Texas Franchise Tax. Internal Revenue Code Capital of Texas Enrolled Agents Conference November 13, 2012 Austin, Texas

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1 Texas Franchise Tax and the Internal Revenue Code Capital of Texas Enrolled Agents Conference November 13, 2012 Austin, Texas Presented by: Janet Spies Texas Tax Training & Consulting

2 Overview IRC References and Code provisions in Chapter 171 What effect does the Tax Code Definition [Section (9)] of Internal Revenue Code have on the computation of margin? What does Section (b) mean when it says a reference to an amount reportable as income on a line number on an Internal Revenue Service form is the amount entered to the extent the amount entered complies with federal income tax law? What do Sections 263A, 460, or 471, Internal Revenue Code, have to do with the computation of cost of goods sold? 2

3 Definition (9) "Internal Revenue Code" means the Internal Revenue Code of 1986 in effect for the federal tax year beginning on January 1, 2007, not including any changes made by federal law after that date, and any regulations adopted under that code applicable to that period. 3

4 IRC Provisions in Texas Tax Code Chapter 171 Section 475(c)(2), Internal Revenue Code definition of a Security Section 761(a), Internal Revenue Code federal partnership rules Sections 671 and 7701(a)(30)(E), Internal Revenue Code Grantor Trusts Section 501(c)(3), Internal Revenue Code Charitable Entities Section 7701(a)(30)(D), Internal Revenue Code Estate of a Natural Person Section 856, Internal Revenue Code REIT s 4

5 IRC Provisions in Texas Tax Code Chapter 171 cont d Section 856(i)(2), Internal Revenue Code Qualified REIT Subsidiaries Section 860D, Internal Revenue Code REMIC Section 501(c)(9), Internal Revenue Code Trusts Section 78 or Sections , Internal Revenue Code foreign royalties and dividends Section 197, Internal Revenue Code Section 174, Internal Revenue Code Section 263A, 460, or 471, Internal Revenue Code UNICAP, Inventory Valuation 5

6 References to IRC in Texas Tax Code Chapter 171 federal gross income - passive entities amount reportable as income on a line number on an Internal Revenue Service form Revenue computation (b) the tax basis as determined under the Internal Revenue Code of securities underwritten revenue exclusion (g)(2) the tax basis as determined under the Internal Revenue Code of securities and loans sold. revenue exclusion (g-2) Medicare wages and tips box of Internal Revenue Service Form W-2 compensation changes to federal income tax return 6

7 Passive Entities TTC / Rule Must be a general, limited, or limited liability partnership, joint venture or a trust (not a business trust). Determination of passive is based on the activity in the applicable accounting period; 90% of the entity s federal gross income must be from passive activities as described in : Dividends Interest Distributive share of partnership income or income from a LLC Net capital gains from sale of real property, commodities (sold on an exchange), and securities Royalties, bonuses, delay rental income from mineral properties Rent is not considered passive income. 7

8 Total Revenue TTC / Rule Total revenue should be based on the equivalent line numbers from the corresponding federal report and computed based on the Internal Revenue Code of 1986 in effect for the federal tax year beginning on January 1, 2007 Must be amounts reported on return not amounts that may be reported on the return as an acceptable method [ (b)] Franchise tax revenue will not always equal revenue reported on federal tax return line items if federal law changed after January 1,

9 Total Revenue - Case Study net vs. gross? Travel agent sells airplane ticket to customer for $1,000. Agent pays airline $900 and retains $100 as a commission. What is the appropriate amount of revenue to be reported for federal income tax reporting? Should line 1c of the form 1120 show $1,000 as the sales price since it was the amount invoiced to the customer? OR should the agent report only $100 on line 1c? 9

10 Total Revenue - Case Study net vs. gross? IRC 446(a) Taxable income shall be computed under the method of accounting on the basis of which the taxpayer regularly computes his income in keeping his books. Form 1120, Instructions for item 1 say to enter gross receipts or sales from all business operations except those that must be entered on lines IRC 6501(e)(1)(A)(i) states in the case of a trade or business gross income means the total of amounts received or accrued from the sale of goods or services prior to diminution by the cost of such sale or service. Do the gross income provisions of IRC 6501 apply when the taxpayer merely serves as a conduit? 10

11 Total Revenue - Case Study net vs. gross? Gross income is defined by IRC 61(a)...all income from whatever sources derived Federal Revenue Rule where a taxpayer receives funds burdened with an obligation to be expended for a specific purpose the funds so held do not constitute gain or income No precise guidance by IRS case by case basis 11

12 Cost of Goods Sold Texas Tax Code (TTC) Section defines goods as real or tangible personal property sold in the ordinary course of business The capitalization rules of IRC Section 263A, generally apply to: 1) real or tangible personal property produced by the taxpayer, and 2) real or personal capital assets that are acquired by the taxpayer for resale. TTC provides for specific costs that can be used in computing COGS in Subsections (c), (d), (e), and (f) More often than not, the COGS computation for federal income tax will NOT be the same as the COGS computation for Texas franchise tax. 12

13 Cost of Goods Sold - differences Item Texas Franchise Tax Federal Income Tax Interest Expense None some Officer Compensation none some Mixed Service Costs 4% if allocable to produced goods 100% if allocable to produced goods 13

14 Cost of Goods Sold Expense vs. Capitalization (g) = A taxable entity that is allowed a subtraction by this section for a cost of goods sold and that is subject to Section 263A, 460, or 471, Internal Revenue Code, may capitalize that cost in the same manner and to the same extent that the taxable entity capitalized that cost on its federal income tax return or may expense those costs, except for costs excluded under Subsection (e), or in accordance with Subsections (c), (d), and (f) (h) = A taxable entity shall determine its cost of goods sold, except as otherwise provided by this section, in accordance with the methods used on the federal income tax return on which the report under this chapter is based. This subsection does not affect the type or category of cost of goods sold that may be subtracted under this section. 14

15 Compensation (a) Except as otherwise provided by this section, "wages and cash compensation" means the amount entered in the Medicare wages and tips box of Internal Revenue Service Form The term also includes, to the extent not included above: (1) net distributive income from a taxable entity treated as a partnership for federal income tax purposes, but only if the person receiving the distribution is a natural person; (2) net distributive income from limited liability companies and corporations treated as S corporations for federal income tax purposes, but only if the person receiving the distribution is a natural person; (3) stock awards and stock options deducted for federal income tax purposes; and (4) net distributive income from a limited liability company treated as a sole proprietorship for federal income tax purposes, but only if the person receiving the distribution is a natural person. 15

16 Questions 16

17 Contact information Janet Spies Texas Tax Training & Consulting P.O. Box Austin, TX (512) cell (512) office 17

18 Disclaimer The information contained herein is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavor to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act on such information without appropriate professional advice after a thorough examination of the particular situation. 18