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					 Texas Margin Tax
on Business Entities
         Texas Margin Tax - Agenda
• Background
• Comparison to current law
• Detailed analysis
• Application and planning
• Financial reporting




                                     2
       Texas Margin Tax – Background
• Texas Supreme Court holds that Texas system of funding
  schools violates Texas constitutional prohibition of a
  state-wide property tax, Neeley v. West Orange-Cove
  I.S.D. (Nov. 22, 2005) and established a June 1, 2006
  deadline for a legislative fix.
• Governor Perry appoints John Sharp to chair a Tax
  Reform Commission to recommend reform of the state’s
  business tax structure to close loopholes, broaden the
  base of businesses that pay the tax, and provide
  significant property tax relief.
• HB 3 (margin tax) enacted in special session and signed
  by Governor Perry May 18, 2006. Part of a package of
  bills that included property tax relief.




                                                            3
      Texas Margin Tax – Background

           Old Law - Delaware Sub “Loophole”

                                 Texas Corp.




                                                  Delaware
                 Texas Corp.
                                                   Corp.
               Gen. Partner                         Ltd. Partner
                                                  (No Texas nexus)

                                  Limited
                                Partnership



                               Texas Operations

Partnership not a taxable entity, Delaware Corp. not taxable (no
nexus), and dividend income from Delaware Corp. sourced to
location of payor (Delaware)



                                                                     4
       Texas Margin Tax – Background
• Solutions Considered
  – Tax the partnership
  – Tax the limited partner (attributed nexus)
• Solution Adopted
  – Tax the partnership
• Constitutional?
  – Texas Constitution Art. VIII, §24(a): “a tax on the net
    incomes of natural persons, including a person’s share of
    partnership and unincorporated association income…not
    take effect until approved by a majority of registered
    voters…” (known as the “Bullock amendment”)



                                                                5
       Texas Margin Tax – Background
                Old Law - “Geoffrey Loophole”

                                    Parent Co.




                                                  Delaware
                Texas Corp.                       Intangible
                                Royalty for use    Holding
                                 of Intangibles      Co.


             Texas Operations                     Intangibles




   Delaware Intangible Holding Co. not subject to Texas
    franchise tax (no nexus)
   Solution: combined reporting




                                                                6
  Texas Margin Tax - Comparison to Current Law
Feature    Current Law         New Law
Taxable    Corporations        Partnerships (other than a general
Entities                       partnership of all natural persons),
           Limited Liability   corporations, savings & loan associations,
           Companies           limited liability companies, business
                               trusts, professional associations, business
           Savings & Loan      associations, joint ventures, joint stock
           Associations        companies, holding companies and other
                               legal entities. §171.0002
           §171.001            Sole proprietorships, certain passive
                               entities, family limited partnerships and
                               statutory exempt entities not taxed.
                               Likely legislative clarification that tax
                               applies to general partnerships that are
                               limited liability partnerships even if all
                               partners are natural persons.




                                                                             7
 Texas Margin Tax - Comparison to Current Law
Feature       Current Law              New Law

Type of Tax   Privilege Tax            Same

Measure-      Pay tax in May for       Generally same
ment          privilege of doing       Special transition rules in HB3 §22
Period        business in Texas          6/1/06 cutoff date
              during the year.           newly taxable entities
              Tax is measured by         terminating entities
              business done in prior
              year.
              Additional tax (exit
              tax) for termination
              year
Reporting     Separate Company         Combined §171.1014
Method




                                                                             8
 Texas Margin Tax - Comparison to Current Law
Feature   Current Law              New Law
Base      Taxable capital or       Margin
          taxable earned surplus   Margin = total revenues minus greater of
                                   - Cost of goods sold
                                   - Compensation
                                   - 70% of total revenues




                                                                              9
 Texas Margin Tax - Comparison to Current Law
Feature      Current Law               New Law
Apportion-   Base is apportioned to    Same apportionment formula and rules.
ment         Texas according to the    No throwback.
             ratio of Texas receipts
             to total receipts         Only Texas receipts of combined group
                                       members having nexus with Texas
             Throwback: sales of       included in numerator. (May be changed
             tangible personal         to include Texas receipts of entire group.)
             property outside Texas
             "thrown back" to Texas    §§171.106
             under certain
             circumstances.

             §§171.106,
             171.103(1),
             171.1032(a)(1)




                                                                                     10
  Texas Margin Tax - Comparison to Current Law
Feature     Current Law             New Law
Rate        Greater of              1% of taxable margin (0.5% of for
                                    taxpayers in retail or wholesale trade)
            0.25% x capital

            or

            4.5% x earned surplus
Exemption No tax due if tax less    No tax due if tax less than $1,000 or total
Amount    than $100 or gross        revenue < = $300,000.
          receipts under
          $150,000                  CPI adjusted in 2009 and later. §171.006




                                                                                  11
 Texas Margin Tax - Comparison to Current Law
Feature     Current Law               New Law

Reporting   Annual report generally   Unchanged
            due May 15, with          Information report for 2007 for large
            special rules for newly   taxpayers
            taxable entities
            §§171.151 - 171.212



Credits     Various special credits   Generally repealed. Accrued and unused
and NOL     under Subchapters L       credits carry forward. Current law loss
Carry       through U                 carryovers converted to temporary credit
forwards    Business loss carryover   against margin tax (requires legislative
            for earned surplus        clarification).
            §171.110(e)               §171.111, HB3 §§17-19




                                                                                 12
  Texas Margin Tax - Comparison to Current Law
Feature     Current Law             New Law
Effective   2006 and 2007 reports   2008 reports filed under margin tax.
Dates       filed under existing    Calendar year accounting taxpayers
            franchise tax.          subject to margin tax on revenue
                                    beginning 1/1/07.
                                    Fiscal year entities subject to margin tax
                                    beginning as early as 6/1/06 (9/1/06?).




