other costs otherwise allowable for the cost of good sold deduction that are used to provide these services are deductible as cost of goods sold. 608 Excluded Income from Low-Producing Wells. Taxpayers may exclude certain oil and gas well income from total revenues during dates that the price of oil or gas sinks below certain specified levels. This includes income from the following types of wells: Oil wells designated by the Texas Railroad Commission or other similar state agency as producing less than 10 barrels a day over a 90-day period. Gas wells designated by the Texas Railroad Commission or other similar state agency as producing less than 250 mcf a day over a 90-day period. The Tax Code directs the Comptroller to certify dates during which the monthly average closing price of West Texas Intermediate crude oil is less than $40 per barrel and the average closing price of gas is below $5 per MMBtu, as recorded on the New York Mercantile Exchange. 608 Comptroller Letter No L (Nov. 17, 2008).

263 Page 252 Texas Franchise Tax Landman Services. Often companies that provide landman services subcontract work out to independent landmen to whom they issue IRS Forms For reports originally due on or after January 1, 2014, a business primarily engaged in performing landman services may exclude from revenue the subcontracting payments made to independent landmen who perform landman services on behalf of the business. 609 Landman services means: 1. performing title searches to determine the ownership of or curing title defects related to oil, gas, or other related mineral or petroleum interests; negotiating for mineral rights to explore, develop, or produce oil, gas, or other related mineral or petroleum interests; 611 or 3. negotiating agreements relating to the ownership of mineral interests in order to explore, develop, or produce oil, gas, or other related mineral or petroleum interests. 612 Oil and Gas Net Profits Interests. A recent case settled challenged the Comptroller s treatment of certain oil and gas flow-through income. 613 The case involved a taxpayer who owns working interests in oil and gas leases. The taxpayer sold a 96 percent net profits interest in the leases to another entity. The taxpayer excluded the amount of its net profits distributions to the second entity from its total revenue, but the Comptroller denied the exclusion. The taxpayer argued that it may exclude the distributions because the revised franchise tax statutes allow a revenue exclusion for flow-through funds that are mandated by law or fiduciary duty to be distributed to other entities. 614 The taxpayer also argued that it may exclude the distributions because the revised franchise tax statutes allow a revenue exclusion for tax basis... of securities and loans sold. 615 The Comptroller settled the case on the eve of trial Texas Tax Code (g-11). Eff. Jan. 1, Texas Tax Code (g-11)(1). Eff. Jan. 1, Texas Tax Code (g-11)(2). Eff. Jan. 1, Texas Tax Code (g-11)(3). Eff. Jan. 1, Basa Resources, Inc. v. Combs, No. D-1-GN , Travis County District Court (filed June 12, 2012). Martens, Todd, Leonard & Taylor represented the plaintiff. Texas Tax Code (f). Texas Tax Code (g-2).

264 Texas Franchise Tax Page 253 Professional Employer Organizations Professional Employer Organizations (formerly Staff leasing companies ) hire a client company s employees and then lease them back to the client company under a co-employment relationship. This arrangement relieves client companies of the paperwork burdens associated with maintaining personnel, including payroll and benefits. The revised franchise tax references the Labor Code definition of professional employer organizations: the services provided through coemployment relationships in which all or a majority of the employees providing services to a client or to a division or work unit of a client are covered employees. 616 Professional employer organizations generally don t sell goods. Their costs relate to the workers they employ. As a result, professional employer organizations are ineligible to deduct cost of goods sold. The special provisions appear to be based upon the notion that the professional employer organizations serve as agents for their clients with respect to the assigned employees. The revised franchise tax statute allows a professional employer organization to exclude from its total revenue the payments it receives from client companies for wages, payroll taxes on those wages, employee benefits and worker s compensation for the employees assigned to the client companies. 617 Since these amounts are excluded from revenue, the professional employer organizations may not deduct them as compensation. Professional employer organizations are allowed to deduct only the compensation they pay to their own employees (generally, their administrative staff) who are not assigned to a client company Texas Labor Code (14) amended by SB 1286 (83 rd Reg. Legis. Session) eff Sep 1, Texas Tax Code (k). Texas Tax Code (d)

