Texas Two Step: Franchise and Property Tax Reform

1. Texas Two Step:Franchise and Property TaxReform William O. Grimsinger Chamberlain, Hrdlicka 713-654-9629 william.grimsinger@chamberlainlaw.com

2. History of Franchise Tax Reform • Neeley v. West Orange – Cove Consolidated Independent School District, 176 S.W. 3d 746 (Tex. 2005) • Required Reform of School Financing System • Texas Tax Reform Commission • Report Issued October 2005 • Special Session – 2005 Legislative Session • Special Session – 79th Third Called Session of the Texas Legislature • Spring 2006 • Legislature Passed 5 Bills

3. Summary of Bills Passed in 3rd Special Session • HB1 Requires School Districts to Reduce Property Tax Rate for Maintenance and Operations from 1.50 per $100.00 to 1.00 per $100.00 by 2007 Tax Years • HB2 Dedicates Funds Raised by Margin Tax and Existing Tax Surplus to Property Tax Relief • HB3 Adopts Margins Tax and Phases Out Existing Franchise Tax • HB4 Requires Transfer Tax on Sale of Used Cars Be Based on Standard Value Rather than on Value Reported by Owners • HB5 Raises Cigarette Tax to $1.00 Per Pack from $0.41 Per Pack

4. Margins Tax • Tax is Based on Gross Margins • Tax Is NOT Based on Net Income • Attempts to Avoid the Texas Constitution’s Bar Against a Tax on the Net Income Tax of Natural Person Unless Approved in a State Referendum • Litigation Likely • Individuals and Businesses with Increased Tax Liability • Special Provision for Litigation Directly in Texas Supreme Court • 120 Days for Texas Supreme Court to Issue Decision After Case is Filed

5. Analysis of Texas Gross Margins Tax • Returns Due May 15, 2008 • Based on Business Activity for 2007 • Fiscal year taxpayers that have a year ending on or after January 1, 2007 and before June 1, 2007 • Based on business activity beginning June 1, 2006 • Information Return on Margin Tax Due with Next Franchise Tax Filing for Businesses Subject to the Franchise Tax • Information returns are to be used in estimating revenues to be generated by margin tax

6. Who is Subject to the Margins Tax? • Taxable Entity is Defined at Section 171.0002(a) and Includes: • Partnerships • Corporations • Banking Corporations • Savings & Loan Associations • Limited Liability Companies • Business Trusts • Professional Associations • Joint Ventures • Joint Stock Companies • Holding Companies, or • Other Legal Entities

7. Who is Not Subject to the Margins Tax? • Section 171.0002(b) Excludes from the Definition of Taxable Entity: • Sole Proprietorships; • General Partnerships, entirely directly owned by natural persons • Passive Entities defined at Section 171.0003 • Entities exempt from taxation under Subchapter B of Section 171 Including: • Non-Profit Organizations • Railway Terminal Organizations; • Lodges, etc.

8. Who is Not Subject to the Margins Tax? • Grantor Trusts as defined by Sections 671 and 7701(a)(30)(E) of The Internal Revenue Code if all of the Grantors and Beneficiaries are natural persons or Charitable Entities, excluding a trust taxable as a Business Entity • Estates of natural persons as defined by Section 7701(a)(30)(D), excluding a trust taxable as a Business Entity

9. Who is Not Subject to the Margins Tax? • Family Limited Partnerships that have the following characteristics: • Passive Entity • At Least 80% of the interests are held directly or indirectly by members of the same family • Is a Limited Partnership formed under • Texas Revised Limited Partnership Act • The Limited Partnership Act of any other state; or • Treated as a Partnership for Federal Income Tax purposes

10. Who is Not Subject to the Margins Tax? • Passive Investment Partnerships that are Passive Entities and that are: • Formed under the Texas Revised Limited Partnership Act, or legislation of any other state or any foreign country

11. Who is Not Subject to the Margins Tax? • Passive Investments Partnerships that are Passive Entities and that are General Partnerships • Trusts that are Passive Entities that have the following characteristics: • Taxable as a trust under Section 641 • All of the beneficiaries are natural persons or charitable entities • Not taxable as a business entity • Organized as a trust

