For most entities subject to the Texas Franchise Tax, a two page form must be completed to calculate the tax due. So how difficult can that be to fill out, right? You’d be surprised. Filing in Texas is a whole lot more complicated than it first appears.
In order to do it correctly, you’ll need to take into account a number of issues, including what entities are subject to tax, which return dates you need to be aware of, how to calculate the tax and revenue – and many other “the devil is in the details” issues.
Here’s some guidance:
Entities Subject to Tax
As a general rule, most types of entities are subject to the TFT. But federal tax treatment of an entity does not necessarily determine its taxability for the Texas Franchise Tax. For example, individuals are not subject to the TFT, but disregarded entities are. If a sole proprietor owns a disregarded entity (SMLLC), a TFT return must be filed for that entity. Also, while most types of partnerships are subject to the TFT, general partnerships that have partners that are “natural persons” are not. A natural person is defined a s a human being or an estate of a human being under 3.581(b)(14).
To further complicate matters, Texas does not subject passive entities to the TFT. A passive entity derives 90% or more of its gross revenue from various sources including dividends, interest, and net gains, capital or ordinary. In addition, a passive entity includes an entity that has a distributive share of income from a partnership as long as it is greater than zero. Some passive entities are GP’s, LP’s and LLP’s, – but not LLC’s or corporations.
Aside from the confusion surrounding entities, you need to be aware of four key dates in order to correctly fill out the form.
Here are the crucial dates:
• The Accounting Period
• The Privilege Period
• The Due Date of the return
• The report year
The Accounting Period has a beginning and ending date and generally coincides with the tax year of the company. In the year a company becomes subject to the TFT, the beginning and ending date can be the same. For example, if an entity has an October 31, 2016 year end and first becomes subject to the TFT on December 1, 2016, the beginning accounting period and ending accounting period would both be December 1, 2016 and a zero report would be filed. If it first became subject to the TFT on October 1, 2016, the beginning accounting period would be October 1, 2016, and the ending would be October 31, 2016 and a TFT return would be filed for that one month’s activity. The next accounting period in both instances would be November 1, 2016 to October 31, 2017.
The Privilege Period is generally the year following the accounting period. However, for initial reports the dates could overlap and a privilege period could be longer than 12 months.
The Due Date of a TFT Return is always May 15th. It does not matter whether a company has a 52/53 week tax year, a fiscal tax year, or a calendar tax year. In the example above, the return with an October 31, 2016 ending accounting year would be due May 15, 2017. The Report Year is the year the TFT return is due. In this example, the Report Year would be 2017.
The next hoop you’ll need to jump through is the calculation of tax. Use the following guidelines to do so:
Calculation of tax
The taxable margin is the lower of four calculations:
a) 70% of revenue,
b) Revenue less Cost of Goods Sold (COGS),
c) Revenue less compensation,
d) Revenue less $1 million.
When calculating revenue for a single entity, most of the numbers are straightforward. However, you need to examine Line 9, (exclusions from gross revenue) very carefully. Among the more common exclusions for single filers are bad debt expense, foreign dividends and royalties, interest from federal obligations, and net distributive income. If a taxable entity receives its pro-rata share of income from another taxable entity, it can deduct its pro-rata share on this line – unless a tiered partnership election is filed. However, if the distributive share comes from a passive entity, it may not be deducted unless that income was picked up in total revenue of another entity. For combined reports, any intercompany eliminations affecting revenue get excluded here, since all the revenue of every member is included in total revenue before exclusions.
Cost of Goods Sold (COGS)
COGS can be a fairly difficult computation for the TFT, and a thorough examination is beyond the scope of this post. You should keep a few things in mind, however. For instance the amount, in many cases, is not the same as on the federal return. COGS, for example, does not include officer’s compensation, freight out, and distribution costs among other expenses. In addition, an entity can subtract indirect costs such as certain mixed service costs, but only to the extent of 4% of these costs. Lastly, although not expressly mentioned, the reclass of costs in the numerator of the absorption ratio from SG&A to COGS would not appear to be deductible as part of COGS.
Compensation consists mainly of Medicare wages on Form W-2 as well as net distributive income reported to natural persons from S Corporations, trusts, partnerships, disregarded entities owned by sole proprietors, and LLCs. Compensation is capped at $360,000 for the 2016 Report Year, per employee, officer, director, etc. If net distributive income is negative, it must be subtracted from other compensation.
A single sales factor is used to calculate the TFT. The denominator of the factor must tie to total revenue. If filing a combined return, only sales from companies included in the combined report that have nexus in Texas are included while all companies, whether or not they have Texas nexus are included in the denominator (Joyce Rule). Any intercompany sales between companies in the combined report that have nexus in Texas get eliminated from the numerator.
Tax Rates for the TFT have been declining since the revised franchise tax was instituted in 2008. One item to note is the rate for qualifying retailers and wholesalers is half that for most entities. To be a qualifying wholesaler or retailer, total revenue from activities in wholesale and retail trade must be greater than total revenue from other types of activities per Texas Admin. Code 3.584(d)(3)(A).