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THE NEWTEXAS FRANCHISE TAX
GREENBERG TRAURIG, LLP | ATTORNEYS AT LAW | WWW.GTLAW.COM
Recent legislation enacted as a result of the Texas school finance crisis has replaced the more or less voluntary Texas franchise tax with a radically expanded business tax, labeled by its critics as the largest tax increase in Texas history. Background Last November, the Texas Supreme Court ruledthat the state’s current school finance system was unconstitutional. The Court set a June 1, 2006 deadline for the Texas Legislature to correct the constitutional deficiencies. In anticipation of the Court’s ruling, Governor Rick Perry called a 30day special session that began on April 17, 2006 to address the school finance problem. After 29 days of arm-twisting, negotiation and several nearmeltdowns, the Legislature adjourned the special session on school finance on Monday, May 15, after passing five bills addressing this issue, and the Governor signed all into law. HB 3 establishes a new mechanism for the calculation of a modified franchise tax, referred to as the new “margin tax,” and expands the taxpayer base to include Texas businesses that currently enjoy state liability protection.The revised tax bill takes effect January 1, 2008, and applies to reports due on or after that date. In addition, the bill appropriates $2 million in general revenue to the Comptroller for fiscal years 2006-2007 for audit and enforcement activities. Summary of the Current Franchise Tax Under Tax Code, ch. 171, the state levies the corporate franchise tax, Texas’ primary business tax, in exchangefor granting the privilege (franchise) of doing business in Texas. The tax applies only to for-profit corporations and, since 1991, to limited liability companies (LLCs) chartered or organized in Texas, as well as to foreign corporations and LLCs based or doing business in the state. As such, franchise taxpayers include professional corporations, banks, savings and loan associations, statelimitedbanking associations, and professional LLCs, but not limited partnerships, sole proprietorships, or non-corporate associations. Insurance and open-end investment companies (e.g., mutual funds) and most non-profit corporations are excepted, as are corporations with gross receipts less than $150,000 or owing less than $100 in tax. Major exemptions and exclusions include interest earned on federalsecurities, business loss carryover, and officer/director compensation paid by companies with 35 or fewer shareholders. A dual calculation method determines the amount of tax liability. Taxpayers pay the greater of a 0.25 percent tax on taxable capital (assets’ net worth) or a 4.5 percent tax on earned surplus (modified net income). The income component generates the most revenue and is paid by about75 percent of franchise taxpayers. In recent years, some large Texas-based firms have reorganized as partnerships under state law. As such, they no longer pay franchise tax. Examples include Dell Computer and SBC Communications (now AT&T). Firms accomplish this by forming wholly owned out-of state subsidiaries, usually in tax-friendly states such as Delaware – hence, the resulting entity has beennicknamed “the Delaware sub.” Typically, the subsidiaries enter into limited partnerships wherein the general corporate partner owns 0.1 percent of the operating assets in Texas and the limited partners own 99.9 percent. Under the Comptroller’s administrative rules, foreign corporations acting as limited partners are not considered to be doing business in Texas for tax purposes and
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