12. Who is Not Subject to the Margins Tax? • REIT’s and Qualified REIT Subsidiaries • Real Estate Mortgage Investment Conduit (“REMIC”) • Certain Corporations and Business Entities which qualify as insurance organizations, title insurance companies or title insurance agents authorized to engage the insurance business in Texas and which pay an annual tax under the Texas Insurance Code

13. Exceptions • Taxable Entities with $300,000 or less in gross receipts per year are excluded • Indexed for inflation beginning 2009 • Taxable Entity with Less than $1,000.00 in computed tax liability

14. Passive Entities • Classification as Either General or Limited Partnership • Income Requirements: • 90% of Federal Gross Income derived from list of income sources • 10% or less of Federal Gross Income due to conduct of active trade or business

15. Passive Entities • Passive Income Sources • Dividends • Interest • Foreign Currency Exchange Gain • Periodic & Non-Periodic Payments with respect to Notional Principal Contracts • Option Premiums • Cash Settlement or Termination Payments with respect to a Financial Instrument • Income from a Limited Liability Company • Distributive Shares of Partnership Income if Those Shares Exceed zero

16. Passive Entities • Passive Income Does NOT Include: • Rent • Income Received by Non-Operator from Mineral properties Under a Joint Operating Agreement if the Non-Operator is a member of an Affiliated Group and another Member of the Group is the Operator Under the Agreement

17. Active Trade or Business Entities • Active Trade or Business Includes One or More Active Operations that Form Part of the Process of Earning Income or Profit; and • Entity Performs Active Management and Operational Functions • Business Activities of Related/Affiliated and Non-Related Entities are Included

18. Active Trade or Business Entities • Ownership of Trademark, Patent, Process used by Related Entity for Consideration Results in Active Trade or Business Characterization • Use of Independent Contractors for Warranty Work if the Contractors Perform Work on Behalf of Entity and the Work Constitutes all or Part of Entities Business Results in Active Trade or Business Characterization

19. Active Trade or Business Entities • Active Trade or Business Entities Do Not Include: • Ownership of a Royalty Interest or Non-Operating Working Interest in Mineral Rights

20. Taxable Margin • Tax Base is Taxable margin • Taxable Margin is Either of: • 70% of Total Revenue Apportioned to Texas • Total Revenue Apportioned to Texas Less Cost of Goods Sold Deduction • Total Revenue Apportioned to Texas Less Compensation Deduction

21. Taxable Margin • Apportioned to Texas using Single Factor Apportionment Factor • Texas Receipts over World Wide Receipts • Tax Rate Applied to Apportioned Margin • .5% Tax Rate for Taxable Entities Engaged in Wholesale or Retail • 1% Tax Rate for other Entities

22. Total Revenue • Starting Point is Federal Income Tax Return • Corporations • Sum of lines 1e and 4-10 on Form 1120 • Partnerships • Sum of lines 4-7 on Form 1065 and lines 2-11 on Schedule K • Less • Bad Debts • Dividends that Qualify for Dividends Received Deduction

23. Total Revenue • Net Distributive Income from Partnerships, Trusts, and LLC’s Treated as partnerships for Federal Tax Purposes, unless • Net distributive income is from a passive entity and • Such income was not generated by the margin of any other taxable entity • Net Distributive Income from LLC’s and Corporations Treated as S Corporations for Federal Tax Purposes • Items of Income Attributable to an Entity that is a Disregarded Entity for Federal Tax Purposes

24. Total Revenue • Specific Items Related to Certain Industries and Businesses: • Flow through Funds Mandated by Law, such as Sales Taxes, Sales Commissions to Non-Employees • For Health Care Providers, Medicaid, Medicare, and Similar Payments, including Worker’s Compensation Payments • For Staff Leasing Companies, Payments Received from Clients for Wages, Payroll Taxes, Employee Benefits and Similar Payments • Dividend Interest from Federal Obligations

25. Cost of Goods Sold Deduction • Similar to Federal Deduction, But not based on it • Includes all Direct Costs of Acquiring or Producing Goods as well as Indirect, or Administrative Costs

26. Cost of Goods Sold Deduction • Direct Costs Include • Labor • Material • Handling, Processing, Assembling, Repackaging, Inbound Transportation, Storage • Depreciation, Depletion, and Amortization to the Extent Associated with and necessary for Production of the Goods (including Recovery under Section 197) • Rental or Leasing Equipment, Facilities, Real Property

