New Margin Tax Will Impact Texas Contractors

By Jim Jordan

Jim Jordan is director of construction services for Dallas/Fort Worth-based Weaver and Tidwell LLP.

Jordan suggests that Texas contractors prepare to comply with the state's new margin tax law.

Since Gov. Rick Perry signed the new margin tax into law on May 18, an increasing number of contractors have come to see the writing on the wall: The construction industry is going to be hit hard when the new law takes effect in 2008. Considered by some to be the largest tax increase in the state's history, the margin tax replaces the franchise tax of 4.5 percent of taxable income with a 1 percent margin tax based on Texas gross receipts, less certain deductions. Expected to raise an additional $3.4 billion per year in taxes, the law will impact any Texas business organized to provide some form of limited liability protection.

Excluded from the margin tax are sole proprietorships, which account for about 1.6 million of the state's 2.4 million businesses, and all businesses with less than $300,000 in revenue. Also exempt are general partnerships, certain passive limited partnerships, passive family limited partnerships and businesses whose tax liability is less than $1,000. While contractors will pay a 1 percent tax, wholesalers and retailers will pay half that. The law provides for lower property taxes to help offset the new tax.

Contractors are going to be responsible for a significant share of the new tax because so many reorganized their businesses as limited partnerships to escape paying the loophole-riddled state franchise tax. It was a great idea - while it lasted. The problem, however, was only about one out of 16 Texas businesses actually paid the previous franchise tax. Hence the new margin tax, which is designed to close those loopholes in a huge way. Once the law begins, about 50,000 limited partnerships will join the state's tax base, according to the Texas Taxpayers and Research Association in Austin.

There are still a few issues about the margin tax that remain unresolved. In fact, the law states that if anyone challenges the margin tax, the State Supreme Court automatically will be asked to determine within 120 days whether the tax is merely a variation on the existing franchise tax or a thinly disguised income tax, which is unconstitutional without voter approval.

The first margin tax payment will be due in May 2008. Contractors should begin to plan their compliance strategies. For calendar year companies, the tax will be computed by using revenues and costs beginning Jan. 1, 2007. In contrast, the new rules will apply to some >> fiscal-year companies as early as June 1, 2006.

The new 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 percent of gross revenue. The smallest computed amount is called taxable margin. The contractor will then apportion it to business conducted in Texas. The tax rate is then applied to the apportioned margin to arrive at the tax due.

The compensation deduction includes payment -- to employees, partners, officers, directors and owners -- of wages, salaries, stock options and net distributive income up to $300,000 per individual. In addition, the cost of employee benefits may be included if they are deductible for federal income tax purposes. These benefits include health insurance, workers compensation and pensions, but exclude payroll taxes. For companies expecting to take the deduction, it may make more sense to hire workers as employees. Wages and benefits paid to employees will be deductible. Payments to independent contractors and temporary staffing companies won't be. However, there are special rules for staff-leasing and management companies and their customers.

While many have the impression that the new tax will be simple to compute, application of the provisions in the law are complex. For example, the cost of the goods-sold deduction for Texas purposes is not the same as that allowed for federal income tax purposes. Accordingly, contractors will have to make cumbersome adjustments to their federal tax cost-of-goods-sold to conform to the Texas definition. The legislation has an extensive list of what can and cannot be deducted. Under the new law, a "good'' only includes real or tangible personal property, but the definition of tangible personal property is quite broad.

Another issue relates to the introduction of combined unitary filing requirements, a dramatic shift from the separate return policy.

Under the new law, affiliated companies must 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 percent of revenue, cost of goods sold or compensation. All group members must make the same deduction.

Again, school property taxes are supposed to be reduced by roughly one-third to offset higher tax payments. However, many contractors don't own much land and many lease their equipment. That means lower school taxes won't provide much tax relief for some small and mid-size contractors.