265 Page 254 Texas Franchise Tax Client Companies of Staff Leasing Companies. Client companies of professional employer organizations that elect to deduct compensation may deduct the wages and benefits paid to the professional employer organization for the assigned employees as if the assigned employees were actual employees of the client company. 619 However, the client company may not deduct administrative fees, payroll taxes or any other amount paid to the professional employer organization in connection with the assigned employees. 620 Real Estate Industry The revised franchise tax contains multiple preferences, some intentional, others apparently unintentional, which benefit taxpayers in the real estate industry. Passive Entities. A real estate investor organized as a general or limited partnership or a non-business trust may qualify as a passive entity exempt from franchise tax if it generates capital gains from the sale of real property. 621 Note: The 2007 Legislature modified the term gains from the sale of real estate by adding the word capital. This modification affects the gains that are treated as passive for purposes of the 90% passive income test. We believe the drafters added the word capital to limit the type of qualifying gains to noninventory sales of real estate. This rationale is consistent with the Internal Revenue Code s definition of a capital asset. By rule, the Comptroller defines net capital gains and net gains according the Internal Revenue Code s definition of these terms. 622 Internal Revenue Code 1211(11) defines a net capital gain to mean the excess of the net long-term capital gain for the taxable year over the net short-term capital loss for such year. We searched the Internal Revenue Code and couldn t find a definition of net gains. Exempt Entities. Exempt entities include those organized as real estate investment trusts, qualified REIT subsidiaries and real estate management investment companies Texas Tax Code (k) Texas Tax Code (e) 621 Texas Tax Code Comptroller Rule 3.582(b)(7) & (8).

266 Texas Franchise Tax Page 255 REITs. Real estate investment trusts (REITs) are exempt from the Texas revised franchise tax as long as they don t own a direct interest in property. Real estate investment trusts are entities formed to hold interests in real estate. Most REITs hold the real estate interests indirectly through limited partnerships. The limited partnerships own office buildings and collect rent. Businesses form REITs in order to take advantage of special federal tax preferences. Unlike other businesses, REITs may exclude dividend distributions from income. The Internal Revenue Code allows REITS to exclude dividend distributions because the income will be taxed at the beneficiary/shareholder level. REITs are also exempt from Texas revised franchise tax because the limited partnerships that directly own the office buildings will pay tax based on the revenue the real estate generates. Exception. The only way the revised franchise tax statute allows a REIT to hold a direct interest in real estate is if it occupies that real estate for business purposes (e.g., the building it uses for its own office). Otherwise a REIT with any amount of its assets in direct holdings of real estate (as opposed to holding interests in limited partnerships or other entities that directly hold the real estate) is a taxable entity. 623 Qualified REIT Subsidiaries. Qualified REIT subsidiaries (QRSs) are also exempt from the Texas revised franchise tax. REITs must be passive landlords. Federal law limits REITs to holding only interests in real estate. REITs may not conduct an active trade or business. Federal law allows REITs to form subsidiaries, which may perform certain services in connection with the real estate that the REIT owns. For example, a REIT that holds interests in partnerships that own office buildings may form a subsidiary to provide parking services, janitorial services, lawn and yard maintenance and other services to the tenants at the properties. Unlike REITs, the QRSs may not deduct from income the dividends they distribute to the REIT. They must pay federal income tax. 623 Texas Tax Law (c)(8)(A). See also Texas Tax Law (c)(8)(B) (which states that a limited partnership or other entity that directly holds the real estate as described in Paragraph (A) is not exempt under this subdivision, without regard to whether a REIT holds an interest in it. ).

