What the Texas Legislature Hath Wrought

What the Texas Legislature Hath Wrought

 

We have been saying all along that we thought that Texas legislators didn't really understand what they were voting for when they enacted this new "margin tax" in Texas. Texas has alway been "business friendly". It's a major factor businesses consider when deciding to relocate to this fair state. But the special committee headed by John Sharp that conceived of this tax apparently suffered from California envy. Now Texas has the most onerous corporate income tax in the Union. The legislators who voted for this thing are already hearing it from the Taxpaxers and you can bet the noise will get louder and louder. The Comptroller's Office is charged with implementing this stinker and they seem to making a huge effort to educate the public. The office of Texas Comptroller is an elected position. How would you like to be the Comptroller responsible for implementing the worst tax ever passed by the State of Texas? Susan Combs is just the messenger, but she's getting an earful. She could turn into a hero, if she becomes the public champion of the "Let's Repeal this Tax" committee. Then the legislature would be under a huge amount of pressure. We'll see how this all develops.

 

Taxation is not usually headline news, but this tax is drawing a lot of press. Here's some news from around the state.

 

First out of the gate is an article by Kate Alexander of the AUSTIN AMERICAN-STATESMAN on Friday, May 16, 2008. Demands for changes to Texas' new business tax grew louder Thursday from small-business owners who say they will be unfairly burdened. (See this link.)

 

Speaking at an event to launch the Texas Business Tax Coalition, electrical contractor Keith Bell said the tax bill for his Dallas-area firm will skyrocket from about $3,900 to $50,000 under the so-called margin tax, which is due for the first time in June.

 

"I cannot believe that if the legislators knew that the inequities and the unintended consequences were going to occur ... that they would have voted for it," said Bell, who leads the government affairs committee for the Independent Electrical Contractors of Texas, a trade association.

 

But now that "the devil has been exposed in the details," Bell said, the Legislature needs to act.

 

For most qualifying businesses, the tax is 1 percent of their total revenue minus one of three options: the cost of goods sold, employee compensation or 30 percent of total revenue. Adopted in 2006, the tax applies to about 200,000 more businesses than the franchise tax it replaced.

 

State Reps are Hearing It 

 

State Rep. Jim Keffer, chairman of the House Ways and Means Committee, said legislators are sensitive to the concerns about the tax and are open to addressing any problems once more is known about the tax impact.

 

"Our goal is always to keep Texas business-friendly," said Keffer, an Eastland Republican. "We will work hard to make sure that no industry is overtaxed and overburdened."

 

"It is a mess," said Sen. Dan Patrick, R-Houston, who was not in the state Senate in 2006 when the margin tax was adopted.

 

The tax is convoluted and confusing, and it punishes many small businesses, Patrick said.

State Rep. Debbie Riddle, R-Tomball, opposed the tax in 2006 and said it continues to be a mistake.

 

"We need to nuke the tax, we need to repeal the tax, we need to drive a stake through the heart of the margin tax," said Riddle, who attended the coalition event Thursday.

 

The Governor is Hearing It

 

Gov. Rick Perry has said the Legislature should revisit the business tax if it brings in more revenue than anticipated or if there are unintended consequences, spokeswoman Allison Castle said.

 

 

 

Check out this Article in the Dallas Business Journal by Dave Moore. 

 

 

"It's the only tax of its kind in the United States, and perhaps the world... "

This isn't the type of headline the Comptroller is hoping for.

 

According to Dave Moore: Beyond the tax measure's complexity, business owners are hoping to squelch what they claim is the law's punitive nature.

 

"It's not a fairly levied tax," said Pete Snider, president of Mesquite-based Alco Glass Inc., which does high-rise commercial and residential glass replacement." It penalizes a businesses when they're not in a profitable mode. It disregards your net revenue."

 

Snider, for example, reported a loss of $18,000 in 2007, but he calculates he'll owe Texas $6,000 in margin taxes, because the margin tax applies to his cost of material, not his relatively thin profit. Snider said he'll have to take a loan out to cover the tax bill.

 

So Who Came Up With this Tax?

 

Dave Moore names names: Efforts to contact the leading author of the tax, John Sharp, were unsuccessful. Sharp was chairman of the Texas Tax Reform Commission that formulated the margin tax; he was Texas' comptroller in the 1990s.

 

Rich Parsons, press secretary of Lt. Gov. David Dewhurst, said it's likely Dewhurst will wait until after the tax is collected before he decides if it should undergo further reform. As lieutenant governor, Dewhurst sets the legislative agenda for the Texas Senate.

