The Texas Margin Tax: Still Darn Crazy After All These Years
Did you know that if you have been doing business in Texas for over a decade, then by November 15th you will be filing your Texas franchise tax return under the “new” Margin tax regime for the eleventh time? You would think after that many years, the tax would have matured to a level of certainty where we could all feel comfortable that we aren’t missing anything. But if you look back at the guidance we’ve received, you quickly realize that might not be the case. This tax has had a complicated history. It has caused the Texas legislature to hold two special sessions, resulted in two Texas Supreme Court decisions, created three blue ribbon committees and a herd of lower court decisions and administrative hearings. In the 2015 legislative session alone, close to 100 bills and resolutions to the Margin tax were filed. Thirteen of those proposals would have repealed this tax in its entirety.
If the implementation of this version of the Texas franchise tax has caused so much commotion, why did the state change from the old method? Basically, they were forced into it by the Texas Supreme Court in 2005 declaring that the school financing system was unconstitutional. The court gave Texas legislators seven months to correct the problem and the Margin tax was born. It is best described as a “modified gross receipts tax” and not an income tax. Those two words (income tax) are burrs under the saddles of Texas legislators, because a majority of state voters would be required to approve any income tax. Luckily, Texas courts have sided with the legislators, finding that this is not an income tax.
I note that some pretty smart buckaroos at the FASB disagree. I guess if it looks like a duck and quacks like a duck…
Texas Margin Tax At a Glance
Texas also voted to apply the new Margin tax to nearly all entities, including partnerships that were not taxed under the old regime. We all remember that loophole. It was as big as a Texas lasso and if you were a state tax planner, it was always one of the first tricks you’d pull out of your cowboy hat. In 2002 alone, close to one thousand corporations converted to limited partnerships to take advantage of that loophole and the state estimated that it lost $143 million in revenue in 2003 from these converted legal entities. Texas needed to put that planning idea out to pasture, and they did just that with the new law.
As we all know, any time a legislature devises a new tax plan the goal is almost always to increase revenue. Can you say BINGO? In the first year of Margin tax filings in 2008, the new tax produced almost $4.5 billion of revenue; or over 40% more than was collected under the old format in the prior year. I was in the corporate world back then and remember how we got completely whipsawed by the new regime.
The Margin tax looks relatively simple on its face. In short, a business’ Margin tax liability is based on that entity’s “taxable margin.” Your taxable margin is the lesser of three calculations; 70% of total revenue, total revenue less cost of goods sold (“COGS”), or total revenue less compensation. You then apply the Texas sales apportionment factor to the lowest margin and multiply the result by the appropriate tax rate.
The 70% of revenue calculation is just that…so, very straightforward. The compensation method gets a little tricky due to a few quirks, including the limitation it places on the compensation it allows as a deduction per employee, but still reasonably underwhelming. And although we tax folk can argue about anything, both methods leave little room for controversy.
Texas COGS and IRC Section 174 Costs
Too bad they didn’t just stop there, am I right? No, they had to add one more method. Since day one, the elephant in the room has been the COGS method. Texas COGS is not your father’s (I mean federal) COGS. In fact, Texas law disallows a plethora of items that are required to be capitalized into federal COGS. It is also not your book COGS. Then why call it COGS? The answer actually makes horse sense. Texas has always considered itself a country, and as noted above, they don’t agree with the FASB on whether the Margin tax is an income tax. So, they invented their own COGS. That said, the typical taxpayer will use their federal COGS as a starting point. Your typical Texas auditor will start with your federal COGS detail, and – based solely on the description of the line item – take a pen and just start crossing things out. The point here is that if you have items that are properly includible in Texas COGS but are not in your federal COGS, you might not be getting those dollars into Texas COGS.
In our many years of working with clients on Margin tax matters, one of the most common and biggest “misses” by taxpayers is that they do not include some or all of their IRC section 174 costs in their Texas COGS deduction (specifically allowable under Texas law) simply because of how their general ledger accounts are mapped into their tax preparation software. And when I say big, I mean Texas big.
Generally, 174 costs will be spread across many line items, including salaries and depreciation, or even end up buried in other deductions. In many organizations, total 174 costs can be twice the amount shown as qualified research expenses, or QREs, on Form 6765. For major technology and similar companies, those numbers can be staggering. We have literally added billions of dollars to existing COGS calculations, leading to millions of dollars of client refunds, solely from “missed” 174 costs.
That said, what we have also seen many times is for Texas to then scrub your 174 cost calculation (similar to the way they scrub your federal COGS) and attempt to throw some or all of them out saying that those line items are not “directly related to the production of goods.” But wait: by definition, 174 costs are not directly related to the production of goods. They occur before the production of goods. This reasoning of the Texas Comptroller’s office is all hat and no cattle, because no 174 costs would ever get into Texas COGS, rendering the relevant statutory language/deduction moot. Confused? Don’t worry, so is Texas.
Don’t Be a SALY
We all know that once you get comfortable with a tax (or any other) calculation, you tend to take the SALY (same as last year) approach. If you file your Texas return with that mindset, it’s probably time to rethink. There have just been too many changes to the “rules” since 2008. Remember when Texas said you couldn’t elect COGS or Compensation on an original return, and then change to another method on an amended return? That position lasted from 2008 until it was changed in 2012. Another approach in the early days was for a Texas auditor to posit that the COGS deductions wasn’t an allowable method for many of our clients. As you guessed it, many of those rules were later changed.
One thing to be wary of is a “no change” by a Texas (or any other, for that matter) auditor. This is not an indicator that we simply did everything right. Nine times out of ten, this is exactly when the taxpayer should take a look back and revisit that COGS deduction.
Further evidence that one should never rest on their laurels (or their previous Texas COGS calculation) is the language that Texas includes in their closing letter approving our clients requests for refund:
“The results of this refund should not be taken as approval of your tax operating system. Law changes and new rulings might result in different findings in the future and you will be responsible for any taxes found owing and due.”
Yep…even Texas recognizes that these changes will continue so keep watching. We promise to do the same.
Maximize Your COGS Deduction
So, why write on this topic now? To give you time before November 15th to dig deep into your general ledger to insure you are maximizing your COGS deduction before filing this year’s return. Remember, Texas has a four-year statute of limitations. Thus, any additional deductions you uncover now could have a five-year impact, when you include the four years of refunds we would love to help you recover.
Good luck, and remember: we are here to help if you need us. This ain’t our first rodeo! You can holler at us via phone: 617.451.0303 or email: firstname.lastname@example.org.
GAGNONtax works closely with professionals nationwide to solve their tax challenges, using creative strategies and leading-edge technology. Whether it’s through our tax consulting, tax compliance, or tax technology practices, we look at your specific challenges and find the perfect balance between risk and reward. Let’s talk about how we can help you.