                                                                                 13
       Texas Margin Tax – Taxable Entities
          Taxable Entities               Non-Taxable Entities
•   Partnership                   • Joint Operating arrangements electing
•   Corporation                     out of IRC subchapter K
•   Banking Corporation           • Sole proprietorships
•   Saving and Loan Association   • General partnership directly owned only
                                    by natural persons
•   Limited Liability Company     • Passive entities
•   Business Trust                • Entity exempt under Ch. 171(B)
•   Professional Association      • Escrows
•   Business Association          • REMICS (IRC § 860)
•   Joint Venture                 • Estate of Natural Person
•   Joint Stock Company           • Certain:
•   Holding Company                  –   Grantor trusts
•   Other Legal Entity               –   Estates
•   “Combined Group”                 –   Family limited partnerships
                                     –   Passive investment partnerships
                                     –   Trusts
                                     –   REITS




                                                                           14
  Texas Margin Tax - Nontaxable Entities
• Passive Entity § 171.0003
  – Must be a general partnership, limited partnership or trust that is not a
    business trust
  – At least 90% of Federal gross income for measurement period must be:
      • dividends, interest, foreign currency exchange gain, certain payments with respect to notional
        principal contracts or financial instruments, option premium and income from LLCs.
      • positive distributive shares of partnership income
      • gain from the sale of real property, traded commodities and securities
      • bonuses, royalties, delay rentals from mineral properties and income from nonoperating mineral
        interests
  – No more than 10% of Federal gross income (presumably for the same measurement
    period) is from conduct of an active trade or business. (?)
  – Passive income not treated as active even if earned in an active business. (But
    Instructions for 2007 Information Reports are contrary)
  – Rent and income from mineral properties operated by an affiliated group member
    under a joint operating agreement are always active income.




                                                                                                         15
 Texas Margin Tax - Nontaxable Entities
• Family Limited Partnerships
  – § 171.0002(c)(4) . . . not taxable if:
     • A passive entity; and (?)
     • ≥ 80% owned directly or indirectly by members of same family,
       including ancestors and lineal descendants
     • A limited partnership formed under Texas or another state’s law
       or treated as a partnership for federal income tax purposes




                                                                         16
 Texas Margin Tax - Non-Taxable Entities
• Passive Investment Partnerships
  – § 171.0002(c)(5) & (6) . . . not taxable if:
     • A passive entity, and (?)
     • Formed under the limited partnership laws of Texas, another
       state or any foreign country.

• Trusts
  – § 171.0002(c)(7) . . . not taxable if:
     • A passive entity, and (?)
     • Taxable as a trust under IRC § 641
     • All beneficiaries are natural persons or 501(c)(3) charities
     • Not taxable as a “business trust” under § 301.7701-4(b); and
     • Described in 7701(a)(30)(e) of IRC.




                                                                      17
 Texas Margin Tax - Non-Taxable Entities
• REITS and “qualified REIT subsidiary entities” (IRC § 856
  defined)
  – § 171.0002(c)(8) . . . not taxable unless:
     • REIT holds “any amount” of its assets in direct holdings of real estate not
       occupied by the REIT for business purposes.
  – An entity that holds a direct interest in real estate is not exempt as
    a REIT, even if owned by a REIT.
• Grantor Trusts
  – § 171.0002(c)(1) . . . not taxable if:
     • A grantor trust as defined in IRC §§ 671 & 7701(a)(30)(E) [i.e., a “US”
       trust], and
     • All grantors are natural persons or 501(c)(3) charities, and
     • It is not a trust taxable as a business entity under Reg. § 301.7701-4(b).




                                                                                     18
       Texas Margin Tax – Type of Tax
• Tax imposed on each “taxable entity” that
 – does business in this state, or
 – is chartered or organized in this state
• Not an “income tax” HB3 §21 (?)
 – Effect = P.L. 86-272 (restrictions on taxation of out-of-state
   entities) does not apply to the tax
 – Deductible in other states?
 – NB: is an income tax for financial reporting (FAS 109)
   purposes




                                                                    19
     Texas Margin Tax – Measurement
• Measurement Periods
 – Generally imposed for current calendar year based on
   business done in most recently ended prior accounting period
   (i.e., 2008 tax is based on 2007 FYE business)
 – Complicated rules regarding initial tax calculations for newly
   formed entities are retained. §§171.151-153, 171.201.
 – Additional tax on termination (a/k/a “exit tax”) is also
   retained. §171.0011
    • Exit tax not imposed on a taxable entity that becomes a passive
      entity. §171.0011(e)




                                                                        20
  Texas Margin Tax – Reporting Method
• Combined Reporting Requirement
 – Required of all taxable entities that are part of an affiliated
   group that is engaged in a unitary business. Treated as a
   single taxable entity for margin tax purposes. § 171.1014




                                                                     21
  Texas Margin Tax – Reporting Method
• Affiliated Group Test - § 171.0001(1), (8)
  – Affiliated group = group of one or more entities in which a
    controlling interest is owned by a common owner or
    owners.
  – Controlling Interest =
     • Corporation:
       – ≥ 80% direct or indirect ownership of voting power; or
       – ≥ 80% direct or indirect ownership of beneficial ownership of voting
         stock (different than voting power?)
     • Other entities:
       – ≥ 80% direct or indirect ownership of capital, profits or beneficial
         interest.




                                                                                22
  Texas Margin Tax –Reporting Method
• Unitary Business Test § 171.0001(17)
 – Divisions or entities that are “sufficiently interdependent,
   integrated, and interrelated through their activities so as to
   provide a synergy and mutual benefit that produces a
   sharing or exchange of value among them and a significant
   flow of value to the separate parts.”
 – Factors
    • Whether activities of group members are in same general line
      of business or are steps in a vertically structured business
    • Whether members are functionally integrated through strong
      centralized management
 – Concept of unitary has been in franchise tax since §
   171.1061 was added in response to Allied Signal, 504 U.S.
   768 (1992)



                                                                     23
   Texas Margin Tax –Reporting Method

           Corporation A                 Corporation B
                                               (Service Partner)
         90% capital                          10% capital
         20% profit                           80% profit



                           Partnership


 No common ownership of A or B.
 Unitary with both A and B
 Which group is partnership in? A’s, B’s or both?




