Texas’ primary tax on business, the franchise tax, is an important revenue source for state government — and often a controversial one, given the Legislature’s consistent focus on maintaining Texas’ business-friendly reputation.
In the past few decades, the tax (sometimes called the “margin” tax) has had a complex history as the focus of at least two special sessions, two Texas Supreme Court decisions (with more to come), three blue-ribbon committees and countless lower court decisions and administrative hearings.
As described in Texas law, the franchise tax is levied in exchange for the “privilege” of doing business in the state. Part of this privilege includes liability protections under state law.
A business’ tax liability is based on its “margin,” which state law uniquely defines as total revenue minus one of four possible deductions (some of which are highly complex).
Once determined, this margin is multiplied by the percentage of the firm’s business revenues earned in Texas during the year. The tax typically is due in May of each year. The current franchise tax is levied on the apportioned margin at the following rates:
For 2015, no tax is due from companies with $1,080,000 or less in total revenues, or with less than $1,000 in tax liability.
The 2013 Legislature enacted a temporary reduction in franchise tax rates. For tax reports due in 2015, the rates will be 0.475 percent for retailers and wholesalers and 0.95 percent for other entities (the small business rate remains unchanged). Under current law, the tax will revert to its previous rates for reports due in 2016.
In terms of its contributions to the state’s tax revenues, the franchise tax is a distant second in size to the sales tax. In 2014, the franchise tax generated 9.3 percent of the state’s total tax collections, while the sale tax accounted for almost 54 percent. Recent projections from the Comptroller’s office have its share of tax collections shrinking to 8.6 percent by fiscal 2017.
The Texas franchise tax accounted for more than 9 percent of total tax collections in fiscal 2014.
|Tax||Fiscal 2014 Collections||Share of Total Collections|
|MOTOR VEHICLE SALES/RENTAL TAXES||$4,209,952,925||8.3%|
|Oil Production and Regulation Taxes||$3,874,070,862||7.6%|
|Motor Fuel Taxes||$3,315,952,089||6.5%|
|Natural Gas Production Tax||$1,899,581,526||3.7%|
|Cigarette and Tobacco Taxes||$1,342,454,822||2.6%|
|Alcoholic Beverages Taxes||$1,053,231,009||2.1%|
|Hotel Occupancy Tax||$485,384,563||1.0%|
Totals may not add due to rounding.
Source: Texas Comptroller of Public Accounts
Most of the franchise tax’s history was rather uneventful. First levied in 1907, relatively minor changes were made to the tax for nearly a century. In the 1980s, however, the franchise tax entered a new and much more volatile era.
The first substantial challenge to the franchise tax came in the late 1980s, during a severe state economic downturn fueled by plunging oil prices. San Antonio-based Sage Energy Company filed a lawsuit arguing that the franchise tax violated the state’s “equal and uniform” clause, which requires the state to levy its taxes consistently within each tax “classification” — that is, for each group of businesses to be taxed.
Texas courts traditionally have deferred to the Legislature in determining the makeup of these classifications, as long as they relate to the value of the item being taxed. In the case of the franchise tax, the “item” being taxed is the privilege of doing business in Texas. As a result, classifications made for the franchise tax must relate to differences in companies’ ways of doing business that affect the value of this privilege. The state, for example, may subject a retailer to a different franchise tax rate than a manufacturer, due to their different business models, but two manufacturers in the same franchise tax classification must be treated similarly under the tax.
Sage maintained, however, that the state’s method for determining franchise tax obligations could be affected by an individual company’s accounting practices, which were unrelated to the value of doing business in Texas. (The case primarily concerned the use of “expense” versus “capitalized” accounting, and the way in which assets are treated under each method.) Sage argued further that the Comptroller’s office required some businesses to use one accounting method, while permitting others to use a more tax-advantaged method.
A state court of appeals sided with Sage in the 1987 decision Bullock v. Sage Energy, which had a profound impact on the amount of revenue yielded by the franchise tax. Due to the Sage decision, the state was forced to refund a considerable portion of its franchise tax revenues throughout the late 1980s, with some years’ refunds amounting to half of the tax’s total collections.
In the first four years after the decision, Texas’ annual franchise tax revenues declined by more than 30 percent. By 1991, franchise taxes accounted for just 4 percent of all tax collections, the lowest share in the tax’s modern history.