267 Page 256 Texas Franchise Tax REMICs. Qualified real estate mortgage investment conduits (REMICs) are also exempt from Texas revised franchise tax. A qualified real estate mortgage investment conduit receives money from hedge funds, banks and individuals and invests in real estate mortgage bonds, such as Fannie Mae, Ginnie Mae and corporate bonds. The mortgage bonds represent pools of individual real estate mortgages. The REMIC creates different types of beneficial interests in the real estate bonds. The REMIC sells the various classes of beneficial interests at various prices, depending upon their risk and return. In the absence of special rules, federal law would tax this type of organization as a corporation, even if it were organized as a trust. However, REMICs allow the entity to be formed as a trust or corporation, have multiple classes of ownership and still be exempt from federal income tax. Like REITs and QRSs, REMICs may deduct their dividends to shareholders from their federal taxable income. Commissions. The revised franchise tax excludes from total revenue certain flowthrough funds mandated by contract to be distributed to other entities. 624 This includes sales commissions paid to licensed real estate brokers, licensed real estate sales agents, including split-fee real estate commissions. 625 A split- fee real estate commission is an earned commission that a real estate broker shares with another licensed broker with whom the broker has cooperated in a real estate transaction. Temporary Employment Service Temporary employment service companies hire their own employees and assign them to clients to support or supplement the client s work force in special work situations, including employee absences, temporary skill shortages, or special assignments or projects. Temporary employment service companies pay the temporary workers wages, benefits and payroll taxes. They receive fees from their customers for providing the workers. The statute treats temporary employment service companies similar to other service companies, such as law firms and accounting firms. They are not eligible for a cost of goods sold equivalent deduction because they don t produce or own Texas Tax Code (g). Texas Tax Code (g)(1).

268 Texas Franchise Tax Page 257 goods for sale. As a result, they are relegated to deduct either $1 million or the amounts they pay for wages and compensation, and benefits. 626 The statute does not allow temporary employment service companies to claim deductions for payroll taxes and other payroll-related expenditures. Also, it appears that the statute would not allow temporary employment service companies to deduct the direct costs associated with placing temporary workers. This category of costs includes: Recruiting Pre-employment screening Drug testing Training Continuing education Advertising Parity with Staff Leasing Companies. The revised franchise tax statute grants preferences to temporary employment service companies and their clients identical to those originally enacted for professional employer organizations. 627 It does this by defining a temporary employment services company as a staff leasing services company. The Texas Legislature redesignated Staff leasing services as Professional Employer Organization and redesignated assigned employee to covered employee Texas Tax Code (b). Texas Tax Code

269 Page 258 Texas Franchise Tax Example Dan s Sporting Goods hires temporary workers to supplement its workforce during the busy holiday season. Normally, the company would not be able to include the compensation and benefits paid to these workers because the statute only allows a deduction for compensation paid to employees, officers, owners, partners, or directors of the company. However, if Dan s Sporting Goods qualifies as a client company for a temporary employment services company, then it can deduct compensation and benefits paid to the temporary workers as if they were its own employees. The temporary employment services company, in turn, would not get to deduct the compensation or benefits paid to the workers for the period that they worked for Dan s Sporting Goods. Qualification. In order for the client company and the temporary employment service companies to qualify for this special rule, the temporary service companies must meet the definition of a temporary employment service. This means that the workers must support or supplement the client s workforce in a special work situation, including an employee absence, a temporary skill shortage or seasonal workload increase, or a special project. The special rule does not appear to apply if a temporary workforce is contracted for on a permanent basis. Example Because turnover is great, Dan s Sporting Goods has determined that it is more cost-effective to use temporary workers in its mailroom instead of employees. Because the mailroom workers are not supporting or supplementing the client s workforce in a special work situation, the special rule does not apply, and Dan s Sporting Goods would not be allowed to deduct the compensation and benefits paid to the temporary workers in the mailroom.

270 Texas Franchise Tax Page 259 Calculation, Reporting, and Invoicing. 628 A client company of a staff leasing services company (which now included a temporary employment services company) should compute its cost of goods sold or compensation deductions based on information provided by the staff leasing services company on an invoice or a form promulgated by the Comptroller. A temporary employment services company should document on its invoices that the temporary worker is being hired to support or supplement the client s workforce in a special work situation so that it is clear that the special rule applies. Industry Effect. As a result of this change, businesses may now obtain deductions for payments to temporary employment services for temporary workers. Taylor & Hill v. Combs. In the first case to be tried in the Travis County District Courts, the taxpayer prevailed in proving it qualified as a Temporary Employment Service, rather than as a professional engineering firm as alleged by the Comptroller. In her order, the trial judge ruled that the taxpayer was entitled to claim the compensation deduction for the wages and benefits of the unassigned workers. The taxpayer had previously claimed the COGS deduction. 629 Transportation Companies Under the original Texas revised franchise tax statute, the transportation industry was likely the most disadvantaged by the tax. Taxable entities in this industry paid tax at the highest rate, weren t eligible for the COGS deduction and had so little W-2 payroll, that they were relegated to claiming the standard 30% of revenue deduction. Over the years, the Texas Legislature passed amendments to the revised franchise tax statute designed to mitigate the harsh effect of the franchise tax on this industry Texas Tax Code Taylor & Hill v. Combs, Cause no. D-1-GN , 53rd District Court, Travis County, Texas, July 7, James Martens and Lacy Leonard with Martens, Seay & Todd tried this case.