 

The El Paso Times Weighs In 

The El Paso Times had this article in the May 12 edition. It was a report about a recent visit by Texas Comptroller Susan Combs to El Paso at the invitation of the Greater El Paso Chamber of Commerce, who apparently gave her an earful. She noted that the first year of the tax "is really tough" and that she would furnish the Legislature with as much information as possible about the tax's effects. That includes some business being hurt.

 

They make a good point about attracting business to Texas: "Also, a destructive franchise-tax structure would be a huge deterrent to businesses thinking about coming to Texas. We need to be thinking about ways to attract business, not drive it away ... So far, Texas is in better economic shape (knock on wood) than most of the rest of the country. We need to keep it that way, and a devastating franchise tax isn't a good way to do that." Ouch.

 

 

  

The Service Industry May Be Hardest Hit

 

Leslie Wimmer of the Fort Worth Business Press had this quote from Cyndy Kimberling, owner of Kimberling, McFarland and Associates accounting firm. "I know of several of our clients who could be put out of business because the new franchise tax is based on gross receipts rather than bottom line profits," Kimberling said. "It is really going to hurt some of our clients."

The service industry may be hardest hit, she said.

 

"The ones who are really suffering are going to be your service businesses such as trucking companies," Kimberling said. "They have a lot of expenses such as fuel and truck maintenance. The new franchise tax does not consider these expenses as cost of goods sold so they do not get to deduct them from their gross receipts."

 

 

 

"I think you're going to see some people get voted out of office because of this..." This was a statement of a business owner quoted in an article in the Dallas Morning News by Terrence Stutz.

 

Among the disenchanted taxpayers is Dallas businessman Andy Ellard, owner of a machine shop with 28 employees. Mr. Ellard said the size of his tax bill doesn't match up with the pledges of state lawmakers. "We were promised a number of things, and none of them happened," said Mr. Ellard. He estimated that he would pay about $8,900 under the new business franchise tax, more than double the $4,200 he paid last year.

 

"There are going to be some mad business owners [on June 16], and I think you're going to see some people get voted out of office because of this," he said.

 

"Businesses are just waking up to this," said Will Newton of the National Federation of Independent Business, which has become one of the biggest critics of the new tax. "Texas used to be good for business, but this new tax is making us one of the most anti-business states in the country."

 

To top it off, Mr. Newton said, "It's the most confusing, complicated system of taxation ever devised. Just the cost of compliance [preparing tax returns] has been devastating for some of our members."

 

"This tax is going to cost jobs in the long run," he said. "If you want to make sure the Texas economy tanks, just enact a tax that hits small businesses hard."

 

 

"The way I see it, it's like kicking a guy when he's down," Mr. Snider said, referring to the slowing economy in Texas.

 

Major Defeat Dealt to States Seeking to Apportion Income Using the "Operational Function Test"

The U.S. Supreme Court issued a very interesting ruling affirming its earlier decisions related to the taxation of "unitary businesses".  (See MeadWestvaco Corp. v. Illinois Department of Revenue, U.S. Supreme Court, Dkt. 06-1413, vacating the Illinois Appellate Court, April 15, 2008).

 

In this case, Mead had sold Lexis-Nexis for a $1Billion gain. That gain was allocated to Ohio by Mead. Illinois audited them and took the position that the gain should have been apportioned to IL. IL made the argument at the trial court (which agreed with the State) that although the businesses weren't unitary, the asset (Lexis-Nexis) was used in an "operational function", it should be apportioned. This "operational function" concept has arisen in a couple of recent US Supreme decisions. It has apparently given the states the idea that there is no such thing as allocable income anymore because all they have to do is argue that the asset involved was used in an operation function and they can apportion it. Of course, only the extraterritorial states want to make this argument. But the Supremes in this case, say the IL court erred in their interpretation of this test. See below for their commentary:

"As the foregoing history confirms, our references to "operational function" in Container Corp. and Allied-Signal were not intended to modify the unitary business principle by adding a new ground for apportionment. The concept of operational function simply recognizes that an asset can be a part of a taxpayer's unitary business even if what we may term a "unitary relationship" does not exist between the "payor and payee." See Allied-Signal, supra, at 791-792 (O'Connor, J., dissenting); Hellerstein, State Taxation of Corporate Income from Intangibles: Allied-Signal and Beyond, 48 Tax L. Rev. 739, 790 (1993) (hereinafter Hellerstein). In the example given in Allied-Signal, the taxpayer was not unitary with its banker, but the taxpayer's deposits (which represented working capital and thus operational assets) were clearly unitary with the taxpayer's business. In Corn Products, the taxpayer was not unitary with the counterparty to its hedge, but the taxpayer's futures contracts (which served to hedge against the risk of an increase in the price of a key cost input) were likewise clearly unitary with the taxpayer's business. In each case, the "payor" was not a unitary part of the taxpayer's business, but the relevant asset was. The conclusion that the asset served an operational function was merely instrumental to the constitutionally relevant conclusion that the asset was a unitary part of the business being conducted in the taxing State rather than a discrete asset to which the State had no claim. Our decisions in Container Corp. and Allied-Signal did not announce a new ground for the constitutional apportionment of extrastate values in the absence of a unitary business. Because the Appellate Court of Illinois interpreted those decisions to the contrary, it erred."

 

How did the IL courts err? Well, this is where it gets interesting. If it were just an asset, they would have been fine, I guess. But this was not just an asset, but another business. Therefore, this "operation function test" doesn't apply. You must apply the unitary test. I'm not sure I understand the distinction. But here it is in their words:

"Where, as here, the asset in question is another business, we have described the "hallmarks" of a unitary relationship as functional integration, centralized management, and economies of scale. See Mobil Oil Corp., 445 U. S., at 438 (citing Butler Brothers v. McColgan, 315 U. S. 501, 506-508 (1942)); see also Allied-Signal, supra, at 783 (same); Container Corp., supra, at 179 (same); F. W. Woolworth Co. v. Taxation and Revenue Dept. of N. M., 458 U. S. 354, 364 (1982) (same).
 
So on that basis they vacated the appellate court's decision. They did point out that although the trial court had concluded that Mead and Lexis-Nexis were not unitary, that issue wasn't considered in the appeal. The appellate court was invited to consider that question on remand.

Since the trial court already determined that they weren't unitary, it seems logical that IL will lose this case. We will be interested to see how it turns out.

Texas Offers 30 Day Extension on Margin Tax Filing

Texas --Corporate Income Tax: Comptroller Extends Filing Date by 30 Days

In a Press Release, issued by Texas Comptroller Susan Combs, dated, April 22, 2008 it was announced that businesses unable to meet the May 15 due date for the revised franchise tax, also referred to as the business margin tax, are being granted a 30-day extension to submit their returns or file an extension without penalty. Reports filed on or before June 16, 2008, for annual reports and June 2, 2008, for initial reports will be considered timely. Prior to the extension, a 5% penalty would have been imposed on those not filing by May 15. The comptroller's office is allowing the additional 30 days due to the complexity of the revised franchise tax and the newness of the enhanced electronic reporting methods.

 

 

 

Millionaires in MD Beware

I don't know how many of our Blog readers in MD are Millionaires -- probably a lot I would guess. Here's a recent development targeting you or your client:

 

Senate Bill 46, effective July 1, 2008, temporarily (yeah, right) increases the personal income tax rate for those with Maryland taxable income in excess of $1,000,000. For taxable years beginning after December 31, 2007, but before January 1, 2011, the Maryland personal income tax for an individual, including spouses filing a joint return or a surviving spouse or head of household, is 6.25%. Currently, the highest income tax rate is 5.5% and applies to individuals, spouses filing a joint return or a surviving spouse or head of household with Maryland taxable income in excess of $500,000. Those with a Maryland taxable income of $500,001 through $1,000,000 are taxed at the rate of 5.5% for taxable years beginning after December 31, 2007, and ending before January 1, 2011.

I guess MD, doesn't like high earning individuals living in their state.

AL Loses in Bid to Classify Sale of Land/Plant as Nonbusiness Income

In a recent case decided by the AL Supreme Court, Kimberly Clark won its appeal. Kimberly Clark had classified the income from the sale of timberland and a paper processing plant as business income. AL is a UDITPA state and as such follows the transactional test when it comes to classifying income. If the transaction can be said to occur in the normal course of business of the taxpayer, then it is business income. States are notorious for taking positions that are in their favor of course. Taxpayers are also wise to take positions in their own favor. In this case, the property sold was located in AL. Therefore, its no surprise that AL is going to take the position that the income from the sale is nonbusiness. Nonbusiness income is allocable as opposed to apportionable. Inasmuch as the property is located in AL, the income would be all allocable to AL, if AL could win their argument. AL argued that Kimberly Clark was not in the business of selling timberland and processing plants. In fact, Kimberly Clark had classified the sale as "extraordinary" in its own financial statements.

