With New Margin Tax, Keep Your Eraser Handy

By Jim Jordan

Jim Jordan is director of construction services for Weaver and Tidwell LLP. With offices in Dallas, Fort Worth and Houston (weaverandtidwell.com).

Five months before contractors must pay the state’s new margin tax, the rules are still changing. In fact, several revisions are scheduled to go into effect this month, changes that will only muddy the waters further for contractors who haven’t kept up with the issue.

On May 18 of last year Gov. Rick Perry signed SB 3, a bill establishing a margin tax that replaced the state’s franchise tax of 4.5% of taxable income. The margin tax levied a 1% tax based on Texas gross receipts, less certain deductions. Excluded from the margin tax were sole proprietorships and all businesses with less than $300,000 in revenue. Also exempted were general partnerships, certain passive limited partnerships, passive family limited partnerships, and businesses whose tax liability is less than $1,000.

The new tax hits contractors especially hard because many organized their businesses as limited partnerships to avoid paying the loophole-riddled state franchise tax. That was a major reason why the law was changed: Each year only about one of 16 Texas businesses actually paid the franchise tax.

As you may remember, the margin tax applies to the lower of three calculations: gross revenue less employee compensation including benefits; gross revenue less cost of goods sold; or 70% of gross revenue. The smallest computed amount is called taxable margin. The contractor then must apportion it to business conducted in Texas. The tax rate then is applied to the apportioned margin to arrive at the tax that is due.

The new margin tax has been controversial from the beginning. Perry swears it isn’t an income tax, but many others feel differently. The accounting industry, for its part, says that the magnitude of the deductions applied in determining the tax base make the new tax a tax on income, and therefore it must be accounted for under Financial Accounting Standards 109, Accounting for Income Taxes.

Income tax or no, some rules changed again this year when the governor in June signed HB 3928, which added numerous technical corrections. For contractors, the most important are these:

E-Z Tax Computation HB 3928 adds an “E-Z” tax computation for a taxable entity with less than $10 million of revenue from its entire business. Tax is calculated on apportioned revenue at a rate of 0.575 percent. However, no deductions, credits or other adjustments are allowed if the company chooses to pay the “E-Z” tax.

Tax Credits Franchise tax credits available prior to enactment of the margin tax may generally be carried over and applied against margin tax liability. HB 3928 specifies that only those credits that were established by a taxpayer prior to the effective date of HB 3 (Jan. 1, 2008) are eligible for carry-forward. Originally the law required that credits must be “accrued’’ prior to the SB 3 effective date.

Reduced Tax for Certain Small Businesses HB 3928 provides some small business relief by providing a tax reduction or discount tied to the company’s “total revenue from its entire business.’’ The discount is applied after the tax liability has been computed less any allowable credits as follows:

• Revenue greater than or equal to $300,000 but less than $400,000: 80-percent discount
• Revenue greater than or equal to $400,000 but less than $500,000: 60-percent discount
• Revenue greater than $500,000 but less than $700,000: 40-percent discount
• Revenue greater than or equal to $700,000 but less than $900,000: 20-percent discount

Flow-Through Deduction The flow-through deduction is now included in the Texas margin tax calculation for large businesses. This means that businesses in Texas with more than $10 million in taxable business will still pay the 1-percent margin tax (on total revenue minus flow-through deductions) on one of either three methods of calculations:

• A: Pay 1 percent on 70 percent of total revenue, apportioned for Texas.
• B: Pay 1 percent of total revenue minus cost of goods sold, apportioned for Texas.
• C: Pay 1 percent of total revenue minus employee compensation, again apportioned for Texas.

Combined Reporting One of the most challenging aspects of the new margin tax involves its introduction of a combined unitary filing requirement. SB 3 requires that affiliated companies file a single return as a combined group. Once a combined group is identified, each entity must determine its revenue and deductions for compensation or cost of goods sold. Each entity’s amounts are then added to the other entities, and any inter-company transactions are eliminated. The combined entity, not the individual members, must then decide which deduction to take - 30% of revenue, cost of goods sold, or compensation. All members must make the same deduction.

HB 3928 brings a little better clarity to the issue of combined reporting. It states that:

• The group’s ownership requirement for an affiliated group is reduced from 80% or more to 50% or more.
• Every member of the combined group has to include its activity for the same period as used by the combined group.
• The combined group’s taxable margin can’t exceed 70% of the combined group’s total revenue.
• A member of the group may claim as COGS those costs that otherwise would qualify as valid expenses if the goods for which the costs are incurred are owned by another member of the combined group.

HB 3928 won’t end the amendment/modification process because there are still many issues that should be addressed.

In the frenetic world of construction, it’s easy for contractors who are consistently profitable to focus on construction and not worry much about taxes. Yet taxes are one of the largest expenses on the income statement.

At the same time, sureties and bankers are anxious to learn how the margin tax will affect a construction company’s financial health. To remain on sound footing with financial partners, Texas contractors must be able to provide a thorough accounting of the effect of the tax.