                                                                   24
   Texas Margin Tax –Reporting Method


   A                  B          A                 B
     99%                1%        1%                 99%


    Partnership 1                Partnership 2


 Combined reporting required? Cf. IRC § 1563(a)(2) (lowest
  common ownership percentage).




                                                              25
        Texas Margin Tax – Basic Calculation
(1) TOTAL REVENUE – ENTIRE BUSINESSA


(2) SUBTRACT EITHER:
       (A) Cost of Goods Sold, or
       (B) Total Cash CompensationB and Employee Benefits
(3) GROSS MARGIN (Limited to 70% Total Revenue)



(4) APPORTION TO TEXASC
                                  TEXAS GROSS RECEIPTS
                         GROSS RECEIPTS – ENTIRE BUSINESS
(5) TAXABLE MARGIN



(6) TAX RATE
       1% (.5% if retail/wholesale trade)

(7) FRANCHISE TAX PAYABLE
       N/A – Tax is less than $1,000
       N/A – Total revenue <= $300,000

A. Combined reporting required for certain affiliated groups.
B. Cash Compensation limited to $300,000 per individual.
C. Gross receipts for apportioning margin differ from total revenue.




                                                                       26
Texas Margin Tax – Calculation of Margin
• Margin is generally the lesser of
  – 70% of taxable entity’s total revenue; or
  – Total revenue less, at entity’s election, either
     • Cost of Goods Sold (COGS) or
     • Compensation
  §171.101(a)(1)
• Election to deduct either COGS or compensation
  is a year by year election and can be changed
  by filing an amended report. §171.101(d)




                                                       27
 Texas Margin Tax – Calculation of Margin
• For corporations total revenue is the sum of the amounts on
  line 1(c) and 4 through 10 of the Form 1120




                                                                28
Texas Margin Tax – Calculation of Margin
• Corporate Subtractions:
  – bad debts
  – certain foreign income
  – income allocated to corporation from or by partnerships, S
    corporations, trusts, LLC’s and disregarded entities (avoids
    multiple taxation of same revenue)
  – Form 1120 Schedule C deductions (i.e., dividend received
    deductions, to extend dividends included in income)
  § 171.1011(c)(1)(B)




                                                                   29
Texas Margin Tax – Calculation of Margin
• Partnerships
  – Total revenue is the sum of the amounts on lines 1(c) and 4
    through 7 of Form 1065 and on lines 2 through 11 of Form
    1065 Schedule K (see next slide)
  – Subtractions are similar to corporate subtractions
     • bad debts
     • certain foreign income
     • income allocated to partnership from or by another partnership,
       trust, LLC, disregarded entity and S corporation




                                                                         30
Texas Margin Tax – Calculation of Margin




                                           31
Texas Margin Tax – Calculation of Margin
• Other Entities
  – Margin is computed in a manner substantially similar to rules
    for corporations and partnerships as determined by
    Comptroller rules. §171.1011(c)(3)
• Consolidated group members
  – Corporations that are part of consolidated Federal returns
    compute margin as if a separate federal return had been
    filed (which will then be combined with other members of the
    Texas combined report). §171.1011(d)




                                                                    32
Texas Margin Tax – Calculation of Margin
• Provisions to Avoid Double-Counting
 – Deduction for Income from Pass-Through Entities
    • Taxable entity can deduct net income from federal pass-through
      and disregarded entities. §171.101(c)(1)(B)(iii), (iv)
    • Can’t exclude income from a passive entity (PE) §171.1011(e)
    • Note: Owners can election to pay tax on behalf of the pass-
      through entity. §171.1015.
 – Exclusion of income from passive entity
    • Margin of taxable entity does not include income from a passive
      entity (PE) not in a combined report to the extent attributable to
      margin of a taxable entity. §171.1011(e)
    • Applies when taxable entity owns a PE, which in turn owns a
      lower-tier pass-through taxable entity (a PE “sandwich”)




                                                                           33
Texas Margin Tax – Calculation of Margin
• Provisions to Avoid Double-Counting (con’t)
  – Flow-through funds §171.1011(f) – (g-3)
     • Items mandated by law or fiduciary duty (e.g., sales tax).
     • Items mandated by contract involving only the following:
        – Sales commissions to non-employees
        – Tax basis of securities underwritten
        – Subcontracting payments for services, labor, or material provided in connection
          with real property construction or surveying
     • Lending institution’s proceeds from loan principal repayments
     • Tax basis of securities and loans sold
     • Legal services entity’s flow through funds and reimbursements for out-of-
       pocket costs
  – Flow-through funds exclusion is not applicable if receipt is paid to
    an affiliated group member §171.1011(g)




                                                                                            34
Texas Margin Tax – Calculation of Margin
• Provisions to Avoid Double-Counting (con’t)
  – Staff leasing company can exclude payments received
    from clients for wages etc. of assigned employees
    §§171.1011(k), 171.0001(11)
  – Management company can exclude reimbursements of
    costs incurred to conduct the business of the managed
    entity, including wages and cash compensation
    §§171.1011(m-1), 171.0001(11)
• Other Revenue Exclusions
  – Dividends and interest on federal obligations §171.1011(m)




                                                                 35
Texas Margin Tax – Calculation of Margin
• Health Care Providers §171.1011(n)
 – Exclude from revenue payments received
    • under Medicaid program, Medicare program, Indigent Health
      Care and Treatment Act, and Children’s Health Insurance
      Program (CHIP);
    • for professional services provided in relation to a workers’
      compensation claim; and
    • for professional services provided to a beneficiary rendered
      under the TRICARE military health system.
 – Exclude from revenue the cost for uncompensated care
 – Health care provider = taxable entity that participates as a
   provider in programs listed above




