The Texas Franchise tax is rumored to be a bigger burden on companies than the impact of sales and income tax in other states. That’s usually because companies aren’t calculating their tax obligation in the smartest way. We just finished filing taxes for hundreds of companies across Texas – here’s what we know about Texas Franchise Tax and how you can build your tax strategy around it in 2021.
Texas Franchise Tax 101
With Bloomberg reporting that large tech companies and hedge funds are moving operations to Texas for “lower taxes”, there must be a good reason, right? While it’s true that there is no Texas corporate income tax, businesses do still have state tax obligations, namely the Texas Franchise Tax.
What is Texas franchise tax?
Texas is one of only six states that do not have a corporate income tax. Texas businesses are instead required to pay a franchise tax – companies pay what is basically an annual fee to Texas for the privilege of doing business in the state. It is a tax on revenue and is less than 1%.
Who pays it?
All taxable entities formed, organized, or doing business in Texas, with revenue over $1.18M, are subject to the franchise tax. Exceptions include sole proprietorships not registered as an LLC, passive partnerships, and certain non-profits and trusts.
What are the Texas franchise tax rates?
For 2020 and 2021 the tax rates are as follows:
|Revenue < $1.18M||No franchise tax due|
|Revenue > $1.18M||Retail or Wholesale = 0.375%|
|All other industries = 0.75%|
How is Texas franchise tax calculated?
The Texas franchise tax calculation is based on margin, which can be calculated using one of the following methods:
- Total revenue times 70%
- Total revenue minus cost of goods sold (COGS)
- Total revenue minus compensation
- Total revenue minus $1M
- EZ Computation* – Total revenue times apportionment factor, then apportioned total revenue times tax rate of 0.331%.
*Only businesses with an annualized total revenue of $20M or less qualify for EZ Computation
Who does it impact the most?
Service industries, especially those with a low employee count, are generally the most affected by the Texas franchise tax as they do not have a COGS deduction. Manufacturing and retail, on the other hand, do have the COGS deduction as well as the advantage of a reduced 0.375% tax rate, both of which help minimize their tax burden.
How does economic nexus factor in?
As of January 1st 2020, out-of-state taxable entities with annual gross receipts over $500,000 from business in Texas must file a Franchise Tax Report even if the entity has no physical presence in this state.
Preparing for (and reducing) your Texas Franchise Tax
While the filing date for Annual Franchise Tax Reports is May 15th (in non-pandemic years), what you do the other 364 days of the year can play a big part in making sure your company pays only the minimum tax required.
Diligently track your sales
As a general rule, keeping good records of two key components: sales by state and cost of goods sold (both direct and indirect) will ensure that when it’s time to file, the most optimal method to calculate the franchise tax due can be used.
Working with a tax professional to plan the best approach (and therefore knowing exactly what to track throughout the year) can also help avoid some of the other common mistakes we’ve seen, such as:
- Missing exclusions for Medicaid and Medicare income (for medical providers)
- Not structuring commission agreements so that the commission expense is an exclusion
- Double counting income that was already reported on a flow-through franchise return
- Not realizing some real estate providers may qualify for the COGS deduction
- Not applying the reduced 0.375 rate for retailers and wholesalers
In many situations, forethought and tracking can make a big difference. As an example, one of our clients recently changed the way they were invoicing customers to reduce their franchise tax obligation. Initially, they were paying for project-related costs on behalf of their customer and then invoicing for the grand total. Since they were not eligible for the COGS deduction, this caused a higher tax burden for them. By moving the costs directly to the customer and only billing for the direct service provided, they were able to lower their tax. Simple change, big difference.
Available Tax Credits
Another reason to think ahead is to take advantage of available tax credits that may be applicable to your business. Knowing which credits you are eligible to earn translates into knowing the documentation you’ll need to maintain over the course of the year. (And saves you from the last-minute scramble to find or request needed documents when it’s time to file!) Below are a few examples of available franchise tax credits.
- Clean Energy Project Credit – A franchise tax credit for up to three clean energy projects, for the lesser of $100 million or 10% of the total capital cost of the project. The credit can be carried forward for up to 20 consecutive years.
- Certified Historic Structures Rehabilitation Credit – A franchise tax credit for up to 25% of eligible costs and expenses relating to the certified rehabilitation of certified historic structures. The credit can be carried forward for up to 5 years.
- Research and Development Activities Credit – A franchise tax credit of 5% of the difference between the amount of qualified research expenses incurred in the current period and the base amount (defined in Texas Tax Code § 171.654(a) as 50% of the average amount of qualified research expenses incurred during the three tax periods preceding the period on which the report is based). The credit can be carried forward for up to 20 years.
Calculation methods, available credits, billing/contracting changes…it’s a lot to think about. Working with a Texas CPA can set you on the right path to painlessly filing your 2021 Annual Franchise Tax Report next year. The May 15th deadline may seem far away, but we all know it’ll arrive fast. Have questions about your company’s Texas franchise tax situation? Contact us today.