The “New Texas Business Tax”

The intent, the reality, and the future.

By Jay Propes & Jay Brown of The Graydon Group

The story of the new Texas business tax is a tale with a long tail. But, because so many SouthWestern Association members are requesting more information, I will try to make this re-telling concise and useful. If this brief article invites more questions, that’s fine, too.

The business tax of 2006 was actually birthed by the November 2005 announcement of Governor Rick Perry that former Democratic Comptroller John Sharp would chair a 24-member Commission on Property Tax Reform. “Reform” in this sense means “reduction” by applying a new model of business tax to a larger number of enterprises operating in the state. It has been often repeated that only one out of 16 businesses in Texas was paying the franchise tax. Applying a broad-based, low-rate tax to more payers, in theory, would lower the burden of taxation on those already paying the franchise tax and proved enough revenue to “buy down” the local maintenance and operation (M&O) property taxes of homeowners and businesses.

Preliminary leaks of discussions within the commission, as early as February 2006, made clear that a tax based upon the gross receipts of a business (rather than as previously applied to earned surplus and capital) would be the model going forward. As most businesspeople are aware, an income tax is unconstitutional in Texas, thereby making a tax that makes no consideration for profitability or loss of a business more defensible in the face of the litigation. Because the term “gross receipts” invokes a vitriolic reaction in the wholesale and retail sectors, the term “Alternative Margins Tax” is used to describe the new levy.

The Tax Reform Commission held public hearings around the state asking businesspeople to share with them the effect of the current franchise tax upon their businesses, what effect a gross receipts-based tax would have upon their businesses, and how much an offset in the current property tax would mean to them. Chairman Sharp and the members of the Commission stated on many occasions that if a business was currently paying the franchise tax there should be very little difference in the tax burden accrued to that business by the new tax structure when property tax reductions are considered, as well. This was a primary tenet upon which the Commission based its work. At the end of March, everyone was able to view the proposed tax bill that was, ostensibly, the product of these many hearings. Needless to say, retailers and wholesalers with high gross revenues and low margins were concerned.  Members of the SouthWestern Association in Texas will have to let us know if the goal of tax-neutrality has been realized. 

Governor Perry signed the tax bill in exactly the same form as it left the House of Representatives. In a highly unusual study in the legislative process, no changes were made to the bill in the Senate so that a second vote on the tax bill by House members would not be necessary. In truth, there was developing a political cloud over the Capitol, which led the House leadership to believe that a second consideration of the tax bill might not result in success. That means that 31 senators and a Lt. Governor have yet to offer their contributions to the future of Texas’ taxes. These pent-up ideas alone will generate enough tweaking to the system that our vigilance will be very important.

It is not easy to clearly define winners and losers immediately after a new tax is passed.  As this tax will not be due for the first time until 2008 (as applied to the 2007 calendar year) this is even more difficult to surmise. However, some changes are clear. The early winners appear to be property-intensive manufacturers that were paying the old franchise tax. All business forms that have liability protection will pay the new business tax. The losers, for lack of a less sympathetic term, are those corporations that had been avoiding the franchise tax by utilizing partnership structures. The service industry, including law firms and accounting firms, will pay the new business tax. Another perceived partial “winner” under this plan is the wholesale and retail sales industry. They get to pay the tax at half the rate of other businesses. Yet, concerns remain here, too. One concern of our members, for example, is that in taking a deduction for costs of goods sold, a business cannot deduct from its receipts the costs of labor associated with generated revenues (shop labor). Issues like this one are shared by several industries and will be addressed in some form starting in January. It also seems logical to some legislators that a percentage of advertising costs might be considered a cost of goods sold and should be deducted from the adjusted gross receipts subject to the tax. There will be changes to the new tax plan in the next session (2007) of the legislature.  Just last week, Ways and Means Committee Chairman Jim Keffer commented that “the jury is still out” on the appropriateness and fiscal performance of the new tax. 

All of the increases in business tax liability should be weighed against the reductions in property taxes – those achieved by the recently passed legislation and those that might be even larger in the future.  How effectively the tax-reduction mechanism works will depend on the amount of revenue the new business tax ultimately raises.

This requires a little explanation.

This year M&O taxes are reduced by 17 cents (with the ability for the district to add back up to four cents without a vote of the citizenry). Property taxes are to be reduced by an additional 33 cents next year. The property tax cuts are fairly significant and, potentially, growing larger in the succeeding years. The new business tax revenues are dedicated solely to the reduction of property taxes until taxes are reduced 50 cents/$100 valuation. After that point, 2/3 of the tax will continue to be dedicated to further reductions of property taxes. If the new Alternative Margins Tax performs as it has in Kentucky (a similar tax structure was recently implemented there) the state could return to the role of majority payer for the cost of public education. There is a general and genuine concern that the real dollar value of property tax cuts will be eroded by annual appraisal increases.  Those of you in the Harris county vicinity have heard this message for a long time. Therefore, you can count on dozens of bills dealing with this issue to be introduced in the next session.

With the numerous concerns that businesses have with the applicability and administration of the new tax, this is far from being a done deal on which you can plan for your business future.  The discussions about “improving the tax system” are already under way. Stay tuned to these pages to find out what is happening and what you can do to influence the conversations in Austin.