The relative importance of the Texas franchise tax in the state’s tax mix has varied widely over the years, fluctuating along with events that affected the tax’s reach and returns. Since 1980, the franchise tax has accounted for as little as 4 percent of total tax collections and as much as 11 percent.
Roll over the chart for specific values.
Source: Texas Comptroller of Public Accounts
To counter this erosion in the franchise tax, the 1991 Legislature passed sweeping changes that raised taxes on most corporations. This overhaul included adding a new base component: “earned surplus,” which was roughly defined as federal taxable income plus officer and director compensation, and was taxed at 4.5 percent. At the same time, the rate at which capital could be taxed was reduced from $5.25 to $2.50 per $1,000 of taxable capital.
Businesses would now have to calculate their tax obligation on both base components. They would still be required to pay taxes based on their capital, albeit at the reduced rate. But businesses then had to calculate their tax liability based on the new earned surplus component. If this amount were larger than the capital-based amount, businesses also had to pay the difference between the two figures. For many businesses, this resulted in a higher overall tax obligation.
As a result, franchise tax revenue immediately rebounded, rising 82.2 percent in a single year to $1.1 billion, or 7 percent of all state tax revenue.
Historically, the Texas franchise tax was levied only on corporations and, beginning in 1991, limited liability companies (LLCs) — the latter an alternative form of business that, like a corporation, offers some liability protection to its owners. This left other types of businesses, such as limited partnerships, limited liability partnerships (LLPs), general partnerships, sole proprietorships and business trusts, untaxed.
After the 1991 expansion, many Texas businesses began to take advantage of the fact that partnerships were not taxed under the franchise tax, and reorganized to minimize their tax liability. In 2002 alone, about a thousand corporations converted to limited partnerships to take advantage of this loophole, costing the state an estimated $143 million in 2003.
As a result of the loophole, tax cuts and broader economic trends, the explosive growth of the tax seen in 1992 did not last. Total revenue brought in under the franchise tax began a four-year slide in 2000; in 2003 alone, franchise tax revenues declined by 11.3 percent.
Meanwhile, the Texas economy was changing in ways unanticipated by lawmakers in 1991, leaving the business tax burden increasingly borne by capital-intensive industries such as mining (in Texas, primarily oil and gas production), while leaving a booming services sector relatively untouched. In 2004, for instance, mining companies contributed $10,840 in state and local taxes per employee; the services sector, which had experienced a tenfold increase in employment in the preceding decade, contributed just $407 per employee.
In the same period, pressure to reduce property taxes was building in the Legislature. During the 1997 legislative session, then-Governor George W. Bush pushed for sweeping legislation that would have raised the homestead exemption from $5,000 to $20,000, and reduced school district maintenance and operations (M&O) tax rates by 20 cents per $100 in property value. This bill also would have repealed the franchise tax and replaced it with a broader business activity tax. According to estimates at the time, this new business tax would have generated about a $1 billion more each year than the existing franchise tax.
Over the course of the session, however, the proposals were reduced to a more modest set of reforms, including a $10,000 increase to the homestead exemption and other changes to the school finance system. The proposed new business tax never made it into law.
Legislators continued grappling with the shrinking franchise tax base, but no significant reforms were enacted until the Texas Supreme Court forced the 2005 Legislature’s hand by declaring the school finance system unconstitutional.
The court found that the $1.50 cap on school-district property taxes was so universally applied that it essentially acted as a statewide property tax, which is prohibited under Texas’ constitution. The court gave lawmakers less than seven months to resolve the issue. Due to the short timeline, constitutional changes, which must be approved by voters, were essentially off the table.
In response, then-Governor Perry formed the Texas Tax Reform Commission, a 24-member panel of business leaders headed by former Comptroller John Sharp. The commission embarked on a whirlwind tour of the state, conducting 16 public hearings in three months and receiving testimony from hundreds of taxpayers. At the end of March 2005, the committee members delivered their recommendations, which included the first outlines of the modern franchise tax.
The most fundamental change to the franchise tax proposed by the commission, and subsequently approved by the Legislature as House Bill 3, was the introduction of the “margin” concept as the new base tax component, and the elimination of the previous bases of earned surplus or capital.
Another very important 2006 reform was the expansion of the tax to nearly all entities with limited liability protection under state law, including limited partnerships. This effectively eliminated the previous incentive for corporate reorganization. Other changes were introduced as well, including an increase to the “small business exception” (the threshold for zero tax liability went from total annual receipts of $150,000 or less to $300,000 in receipts and less than $1,000 in tax liability; the Legislature ultimately raised this threshold to the current $1,080,000 in total revenues).