271 Page 260 Texas Franchise Tax Aggregate Haulers. For reports originally due before to 2014, aggregate haulers may rely on the Titan Transportation case to exclude from revenue the amounts paid to independent contractors. For reports originally due on or after January 1, 2014, aggregate haulers are entitled to exclude from revenue the amounts paid to independent contractors per a new statutory revenue exclusion. 630 In order to qualify, the aggregate hauler must meet these conditions: It must be primarily engaged in the business of transporting aggregates. 631 We presume this means that the majority of revenues earned by the taxable entity must arise from transporting aggregates, It must make subcontracting payments to independent contractors for the performance of delivery services on behalf of the taxable entity, 632 It must haul aggregates, which means any commonly recognized construction material removed or extracted from the earth, including dimension stone, crushed or broken limestone, crushed or broken granite, other crushed and broken stone, construction sand and gravel, industrial sand, dirt, soil, cementitious material, and caliche. 633 Barite Haulers. For reports originally due before to 2014, barite haulers should be entitled to exclude from revenue the amounts paid to nonemployee agents under the Titan Transportation case. For reports originally due on or after January 1, 2014, barite haulers are entitled to exclude from revenue the amounts paid to nonemployee agents. 634 Barite is the powered substance used to make drilling mud Texas Tax Code (g-8). Eff. Jan. 1, Texas Tax Code (g-8). Eff. Jan. 1, Texas Tax Code (g-8). Eff. Jan. 1, Texas Tax Code (g-8). Eff. Jan. 1, Texas Tax Code (g-10). Eff. Jan. 1, 2014.

272 Texas Franchise Tax Page 261 In order to qualify, the aggregate hauler must meet these conditions: It must be primarily engaged in the business of transporting barite. 635 We presume this means that the majority of revenues earned by the taxable entity must arise from transporting barite, It must make subcontracting payments to nonemployee agents for the performance of transportation services on behalf of the taxable entity, 636 It must haul barite, which means means barium sulfate (BaSO4), a mineral used as a weighing agent in oil and gas exploration. 637 Pipeline Companies. Since pipeline companies provide a service and generally don t sell goods, they didn t qualify for the COGS deduction under the statute as it was originally written. For reports originally due on or after January 1, 2014, pipeline companies may subtract as a cost of goods sold its depreciation, operations, and maintenance costs allowed by the COGS section. 638 In order to qualify for the COGS deduction, the pipeline company must: 1. own or lease and operate the pipeline that transports products for others. The COGS deduction authorized by this provision applies only to the product owned by others. Presumably, to the extent the pipeline company owns it own product, it would qualify for the COGS deduction as the owner of goods; and 2. be primarily engaged in gathering, storing, transporting, or processing crude oil, including finished petroleum products, natural gas, condensate, and natural gas liquids, except for a refinery installation that manufactures finished petroleum products from crude oil Texas Tax Code (g-10). Eff. Jan. 1, Texas Tax Code (g-10). Eff. Jan. 1, Texas Tax Code (g-10). Eff. Jan. 1, Texas Tax Code (k-2). Eff. Jan. 1, Texas Tax Code (k-2). Eff. Jan. 1, 2014.

273 Page 262 Texas Franchise Tax Processing means the physical or mechanical removal, separation, or treatment of crude oil, including finished petroleum products, natural gas, condensate, and natural gas liquids after those materials are produced from the earth. The term does not include the chemical or biological transformation of those materials. 640 Marine Transport Companies. 641 Waterway transport companies my exclude from revenue the direct costs of providing the transportation service. This provision applies to both intrastate and interstate transportation. The excluded direct costs are the equivalent of the COGS that an entity that sells goods would qualify to claim. In order to qualify for the exclusion, the waterway transport company must: 1. be primarily engaged in the business of transporting goods by waterways, and 2. not subtract cost of goods sold in computing its taxable margin. 642 This provision will significantly benefit the barge transport companies that travel on the intercoastal waterway. Registered Motor Carriers. A motor carrier registered under Chapter 643 of the Texas Transportation Code is entitled to exclude flow-through revenue derived from taxes and fees Texas Tax Code (k-3). Eff. Jan. 1, Texas Tax Code (v). Eff. Jan. 1, Texas Tax Code (v). Eff. Jan. 1, Texas Tax Code (x). Eff. Jan. 1, 2014.

