Texas Governor Rick Perry on May 18 signed H.B. 3, which expands the number of entities subject to the franchise tax and broadens the tax base by changing the method of computing the tax. H.B. 3 is part of the package of five bills passed in a special session devoted to the school finance reform mandated by the Texas Supreme Court.

The bill replaces the existing franchise tax with a new tax that applies to most business entities that have statutory liability protection, including many partnerships and professional associations. The bill eliminates the provisions that have allowed major companies to avoid the tax.

The new franchise tax is a 1% (.5% for retailers and wholesalers) tax levied on taxable margin. Taxable margin is defined as total revenue less deductions for either cost of goods sold or compensation and benefits. Here is an outline of the bill’s major points:

The tax applies to partnerships, corporations, limited liability companies, business trusts, professional associations, business associations, joint ventures and other legal entities with statutory liability protection, except for:

• Entities with gross receipts of $300,000 or less (inflation adjusted every two years)

• Entities who owe less than $1,000 in franchise tax

• Sole proprietorships

• General partnerships owned by natural persons

• Passive entities – as defined

• Tax-exempt entities – same ones that are tax exempt under current law

• Grantor Trusts where all parties are natural persons

• Estates

• Escrows

• Family limited partnerships that are passive entities and that do not operate a trade or business

The tax base of “taxable margin” is the lower of Texas total revenue less either cost of goods sold or employee compensation and benefits, but not more than 70% of total revenue:

• Total revenue is determined based on federal income tax reporting

• Cost of goods sold is traditionally defined, but excludes officer compensation and includes some specific items for specific industries

  • Affiliated entities may not deduct inter-company transactions as cost of goods sold unless the transactions is made at “arm’s length”

• Taxable entities selling services are not eligible for the cost of goods sold deduction

• Deductible employee compensation and benefits includes:

  • Wages and cash compensation paid to officers, directors, owners, partners and employees (including owner or partner distributions to natural persons), limited to $300,000 per person (the $300,000 is inflation-adjusted every two years)

  • Benefits provided to all personnel, including workers’ compensation, health care and retirement benefits to the extent deductible for federal income tax purposes

• Payments for undocumented workers are not deductible as cost of goods sold or as employee compensation.