 

However, KC was able to show that in fact, it had conducted numerous of these transactions during the audit period. The Supreme Court found KC's argument compelling and ruled in their favor. We can get you a copy of the entire hearing. Of course, AL still got some of the benefit of this transaction, but they wanted the whole thing. KC had argued in the alternative, that if the transaction was nonbusiness in nature, then the income should be allocable to TX. My guess is that KC had a limited partnership structure in place in TX
that could have generated a nice refund for KC in that case. The Supremes didn't comment on the alternative argument since they ruled that it was business income.
--

MA Says 80 New Auditors Will Bring In $60Million

I saw this headline and it piqued my interest. I wondered how this would be. That would mean each auditor would find over $700,000 in assessments each year. That seems a little overstated. Further reading of the article in the Worcester Telegram and Gazette revealed that the estimates are pretty loose indeed. First of all, MA, is going to focus on the cigarrette tax and try to force the wholesalers to collect the tax instead of the retailers as is currently done. Of course, the primary interest there is to only have to audit wholesalers and not the individual retailers. The next thing they'll do is make the wholesalers collect tax on a marked up amount. Whatever is easiest for the State, right? They didn't make much mention of how these 80 new auditors are going to bring in all this money.

 

The other big item, they want to go after, and maybe this is where these auditors are going to be spending their time, is investigating companies' classification of workers as contractors vs. employees. Again, this is mostly a matter of changing who they will go after. Theoretically, there should be no difference in state income tax if a company calls an employee a contractor. However, that contractor/employee may not be paying the taxes due. It's hard to go after individuals -- much easier to go after corporations.

Newspaper Calls Wal-Mart State Tax Planning "Corporate Tax Shenanigans"

I find it interesting how the newpapers and other media report about corporate tax matters. Sometimes it's quite the eye-opener. Take this editorial article in the Carrboro (NC) Citizen which is written by Elaine Mejia who is referred to as the director of the N.C. Budget and Tax Center. In this article she describes a tax planning technique (which I'm sure was done for other than tax-reduction purposes) that was used by Wal-Mart that had the effect of dramatically reducing state income taxes in NC. NC is a separate return state. Following is her description of what Wal-Mart did and take note of the inflammatory adjectives she throws in there. She makes a call for combined reporting -- the bain of state income tax consultants.

 

"At issue is a clever tax scheme that the company used to avoid paying an estimated $230 million in states' taxes across the country, according to the Wall Street Journal. North Carolina's share of that was $33.5 million between 1998 and 2002. So what did Wal-Mart due to earn the state's scrutiny? Essentially, the company put ownership of its properties into a "real estate investment trust." That trust was owned by Wal-Mart Property Co., a separate holding company. Conveniently, Wal-Mart owned 99 percent of this holding company. It used this complicated set-up to avoid state taxes by making rent payments on its stores to the holding company and then deducting that amount from its tax bills.

"Unfortunately for Wal-Mart, the Department of Revenue didn't buy it and neither did the judge. In fact, the judge found that the scheme served no legitimate business purpose and was used solely to lower the company's tax bills.

"What's lost in most of the media coverage about this case is why it really matters and what can be done to prevent these kinds of corporate tax shenanigans in the future.

"So, why should North Carolinians care about this case? If nothing else, we should care because $33.5 million dollars is at stake. But there are much bigger reasons to care. In North Carolina today, much of our quality of life depends upon healthy public structures — things like an educated workforce, the court system and good roads. It's these investments that enable companies like Wal-Mart to profit from doing business in our state. When companies like Wal-Mart don't pay their fair share, two things happen — we forego investments that would improve our quality of life and make our economy stronger and the rest of us pay more. I'd call that a "lose-lose" scenario.

"There is a change we can make to our state tax laws that would prevent corporations from trying many of these types of tax schemes in the future. It's called "combined reporting."

"Under this system, multi-state corporations would have to file a report with the state that discloses their entire business structure, including related entities. This would include relationships with holding companies like the one Wal-Mart owned 99 percent of and paid its rent to. Over time, using this strategy to close corporate loopholes would raise hundreds of millions of dollars that could be used for investments in things like education and roads or put back into the hands of working families by expanding the state earned income tax credit.

"Twenty-two states already have combined reporting and five states have adopted this reform in just the last three years. In North Carolina, not one but two bipartisan study committees recently recommended that our state adopt this strategy as well. In the end, this really isn't about one company. It's a wake-up call that should prompt us to put into place public policies that are fair to everyone and that will improve our lives and strengthen our economy in the decades ahead."