Proposed Franchise Tax Changes

January 2015

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Make Texas franchise tax law consistent with the current Internal Revenue Code. Doing so would simplify compliance by enabling rolling conformity.

Use Federal Cost of Goods Sold. Calculating the cost of goods sold deduction for the franchise tax is complicated and time consuming, frequently requiring recordkeeping not otherwise necessary for a taxpayer. Franchise tax compliance, administration and enforcement would be simplified if taxpayers were allowed to use the cost of goods sold amount as reported on the federal return, or alternatively, given the option of deducting a fixed percentage of the federal return amount, leaving the current method available as an option. Also, consider allowing a cost of goods sold deduction for officers’ compensation that is direct labor.

Make Compensation and Cost of Goods Sold Deductions Consistent. Some taxpayers are allowed to deduct either cost of goods sold and some compensation and benefits. The current law allows deductions for cost of goods sold that are not allowed for compensation and benefits deductions. Certain types of expenditures that are allowed as deductions for cost of goods sold should also be allowed as compensation deductions. Specifically

• Payments to independent contractors
• Employer portion of employee payroll taxes

Losses That Reduce Compensation Deductions. Net distributive income of partnerships, S-corporations and LLCs is allowed for the compensation deduction. However, the State Comptroller has issued a rule that states that negative distributive income (losses) must reduce the amount of other compensation deductions which, will increase taxable margin. The legislature should amend the law to make it clear that losses do not reduce compensation deductions and should not increase taxable margin.

Expand the Deductibility of Certain Partnership Distributions. Partnership net distributive income is deductible as compensation if it is distributed to an individual. Deductible net distributive income from partnerships should be expanded to include distributions to professional corporations and professional associations (which are also taxable entities) that are owned by individuals. Professionals, such as CPAs and physicians, frequently organize as partnerships of PCs of PAs. The current law penalizes these organizations. The tiered partnership provisions, as currently drafted, do not remedy the situation because related deductions may not be transferred to the upper tier entities and are lost.

Passive Entities. Clarify whether or not “capital gains” as used in the law really means “net capital gains” with respect to an entity’s qualification as passive.

Flow-Through Funds. Current law states that certain flow-through funds that are mandated by law or fiduciary duty to be distributed to other entities may be excluded from taxable revenue. The State Comptroller has been applying this provision more narrowly than we believe the legislature intended. To our knowledge, the Comptroller has applied this to only sales and use taxes and similar taxes collected from customers. Clarify that this was intended to apply to other flow-through funds.