                                                                     36
Texas Margin Tax – Calculation of Margin
• Health Care Institution §171.1011(o)
  – Excludes from revenue 50% of the amounts that can be
    excluded by a health care provider
• Federal Facilities Operator §171.1011(q)
  – Exclusion for revenue received from the operation of a
    facility on federal property or to house U.S. armed forces
• Small Oil and Gas Producers §171.1011(r)
  – Exclusion for revenue from oil and gas produced from small
    oil and gas wells on days when WTI <$40/bbl and gas
    <$5/MMBtu




                                                                 37
Texas Margin Tax – Calculation of Margin
• Cost of Goods Sold (COGS) Deduction
  §171.1012
 – Goods = real or tangible personal property sold in the
   ordinary course of business
 – "Production" includes construction, installation, manufacture,
   development, mining, extraction, improvement, creation,
   raising, or growth
 – COGS generally computed in accordance with federal
   methods, including IRC §263A




                                                                    38
 Texas Margin Tax – Calculation of Margin
• COGS includes all direct costs of acquiring or
  producing the goods, including:
• Labor costs and materials                 • Taxes on materials and services
• Handling and storage costs (including     • Cost of producing or acquiring
  pre- and post-production costs)             electricity sold
• Depreciation, depletion, and              • Partnership contributions to fund
  amortization                                production of goods distributed in-kind
• Rental or lease expenses for                to the contributing partner
  equipment, facilities or real property    • Deterioration, obsolescence, spoilage,
  directly used for production of goods       or abandonment
  (including IDC and dry hole costs)
                                            • Insurance on production equipment,
• Repair and maintenance of production        facilities and goods
  equipment, facilities and real property
                                            • Utilities
• Research, experimentation,
  engineering, and design activities        • Quality control
  related to production of goods            • Cost of acquiring rights to produce
• Geological and geophysical exploration      goods
  costs




                                                                                        39
Texas Margin Tax – Calculation of Margin
• Indirect/Overhead Costs
 – COGS includes indirect or administrative overhead costs
   allocable to the acquisition or production of goods
 – Limited to 4% of total indirect or administrative overhead
   costs
 – Includes all mixed service costs, such as security services,
   legal services, data processing services, accounting services,
   personnel operations, and general financial planning and
   financial management costs




                                                                    40
Texas Margin Tax – Calculation of Margin
• Items specifically excluded from COGS include:
  – Selling costs
  – Distribution costs
  – Advertising costs
  – Idle facility expense
  – Rehandling costs
  – Successful and unsuccessful bidding costs
  – Interest
  – Income taxes
  – Strike expenses
  – Officers’ compensation
  – Costs of facilities on federal government property and housing
    military
  – Compensation paid to undocumented workers




                                                                     41
Texas Margin Tax – Calculation of Margin
• Special COGS Rules
 – Lending institution’s COGS = interest expense §171.1012(k)
 – Certain rental activities
    • Motor vehicle, heavy construction equipment, and railcar rolling
      stock rental and leasing treated as selling for purposes of
      deduction cost of goods sold. §171.1012(k-l)
 – Arm’s length standard
    • Costs paid to a member of payor’s affiliated group but not
      included in payor’s combined group are deductible only if made
      in a transaction at arm’s length. §171.1012(l)
    • Appears to disallow deduction completely, not just the amount in
      excess of arm’s length.




                                                                         42
Texas Margin Tax – Calculation of Margin
• Compensation Deduction §171.1013
 – Compensation generally includes:
   • Wages and cash compensation paid to employees, officers,
     directors, owners, and partners
      – limited to $300,000 per person (CPI adjusted in 2009)
   plus
   • Federally deductible cost of benefits for such persons (including
     workers compensation, health care, and employer contributions
     to health savings accounts and qualified retirement plans)
 – No deduction for payments to undocumented workers




                                                                     43
Texas Margin Tax – Calculation of Margin
• Wages and Cash Compensation
 – Generally, Form W-2, Box 5 Medicare wages and tips
   (includes deferred compensation)
 – Net distributive income of natural persons from partnerships,
   trusts, and S corporations (including LLCs treated as a
   partnership or S corporation)
 – Stock awards and stock options deducted for FIT purposes
 §171.1013(a)




                                                                   44
Texas Margin Tax – Calculation of Margin
• Staff Leasing Companies §171.1013(d), (e)
 – Leasing company deducts compensation only for its own
   employees, and not for assigned employees
 – Client company deducts payments to leasing company for
   wages and benefits of assigned employees as if the assigned
   employees were actual employees of client
    • Cannot deduct any administrative fee
    • Cannot deduct any other amount, including payroll taxes
 – Leasing company revenue exclusion is in §171.1011(k)




                                                                 45
Texas Margin Tax – Calculation of Margin
• Management Companies §171.1013(f), (g)
 – Management company can’t deduct compensation costs that
   are reimbursed by a managed entity
 – Managed entity deducts reimbursements made to
   management company for compensation of leased
   employees as if the reimbursements were paid to employees
   of the managed entity
   • Cannot deduct any administrative fee
   • Cannot deduct any other amount, including payroll taxes
 – Management company revenue exclusion is in
   §171.1011(m-1)




                                                               46
Texas Margin Tax – Calculation of Margin
• Federal Facilities Operators §171.1013(h)
  – Can’t include as wages or cash compensation amounts paid
    to an employee associated with the operation of a facility on
    federal property or for housing U.S. armed forces
  – Federal facilities operators’ revenue exclusion is in
    §171.1011(q)




                                                                    47
Texas Margin Tax – Calculation of Margin
• Combined Reporting §171.1014
 – A combined group is a single taxable entity
 – Total revenue for the combined group is sum of each
   member’s separate revenues less intragroup revenues.
 – Single COGS v. compensation deduction election; applies to
   all members
    • Deduction is sum of each member’s separate COGS or
      compensation, less COGS or compensation paid to another group
      member
 – May elect to include in the combined group an “exempt
   entity” that would be in the group if it were not exempt