274 Texas Franchise Tax Page 263 Qualified Courier & Logistics Companies. These entities may exclude from revenue the payments they make to their subcontractors to perform delivery services. 644 To qualify, the company must meet these conditions: The company must earn 80% of its revenues from two of these sources: 645 Expedited, same-day delivery of an envelope, package, parcel, roll of architecture drawings, box or pallet; Temporary storage and delivery of another s property, including an envelope, package, parcel, roll of architecture drawings, box or pallet; Brokering the same-day or expedited courier and logistics services to a person or entity under a contract that contains a provision requiring the company to pay the person or entity. The company must be registered as a motor carrier under Chapter 643 of the Texas Transportation Code; 646 It must maintain automobile liability insurance with combined coverage of $1 million per occurrence; 647 It must maintain cargo insurance of at least $25,000; 648 It must maintain a permanent location that is not a residence; 649 It must employ at least 5 full-time employees; Texas Tax Code (g-7). Texas Tax Code (g-7)(1)(A)-(C). Texas Tax Code (g-7)(2). Texas Tax Code (g-7)(3). Texas Tax Code (g-7)(4). Texas Tax Code (g-7)(5). Texas Tax Code (g-7)(6).

275 Page 264 Texas Franchise Tax It cannot be engaged in any of the following activities: 651 Livery service Floral delivery Taxicab Building supply delivery Water supply delivery Fuel/energy supply service Restaurant supply service Commercial moving & storage Overnight delivery service It cannot be in the business of delivering items that it or an affiliate owns. 652 Utility Industry Businesses in the utility industry pay the 1% franchise tax rate. This includes retail or wholesale utilities that provide telecommunications services and electricity or gas. 653 Utilities electing to subtract cost of goods sold from total revenue may include in cost of goods sold the cost of producing or acquiring electricity sold. However, there is no similar deduction for the cost of acquiring other utilities for resale, such as water or gas Texas Tax Code (g-7)(7). Texas Tax Code (g-7)(8). See Texas Tax Code (c)(3), which specifically excludes taxable entities providing retail or wholesale utilities, including telecommunications services and electricity or gas from the definition of retailers and wholesalers.

276 Texas Franchise Tax Page 265 Chapter VII. Apportionment Allocation and Apportionment These are terms of art in state taxation. Allocation means to determine the tax base by separately accounting for the income and expenses of an activity within a particular state. Apportionment means to divide and share the tax base by multiplying the entity s total taxable income by its relative percentage of business done in the state. A taxable entity s (just entity hereafter) relative percentage of business may be measured by the relative amount of sales, payroll and/or property within the state to those amounts everywhere.

277 Page 266 Texas Franchise Tax Texas s Single Factor Formula An entity apportions its taxable margin to Texas by multiplying it by an apportionment fraction. The apportionment fraction is determined using only gross receipts. The numerator (top number) is the entity s gross receipts from business done in Texas and the denominator (bottom number) is the entity s entire gross receipts. Constitutionally Permissible. The U.S. Supreme Court and Texas courts have upheld the single factor formula despite numerous taxpayer challenges. 654 Three-Factor MTC Apportionment Formula. Graphic Packaging argued and lost cross-motions for summary judgment in state district court challenging the Comptroller s position that taxpayers may only use the single gross receipts factor for apportionment and may not use the three-factor apportionment formula provided under the Multistate Tax Compact. 655 Graphic Packaging filed its Notice of Appeal on April 2, See Moorman Manufacturing Co. v. Bair, 437 U.S. 267, 98 S. Ct (1978). In Texas, the formula withstood challenge in General Dynamics v. Sharp, 919 S.W.2d 861 (Tex. App. Austin 1996, n.w.h.). Graphic Packaging Company v. Combs, No CV. Martens, Todd, Leonard & Taylor represents Graphic Packaging.

