Consider revisiting the Texas franchise tax during inflation

Too often businesses take the same position on state tax returns year after year – lovingly termed SALY (same as last year) by many of us in the accounting industry. This is particularly true when there have not been significant legislative or legal changes in a particular state. Businesses, especially those in the middle market, often fail to take economic conditions into account when preparing returns. This occurs with respect to many types of taxes. Through the last few months, the United States is experiencing the highest inflation rates in over 40 years. High inflation affects many aspects of business operations, profitability, and ultimately tax liabilities. But taxpayers should be aware that rising inflation can have a significant impact on Texas franchise or margin tax liabilities.

As most know, the margin tax applies to corporations, limited liability companies, partnerships, business trusts, professional associations, business associations, joint ventures, and other legal entities organized in Texas or that do business in Texas. Entities with revenues of $1,230,000 or less do not owe the tax. All entities, however, must file franchise tax returns.

Rising inflation can, and likely will, affect the tax base. The base is the entity’s margin which is equal to the lesser of the entity’s: total revenue minus cost of goods sold, total revenue minus compensation, total revenue minus $1 million, or 70% of the entity’s total revenue. The taxable margin is the lowest of the four calculations. The taxable margin is then apportioned if appropriate.

A business’s cost of goods generally is the costs related to the acquisition and production of tangible personal property and real property. Compensation and benefits include wages and cash paid to officers, owners, partners, and employees as well as workers’ compensation, health care, and retirement benefits. In most industries and sectors, the costs of goods sold and compensation have risen significantly due to inflationary pressures and ongoing pandemic response around the globe.

A business subject to franchise tax may have traditionally had higher compensation costs relative to costs of goods sold. The opposite may have been true as well. A business may have long used the 70% of total revenue as the basis for the tax because it had modest cost of goods sold or compensation. Inflationary pressures in both labor and costs of goods may change those outcomes. Higher inflation is projected to last for the foreseeable future. Therefore, understanding and modeling this effect on franchise tax calculations is important not only for the current filing periods but for planning purposes.

Finally, there have also been many legal developments with respect to the Texas franchise tax. Several Texas Supreme Court decisions have been issued concerning the definition of costs of goods sold and sourcing of receipts. See, for example, Hegar v. Gulf Copper & Manufacturing Corp. and Sirius XM Radio Inc. v. Hegar, There have also been statutory developments granting tax reductions to the aerospace industry and revised sourcing rules in the past year or so. While many businesses and tax professionals may be aware of those changes, they should also consider that rising prices may affect the overall franchise tax calculation and ultimate liability in Texas. Taxpayers with questions should speak to their Texas state and local tax adviser for more information.