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Texas Franchise Tax: Whether it is Constitutional or Non-Constitutional is not the issue

Posted by Erick Cutler, CPA on Aug 25, 2011 9:22:29 AM

By now, those who are following the case filed by Allcat Claims Service on the constitutionality of the Texas Franchise Tax have heard or read about the response filed by The Solicitor General of the Texas Attorney General. In summary, The Solicitor General argued that the franchise tax is imposed on the partnership (which does not fall into the category of a “natural person”), not the individual partners. The income is allocated to the partners, who may or may not be natural persons, only after the tax in imposed. In addition, the Solicitor General argued that “even if the Court agrees with the Plaintiff’s contention that the franchise tax cannot constitutionally apply to limited partnerships, the relief Plaintiffs seek is overly broad.”

While I happen to think that Allcat’s case is weak, I am less concerned with the constitutionality of the law and whether or not it is, in fact, imposing a state tax on an individual, than I am about the tax is applies to companies and corporations. Let’s assume the Court rules in favor of the State and the tax remains as is. The bigger problem lies in the fact that the tax is just unfair. Normal taxation is based on a net-net number, as it is calculated on the federal level. The Texas Franchise Tax is not calculated in this manner. The tax is based on margin rather than taxable capital and earned surplus (most entities will owe 1% of the gross margin). The tax allows deductions from revenue for either cost of goods sold or compensation or a default 30% of gross receipt of deduction. This tax does not take into account any other expense, real or necessary, to the operation of the business. So for example, a company earns $1,000,000 in gross revenue. The company is a service business, so no Cost of Goods Sold. The company has $350,000 in salaries and the Client’s Net Gross Margin is $650,000. At a 1% tax rate the company will pay $6,500 in Texas Franchise Tax. Let’s say the company has $650,000 of additional expenses bringing his net income to $0. And because no other expenses are factored into the calculation, the company is still obligated to pay $6,500 in tax to the State of Texas. Fair? I don’t think so.

The Texas Supreme Court has 120 days from the filling date to rule on the challenge. If Allcat loses, the tax will remain as is. So, even though I believe Allcat’s case is weak, I am still hoping for a win, not out of concern for the integrity of our State Constitution, but out of concern for the state of our clients.

Questions?
Contact Erick Cutler at 214-635-2541 or fill out the form below.

As a Partner of Goldin Peiser & Peiser, LLP, Erick Cutler’s diversified background includes an in-depth understanding of tax strategies including cost segregation. Erick’s comprehensive knowledge of segregating hidden costs outside of standard depreciation, helps to reduce property owners’ tax liabilities. Additionally, Erick and his team keep abreast of the complex implications surrounding the Texas Franchise Tax, as well as the manufacturing credit, Section 199.

Topics: General Business