                                                                      48
        Texas Margin Tax – Basic Calculation
(1) TOTAL REVENUE – ENTIRE BUSINESSA


(2) SUBTRACT EITHER:
       (A) Cost of Goods Sold, or
       (B) Total Cash CompensationB and Employee Benefits
(3) GROSS MARGIN (Limited to 70% Total Revenue)



(4) APPORTION TO TEXASC
                                TEXAS GROSS RECEIPTS
                        GROSS RECEIPTS – ENTIRE BUSINESS
(5) TAXABLE MARGIN



(6) TAX RATE
       1% (.5% if retail/wholesale trade)

(7) FRANCHISE TAX PAYABLE
       N/A – Tax is less than $1,000
       N/A – Total revenue <= $300,000

A. Combined reporting required for certain affiliated groups.
B. Cash Compensation limited to $300,000 per individual.
C. Gross receipts for apportioning margin differ from total revenue.




                                                                       49
    Texas Margin Tax – Apportionment
• Basic rules remain unchanged.
• Single factor apportionment based on ratio of
  Texas receipts to total receipts. §171.106(a)
• Generally, receipts for apportionment include
  only receipts considered in calculating margin.
  §171.1055
• Statute allocating non-unitary income to
  commercial domicile is repealed. Former
  §171.1061 (Effect is unclear)
• Throwback statute is repealed. Former
  §171.103(a)(1) and §171.1032(a)(1)



                                                    50
    Texas Margin Tax – Apportionment
• Combined Group Apportionment
 – Texas receipts are only the receipts of members having
   nexus with Texas, whereas total receipts are all receipts of
   members regardless of Texas nexus. §171.103(b),
   §171.105(c).
    • Rule is expected to be changed to include Texas receipts of all
      members regardless of Texas nexus.
 – Intragroup receipts excluded from margin are also excluded
   for apportionment purposes. § 171.1055(b).
    • Special exception where a member with nexus sells tangible
      personal property to a member without nexus that then sells the
      property without modification to a Texas buyer. §171.1055(b).




                                                                        51
        Texas Margin Tax – Basic Calculation
(1) TOTAL REVENUE – ENTIRE BUSINESSA


(2) SUBTRACT EITHER:
       (A) Cost of Goods Sold, or
       (B) Total Cash CompensationB and Employee Benefits
(3) GROSS MARGIN (Limited to 70% Total Revenue)



(4) APPORTION TO TEXASC
                                TEXAS GROSS RECEIPTS
                        GROSS RECEIPTS – ENTIRE BUSINESS
(5) TAXABLE MARGIN



(6) TAX RATE
       1% (.5% if retail/wholesale trade)

(7) FRANCHISE TAX PAYABLE
       N/A – Tax is less than $1,000
       N/A – Total revenue <= $300,000

A. Combined reporting required for certain affiliated groups.
B. Cash Compensation limited to $300,000 per individual.
C. Gross receipts for apportioning margin differ from total revenue.




                                                                       52
          Texas Margin Tax – Tax Rate
• Tax Rate §171.002
  – 1% of apportioned margin for most taxpayers
  – 0.5% of apportioned margin for taxable entities primarily
    engaged in retail or wholesale trade
• Definition of Retail or Wholesale Trade
  – In general, means more than 50% of total revenue is from
    activities described in Division F or G of the 1987 SIC Manual
  – Except for restaurants and bars, of the entity’s retail or
    wholesale trade revenue, less than 50% can come from sale
    of products produced by the taxable entity or members of its
    affiliated group.
  – Can’t provide any retail or wholesale utilities, including
    telecom services and electricity or gas



                                                                     53
         Texas Margin Tax – Tax Rate
• Exemption Amount
  – no tax due if tax is less than $1,000; or total revenue is
    less than $300,000. §171.002(d).
• Statutory limit on rate increase (only with voter
  approval) §171.003
  – NB: statute can be amended




                                                                 54
           Texas Margin Tax - Credits
• Unused credit under former §171.111
 – Relates to 1992 enactment of franchise tax on earnings
 – Intended to mitigate earnings impact of deferred taxes
 – Allows a temporary credit equal to 4.5% of temporary
   book/tax differences as of the end of 1991 accounting period
 – Claimed at a rate of 5% over 20 years
 – Additional tax = 0.2% of net taxable capital imposed on
   entities claiming the temporary credit
 – HB3 §17 preserves the credit
    • Allows 4.5% credit even though margin rate is only 1%




                                                                  55
          Texas Margin Tax - Credits
• New Temporary Credit §171.111
 – Credit is the tax rate times 10% of apportioned difference as
   of end of 2006 accounting year between (i) deductible
   temporary differences and NOL carryforwards (net of
   valuation allowances) and (ii) taxable temporary differences
 – Taxable entity must notify Comptroller by March 1,
   2007 of its intent to preserve its right to take this
   credit
 – Credit may be taken for up to 20 consecutive privilege
   periods.
 – Credit may not be assigned or transferred
 – Tax rate to be used is unclear (4.5% rate on taxable earned
   surplus versus 1% or .5% rate on taxable margin)




                                                                   56
             Texas Margin Tax - Credits
• Tax credits under old law repealed. HB3 §18
  – Subchapter L. Wages paid to Criminal Justice work program participants
  – Subchapter M. Wages Paid To Children Committed to TX Youth Commission
  – Subchapter N. Day-Care Centers Or Child-Care Services
  – Subchapter O. Research And Development Activities
  – Subchapter P. Job Creation Activities
  – Subchapter Q. Capital Investments
  – Subchapter R. Contributions To Before And After School Programs
  – Subchapter S. Credits Limitation
  – Subchapter T. Wages Paid To Persons With Certain Disabilities
  – Subchapter U. Title Insurance Holding Companies

• Accrued and unused credits generally preserved.