278 Texas Franchise Tax Page 267 Gross Receipts The statutory definition of gross receipts means all revenues reportable by the entity on its federal tax return without deduction for the cost of the property sold, materials used, labor performed, or other costs incurred, unless otherwise provided. 656 The Comptroller s Rule clarifies that in most cases, total gross receipts will equal total revenue as calculated under the revised franchise tax, except for three specific circumstances: 657 The entity is a health care provider or institution that takes the revenue exclusion for uncompensated care; The entity is a law firm that takes the revenue exclusion for pro bono services; or The entity is a broker or dealer that accounts for loans and securities as inventory for federal income tax purposes, or Securities Available for Sale or Trading Securities under Financial Accounting Standard No For the first two circumstances, total gross receipts is not reduced by the revenue exclusion. For the third circumstance, the entity will report the gain on the sale of securities as revenue, but it should report the gross proceeds, from the sale of total gross receipts. 659 Combined Apportionment Combined groups create a single apportionment factor by adding the Texas receipts of each member of the combined group and dividing that sum by the receipts from everywhere from each member of the combined group Texas Tax Code (a). Comptroller Rule 3.591(b)(4). Texas Tax Code (f-1) (as amended by HB 4611, 81st Reg. Sess. 2009). Tax Policy News (June 2009). Texas Tax Code (b) and (c).

279 Page 268 Texas Franchise Tax Example P Corp owns 100% of S Corp. P and S are both taxable entities with operations in Texas. P generates gross receipts of $5,000 of which $4,000 arises from sales to customers located in Texas. S generates gross receipts of $5,000 of which $500 arises from sales to customers located in Texas. Corp. Texas Everywhere Margin Name Receipts Receipts P 4,000 5,000 1,000 S 500 5,000 3,000 Total 4,500 10,000 4,000 If P & S are required to file a combined report, the combined entity would owe Franchise tax of $18: P/S: 4,500/10,000 times 4,000 times 1% equals $18. If P & S are able to file separate reports, the two entities would owe Franchise tax totaling $11: P: 4,000/5,000 times 1,000 times 1% equals $8. S: 500/5,000 times 3,000 times 1% equals $3.

280 Texas Franchise Tax Page 269 No Nexus No Texas. If a member of a combined group has no nexus with Texas, then the member does not include any of its Texas receipts in the numerator of the apportionment fraction. 661 This rule is called the Joyce method of apportionment. 662 This method can be contrasted with the Finnigan method, which would include Texas revenues from no-nexus entities in both the numerator and denominator of the apportionment factor. 663 We previously discussed how to determine whether an entity has nexus in Chapter I Basic Concepts. No Nexus Yes Everywhere. Regardless of whether a member of a combined group has nexus with Texas, the member includes all of its receipts (from Texas and everywhere else), in the denominator of the apportionment fraction. 664 Example P Corp owns 100% of S Corp. P and S are both taxable entities. Only S has nexus in Texas. P generates gross receipts of $5,000 of which $4,000 arises from sales to customers located in Texas. S generates gross receipts of $5,000 of which $500 arises from sales to customers located in Texas. Corp. Texas Everywhere Margin Name Receipts Receipts P 4,000 5,000 1,000 S 500 5,000 3,000 Total 4,500 10,000 4,000 P/S owe Franchise tax of $2: 500/10,000 times $4,000 times 1% equals $ Texas Tax Code (b). See Appeal of Joyce, Inc., Cal. State. Board of Equal., November See Appeal of Finnigan Corp, Opn. on Pet. for Rehearing, 88-SBE-022A, Jan. 24, Texas Tax Code (c).

281 Page 270 Texas Franchise Tax No-Nexus Member Reports. This provision is repealed for reports originally due on or after January 1, These rules apply for earlier report years: Even though Texas gross receipts for no-nexus entities will not be used in the combined group s apportionment calculation, the Legislature still requires each member entity to report Texas gross receipts. 666 The report also requires the taxpayer to reveal what portion of the Texas gross receipts are subject to taxation in another state under a throwback law. This data is for informational purposes only; revenues from entities without Texas nexus are still excluded from the Texas gross receipts calculation. The Comptroller obtains this information on Lines 8 and 10 of Form no , the Affiliate Schedule, which all combined groups must complete: H.B (83 rd Reg. Legis. Session) effective Jan 1, Texas Tax Code (c) and (d).