27. Cost of Goods Sold Deduction • Insurance • Repair and Maintenance • Research, Experimentation, Engineering, Design • Geological or Geophysical Costs • Taxes • Cost of Producing or Acquiring Electricity Sold • Costs Associated with Deterioration, Obsolescence, Spoilage, Abandonment • Utilities • Licensing or Franchising Fees • Quality Control Costs

28. Cost of Goods Sold Deduction • Indirect Costs Include: • Administrative or overhead costs • Allowable to the acquisition or production of goods • Limited to 4% of total indirect or administrative overhead costs

29. Cost of Goods Sold Deduction • Excluded Costs • Renting or leasing costs not directly related to production of goods • Sales costs, including employee expenses related to sales • Distribution costs • Outbound transportation costs • Advertising costs • Idle facility expense

30. Cost of Goods Sold Deduction • Rehandling costs • Bidding costs • Interest • Taxes • Strike expenses • Officer’s compensation • Compensation paid to undocumented workers

31. Compensation Deduction • Capped at $300,000 per Employee • Tied to Form W-2, Medicare Wages and Tips Box • Also Includes: • Net distributive income from partnerships, trusts, LLC’s classified as partnerships or S Corporations for Federal Tax purposes • Stock awards and stock options deducted for Federal Tax purposes • Actual Cost of Health, Retirement, and Worker’s Compensation Benefits are Deductible but are not subject to the Cap

32. Compensation Deduction • Compensation Paid to Independent Contractors Is Not Included in Compensation Deduction • May Cause Industry Realignment • Policy or Oversight?

33. Unitary Reporting • Margin Tax Requires Filing on Unitary Basis if Entities are: • Part of an affiliated group • Engaged in a unitary business • Affiliated Group • One or more entities in which an 80% controlling interest is owned by a common owner or owners or by one of the member entities • Different from Federal law which requires 50% stock ownership

34. Unitary Reporting • Unitary Business • A single economic enterprise that consists of separate parts of a single entity or of a commonly controlled group of entities that are sufficiently interdependent, integrated, and interrelated through their activities as to provide a synergy and mutual benefit that produces a sharing or exchange of value among them and a significant form of value to separate parts

35. Combined Reporting • Single Report Filed • Must elect either costs of goods sold or compensation deduction • Subtract items of revenue from total if included in any member’s total • Includes Entities Outside Texas and Without Texas Nexus • But appointment includes only entities with Texas Nexus • If 80% of more of property and payroll is outside U.S., entity is not included

36. Credits and Net Operating Losses • Credits and Net Operating Losses available in 10% Increments until exhausted or until 2026 • Election Required by March 1, 2007 • Includes Amount of Credit or Carryover

37. Example • Super Fast Delivery, LLC • 2M Per Year Sales • 500K For Salaried Employees • Consists of Wages and Benefits for Principals and Administrative Staff • 800K For Contract Drivers

38. Example: Margin Tax Calculation • Gross Margin is 2M • Choice of Deductions, Either: • 30% of 2M = 600K; or • Compensation = 500K • Taxable Margin is 1.4M • 100% Texas Receipts • Margin Tax Total is 14,000 • 1.4M x 1%

39. Example: Employee Conversion • 800K for Employee Drivers • Employment Tax = 61,200 • 800K x 7.65% • Margin Calculation • 2M – 1.3M = 700K • Margin Tax is 7K • 700K x 1% • Saves 7K in Margin Tax • But Net Loss of 54,200 Due to Employment Taxes Alone • Does not Include Costs of Benefits, Additional Staff, Insurance etc.

40. Conclusion • Very early look at new Margins Tax • Substantial Regulations and Interpretations to come • No clear cut exempt entities or loopholes • Complexity appears significant • Property Tax Relief Likely to be Short-Lived • Revenue Estimated in Summer 2007

41. Conclusion • Legislature Meets in January 2007 • Likely to Address Margin Tax Issues • Several Areas Need to be Fixed • Industry Lobbying • Cost of Services Deduction? • Revenue Estimate Required for Any Legislation to Pass • Surplus is Projected to be Large