                                                                             57
          Texas Margin Tax - Credits
• Economic Development Credits Preserved
  HB3 §19
 – A TX Dept. of Economic Development agreement effective
   before 6/1/06 that grants franchise tax credits continues in
   effect and the credits under the agreement continue to
   accrue and may be claimed in the manner provided by the
   agreement against the margin tax for the duration of the
   agreement
 – Rate adjustment required?




                                                                  58
      Texas Margin Tax – Effective Date
• Effective Date
  – Sec. 26: 1/1/08 and reports due on or after 1/1/08
     • 2007 franchise tax reports based on old law
     • 2008 franchise tax reports based on new law
  – Sec. 22: Special transition rules
     • No tax on business done before 6/1/06
     • Newly taxable entities
     • Terminating taxable entities
  – Sec. 27: Sections that take effect 6/1/06 and reference §27
    are deferred to 9/1/06 because Act failed to get 2/3 vote




                                                                  59
    Texas Margin Tax – Effective Date
• Transition Rule for pre-6/1/06 business
 – Margin and gross receipts occurring before 6/1/06 may not
   be considered.
    • Should 6/1/06 date be read 9/1/06? See HB3 §27 and SB6
    • Does cutoff rule apply to currently taxable entities?
      – Introductory language refers to entities “becoming subject to” the
        Act, but other affected provisions deal with currently taxable entities
        (i.e., provisions for taxable entities that terminate before the effective
        date of the margin tax)
      – Better reading is that rule does not apply to currently taxable entities




                                                                                     60
    Texas Margin Tax – Effective Date
• Example 1
 – Texas corporation with April 30 fiscal year end
    • 2007 report (due 5/15/07) based on business done from
      5/1/05 to 4/30/06
    • 2008 report (due 5/15/08) based on business done from
      6/1/06 (or 9/1/06?) to 4/30/07
    • May ’06 (and possibly May ’06 – Aug. ’06) not taxed under either
      old or new tax?
    • Will exit tax apply (because entity becomes “no longer subject to
      the franchise tax” as of 4/30/06)? §171.0011




                                                                          61
      Texas Margin Tax – Effective Date
• Transition Rule for Newly Taxable Entities
  – Special transition rule for entities that become subject to the
    new margin tax on 1/1/08.
     • Generally requires initial report on 5/15/08 for 2008 franchise
       period based on business done in 2007 fiscal year end.
  – Otherwise, complicated rules regarding initial period, second
    period, and regular annual period were retained
  – Impact on Entities Formed in 2006
     • New corps and LLCs subject to normal initial reporting rules
     • New nontaxable entities (LPs) subject to transition rule




                                                                         62
    Texas Margin Tax – Effective Date
• Example 2
 – Texas LLC formed November 10, 2006 (accounting
   period is the calendar year). Under the normal rules:
    • Initial period is 11/10/06–11/09/07
      Second period is 11/10/07–12/31/07
      First regular annual period is 1/1/08–12/31/08
    • A single tax for all three periods is computed on business done
      from 11/10/06 – 10/31/07. The tax and initial report is due
      2/7/08 (89 days after one-year anniversary).
    • The second regular annual period is 1/1/09 – 12/31/09. Tax is
      based on 11/1/07 – 12/31/08 business. Report due 5/15/09.
 – If Texas LP versus Texas LLC:
    • Regular annual period is 1/1/08 – 12/31/08. Report and tax due
      5/15/08 based on 1/1/07 – 12/31/07 business.




                                                                        63
      Texas Margin Tax – Effective Date
• Transition Rule for Terminating Entities
  – Entity taxable after 12/31/06 and before 1/1/08 but not
    subject to the franchise tax on 1/1/08 (“terminating entity”)
    files a final report based on the period beginning on later of
    1/1/07 or beginning date and ending on date no longer
    taxable
  – Integration with current franchise tax is unclear
     • Final period tax based on margin or earned surplus/capital?
     • Existing exit tax also applied?
  – Proposed amendment would clarify that rule for terminating
    entities applies only to non-taxable entities terminating after
    9/1/06. (Retroactivity issue under Tex. Const. Art. III,
    §39?)



                                                                      64
     Texas Margin Tax – Effective Date
• Example 3
 – Texas corporation with calendar year end dissolves
   August 31, 2007
    • Files final report for period 1/1/07 to 8/31/07
    • HB3 §22(b)(3) doesn’t say anything about tax due. Is the tax
      for this privilege period based on margin, old law (i.e., existing
      exit tax), or both?
    • Does business done for period 9/1/06 – 12/31/07 escape tax?




                                                                           65
    Texas Margin Tax – Effective Date
• Continuing Partnerships
 – “A partnership is considered terminated only if no part of any
   business, financial operation, or venture of the partnership
   continues to be carried on by any of its partners in a
   partnership.” HB3 §22(d)
 – Example: Partnership ABC dissolves during 2007. A and B
   then form a new limited partnership and continue their
   portion of the partnership business. It appears that AB
   Partnership will be taxed on ABC Partnership’s 2007 business
   (regardless of the percentage of ownership overlap or
   business continued).




                                                                66
     Texas Margin Tax – Effective Date
• Merged/Divided Partnerships
 – A merged or consolidated partnership is deemed continued if
   its owners hold >50% of the surviving partnership’s capital
   and profits. HB3 §22(e)
 – In a division of a partnership, the resulting partnerships are
   deemed to be a continuation of the former partnership
   unless the former owners own 50% or less of the resulting
   partnership’s capital and profits. HB3 §22(f)




                                                                    67
    Texas Margin Tax – Effective Date
• Loophole for Terminating Partnerships
 – Nontaxable entities that terminate before 1/1/08 never
   become subject to the margin tax
 – Rules for continuing partnerships do not appear to cover a
   conversion to an LLC
 – Proposed amendment (SB 6) would have imposed margin
   tax on period from 9/1/06 to termination date
    • Note: Imposes tax on margin of calendar year entities earned in
      2006 that would not otherwise be subject to tax
    • If enacted in 2007 legislative session, it would in some cases
      impose tax on privileges exercised prior to enactment, which is
      probably unconstitutional under TX Const. Art. III, Sec. 39.




                                                                        68
                  Texas Margin Tax – Effective Date
  •When to convert existing
   LP structures?
       – Don’t convert PEs!                            HC
       – General recommendation =
         wait until 2007 legislative
         session to determine if and
         when loophole for             Texas LLC                 Delaware
         terminating partnerships is      GP                      LLC LP
         fixed
       – Wait to see if there is a
         successful constitutional
         challenge to imposition of
         margin tax on                             Partnership
         partnerships?




1888050.1/SP/0005.0002                                                      69
       Texas Margin Tax – Effective Date
 Conversion Date              Results under HB3*                Results under SB6 (proposed)*
8/31/2006          -Old tax on LLC for rest of 2006          -Same as HB3
                   -Margin tax on LLC combined group
                   beginning 1/1/07
12/31/2006         -No tax for 2006                          -Margin tax on Partnership from 9/1/06 -
                                                             12/31/06 (subject to constitutional
                                                             retroactivity challenge)

                   -Margin tax on LLC combined group         -Margin tax on LLC combined group
                   beginning 12/31/06                        beginning 12/31/06
12/31/2007         -No tax for 2006 or 2007                  -Margin tax on Partnership from 9/1/06 -
                                                             12/31/07; combined report?
                                                             Cutoff date might change from 9/1/06 to
                                                             90 days after end of 2007 legislative
                                                             session
                   -Margin tax on LLC combined group         -Margin tax on LLC combined group
                   beginning 12/31/07                        beginning 12/31/07
1/1/2008           -No tax for 2006                          -Same as HB3
                   -Margin tax on Partnership combined       Note that by waiting unti 2008 to
                   group for 1/1/07 - 12/31/07, and 1/1/08   convert, the Partnership avoids tax on
                   -Margin tax on LLC combined group         2006 income
                   beginning 1/1/08
*Povisions are unclear and are likely to be changed during 2007 legislative session.




                                                                                                        70
     Texas Margin Tax – Effective Date
• Special Information Reports HB3 §23
 – Affected entities = 1000 entities
    • owing the most franchise tax for 2005
    • with the greatest gross receipts in 2005
    • with the most employees in 2005
    • with the greatest school M&O property tax levy
 – Must compute tax due on 2005 FYE data
 – Draft forms and instructions issued 10/13
 – Forms will be mailed 11/15/06 – 12/2/06. Due 2/15/07 (no
   extensions). Failure to file = charter forfeited.




                                                              71
   Texas Margin Tax – Constitutionality
• Texas Supreme Court has exclusive and original
  jurisdiction over challenges to the
  constitutionality of the tax and must rule on
  challenges within 120 days of filing. HB3 §24
• Comptroller Strayhorn has requested Attorney
  General to rule on whether Margin Tax violates
  “Bullock Amendment” to Texas Constitution as
  an unconstitutional tax on natural persons’
  share of partnership income




                                                   72
   Texas Margin Tax




APPLICATION AND PLANNING




                           73
                    UNITARY AND COMBINED REPORTING
                          MAY BE COMPLICATED!

     A    B                           R
90             10                                    Y
                               1/4
     AB
                                                                Public
                                      1/4
         1/2                                                   Company
                           ry
                                                                    10%
     P
          50

                                            JV                 JV         Totals-Combined Entities
                    RP
                                          12%                  55%        Dividends      $200,000
R        50                                                               Rent             10,000
                                                     NT
                         100    100         100                100
                                                                          Interest         30,000
                                                                          Royalties        10,000
                     Oscar            F          S       70     30                       $250,000
                                                           L    N




                                                                                                 74
                                           … BUT NOT EVERY TIME!
 (1) TOTAL REVENUE – ENTIRE BUSINESSA                                  $250,000
 (2) SUBTRACT EITHER:
        (A) Cost of Goods Sold, or
        (B) Total Cash CompensationB and Employee Benefits
 (3) GROSS MARGIN (Limited to 70% Total Revenue)



 (4) APPORTION TO TEXASC
                                   TEXAS GROSS RECEIPTS
                          GROSS RECEIPTS – ENTIRE BUSINESS
 (5) TAXABLE MARGIN



 (6) TAX RATE
        1% (.5% if retail/wholesale trade)

 (7) FRANCHISE TAX PAYABLE                                              ZERO
        N/A – Tax is less than $1,000
        N/A – Total revenue <= $300,000

A. Combined reporting required for certain affiliated groups.
B. Cash Compensation limited to $300,000 per individual.
C. Gross receipts for apportioning margin differ from total revenue.




                                                                                  75
                           … AND WATCH THAT GROSS MARGIN
 (1) TOTAL REVENUE – ENTIRE BUSINESSA                                                                 $350,000
 (2) SUBTRACT EITHER:
        (A) Cost of Goods Sold, or
                                                                                                     (251,000)
        (B) Total Cash CompensationB and Employee Benefits
 (3) GROSS MARGIN (Limited to 70% Total Revenue)                                                        99,000

 (4) APPORTION TO TEXASC                                                                                100%
                                   TEXAS GROSS RECEIPTS
                          GROSS RECEIPTS – ENTIRE BUSINESS
 (5) TAXABLE MARGIN                                                                                     99,000

 (6) TAX RATE                                                                                             1%
        1% (.5% if retail/wholesale trade)

 (7) FRANCHISE TAX PAYABLE                                                                               ZERO
        N/A – Tax is less than $1,000
        N/A – Total revenue <= $300,000

A. Combined reporting required for certain affiliated groups.          Rule: No Texas Franchise Tax WHERE:
B. Cash Compensation limited to $300,000 per individual.                     Wholesale/Retailer Gross Margin    < $ 200,000
C. Gross receipts for apportioning margin differ from total revenue.
                                                                             Other Taxpayers     Gross Margin   < $ 100,000




                                                                                                                              76
             MALCOLM WHOLESALE GOLF, INC.

                                     Existing Law   New Law
Total Revenue (100% Texas)            $1,000,000    $1,000,000
Cost of Goods Sold                     (700,000)    (700,000)
Gross Margin (Taxable Margin)          $300,000      $300,000
Deduction for    Rent,   Salaries,     (300,000)        0
Other Expenses
Net Income                               -0-           N/A
Franchise Tax Rate                      4.5%           .5%
Texas Franchise Tax Payable             ZERO          $1,500




                                                                 77
                    MALCOLM WHOLESALE GOLF, INC.
                    2008 NEW CAPITAL INVESTMENT

                                                      2007               2008
 Total Revenue (100% Texas)                       $1,000,000          $900,000
 Cost of Goods Sold                                  (700,000)         (950,000)*
 Gross Margin                                        $300,000                 0
 Franchise Tax Rate                                    .5%                N/A
 Texas Franchise Tax Payable                         $1,500              ZERO
*2008 COGS reflects accelerated depreciation on new manufacturing equipment

NOTES:
2007 = Positive Net Margin
2008 = Negative Net Margin (Zero Limit); no loss carryover




                                                                                    78
                            2008 – C P PARTNERS, LLP
FACTS:    8 Professionals (4 Partners, 3 Associates and 1 contractor)
               Senior partner receives $500,000 profit allocation
               Contractor receives $100,000

CLASSIFY: General partnership with all individual partners and therefore exempt?

Assume one Partner is a professional corporation so C P Partners is a taxable entity.


Total Revenue                                                                           $2,000,000
Less: Cash Compensation and Distributions
     $300,000 Max Per Partner or Employee
     Form 1099’s Don’t Count
     and Benefits (no dollar limit)                                                     (1,400,000)
Gross Margin                                                                               600,000
Franchise Tax Rate                                                                             1%

Texas Franchise Tax Payable                                                                 $6,000


NOTES:     $200K Compensation > $300k Costs 1%                                            ($2,000)
           Form 1099 Payment of $100K Costs 1%                                            ($1,000)




                                                                                                      79
         Texas Margin Tax – Planning
           PROBLEM                          SOLUTION
1. Passive income in a taxable   Seek to transfer the passive
entity (passive income becomes   income assets to a passive entity
subject to tax)                  which does not allocate its
                                 income to taxable entities.

                                 Alternatively, distribute passive
                                 assets to individuals




                                                                     80
         Texas Margin Tax – Planning
           PROBLEM                         SOLUTION
2. Rental income in a passive   Transfer the rental property to a
entity exceeds 10% (Entity      new subsidiary entity so the old
becomes subject to tax)         entity remains a nontaxable
                                passive entity




                                                                    81
         Texas Margin Tax – Planning
           PROBLEM                             SOLUTION
3. LLC holds only passive           (a) convert the LLC to a
investment assets (LLC’s can’t be   partnership; or
passive entities)
                                    (b) transfer the investment assets
                                    to a passive entity and then
                                    distribute the ownership interests
                                    in the passive entity




                                                                         82
         Texas Margin Tax – Planning
           PROBLEM                            SOLUTION
4. LLC/Corporation with large      Consider cost-effectiveness
upcoming net income events         of 2006 conversion to non-
before 2006 year end (e.g., sale   taxable entity
of assets)




                                                                 83
         Texas Margin Tax – Planning
           PROBLEM                           SOLUTION
5. S corporation has high annual   Reduce salary to minimum
income available to owner-         amount that constitutes
executive. Income currently paid   reasonable compensation for
out as salary to avoid 4.5%        services actually rendered, and
franchise tax on earned surplus.   take the balance of income out as
                                   dividends
Entity has going concern value
and capital is a material income   Avoided SE Tax on salary    2.9%
producing factor.                  Margin tax                 -1.0%
                                   Savings                    1.9%




                                                                       84
           Texas Margin Tax – Planning
• Entity classification
  –   Partnerships of “all” natural persons
  –   Avoid 10% limit on active income in a passive entity
  –   Qualifying for the 0.5% tax rate based on business mix
  –   Losing retailer status by selling utilities
• Combined reporting
  – Avoid mixing manufacture/retail with service business
  – Get passive entities out of combined group
  – Avoid mixing REIT/REMIC eligible income with other income




                                                                85
        Texas Margin Tax – Planning
• Revenue
 – Review revenue accounts and reclassify or restructure flow-
   through items (e.g., consider whether reimbursements
   should be recorded as contra expense, or restructure
   contract to provide direct payment)
• Deductions
 – Employee vs. contractor: wages favored under the tax;
   consider using a staff leasing company for contractors
 – Benefits: not subject to the $300k cap on wages
 – COGS: review inventory costing




                                                                 86
         Texas Margin Tax – Planning
• Apportionment
 – Minimize or resource Texas receipts
 – Hyping non-Texas receipts generally not effective if it creates
   an equivalent amount of taxable margin
• 2006 planning for partnerships
 – Revenue acceleration and basis step-up transactions
 – Defer deductible compensation or COGS (watch $300k limit
   on wages)




                                                                 87
 Texas Margin Tax – Financial Reporting
• Income tax for FAS 109 purposes
  – Exclude from multi-state blended-rate calculations?
• Existing deferred tax assets and liabilities
  – Benefit/liability to be realized prior to FY 2007
  – Benefit/liability to be realized after FY 2007
  – Reassess credit carryforwards (HB3 §§ 17-19)
• Temporary credit under §171.111
  – Probably too uncertain to be booked as a deferred tax asset
• Double tax reported for 2007 if taxed on capital




                                                                  88
                          DISCLAIMER


Any tax advice contained in this document was not intended or written to
be used, and cannot be used, for the purpose of (i) avoiding penalties
that may be imposed under applicable tax laws, or (ii) promoting,
marketing, or recommending to another party any transaction or tax-
related matter.




                                                                           89

				
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