Finally, the 2006 overhaul changed the disposition of franchise tax collections. Revenue that would have been generated under the previous tax structure would still be deposited into the General Revenue Fund, which the Legislature uses to fund a wide range of state programs and agencies. Any franchise tax collections in excess of this amount now were directed to a new Property Tax Relief Fund, which is used to supplement public education funding.
These changes to the franchise tax took effect for tax payments in 2008. In that first year, the franchise tax produced nearly $4.5 billion, 41.6 percent more than 2007 collections under the old formulation.
Despite this increase, however, the franchise tax still performed considerably below the state’s expectations. Initially, the new margin tax was projected to generate $5.9 billion in its first year, 30 percent more than actual receipts. This was problematic because the Legislature also reduced school property taxes by a third in 2006, and the new Property Tax Relief Fund could not entirely make up the difference.
The franchise tax’s underperformance was attributed largely to the “cost of goods sold” deduction used to determine taxable margin, which was selected by unexpectedly high numbers of businesses, and to the broad way in which the deduction was originally interpreted by taxpayers. On the other hand, the new margin-based tax did prove successful in better aligning the tax with the modern Texas economy. Mining, for example, paid approximately 9.5 percent of the margin-based tax in 2008 — down from 16 percent in 2007 — while contributing 11 percent of the gross state product in both years.
The transition to the new margin-based tax and the reduction in school property taxes prompted by the 2006 legislation had varying effects on the state’s industries.
|Industry||Before 2008||In 2008|
|Amount (Millions)||Share of Total Tax Burden||Amount (Millions)||Share of Total Tax Burden|
|Utilities and Transportation||$2,059.80||14.30%||$1,644.90||13.30%|
|Wholesale and Retail||$1,541.10||10.70%||$1,457.90||11.70%|
|Finance, Insurance and Real Estate||$3,867.85||26.90%||$3,004.20||24.20%|
|All Other Services||$1,467.80||10.20%||$1,673.60||13.50%|
Source: Texas Comptroller of Public Accounts, Business Tax Advisory Committee Report January 2009
Unsurprisingly, given the sweeping nature of the changes to the franchise tax, virtually every facet of the new system soon faced administrative and legal challenges, two of which were ultimately decided by the state’s Supreme Court.
The first major challenge to the new margin-based tax came in 2011, when Allcat Claims Services filed a lawsuit arguing that, among other things, the tax amounted to a de facto personal income tax.
According to the Texas Constitution, voters must approve such a tax through a state-wide referendum. Specifically, Allcat claimed that the franchise tax violated what is commonly referred to as the “Bullock” amendment to the constitution (due to the former lieutenant governor’s role in the negotiations leading to it).
This amendment reads, in part:
[a] general law enacted by the legislature that imposes a tax on the net income of natural persons, including a person’s share of partnership and unincorporated association income, must provide that the portion of the law imposing the tax not take effect until approved by a majority of the registered voters voting in a statewide referendum held on the question of imposing the tax. [emphasis added]
According to the firm, which was established as a limited partnership, the franchise tax reduced Allcat’s income, in turn reducing each partner’s share and thus violating the Bullock amendment. During the trial, the plaintiffs also pointed out that the proportional income of a limited partnership is treated as income to each partner for federal tax purposes.
The Texas Supreme Court, however, agreed with the state’s argument that Texas law considered limited partnerships to be separate entities from their owners, and that the franchise tax was strictly a tax on these businesses, not on the individuals or “natural persons” owning them.
Much was riding on this decision. Had partnerships been excluded from the new franchise tax, it would have represented a significant loss of revenue to the state. Partnerships accounted for approximately $579 million of franchise tax revenues in 2011, or about 13 percent of the total.
The next significant court challenge came in 2012, from food giant Nestlé, and represented a much broader attack on the new franchise tax’s constitutionality than the Allcat case.
Nestlé contended that the new tax had no genuine relationship to the value of the “privilege” of doing business in Texas because of its many deductions and exemptions, and was thus unconstitutional under both the state and federal constitutions. The company also maintained that, while it certainly manufactured food and beverages, it had no manufacturing operations in Texas. Instead, its Texas operations were more akin to retail or wholesale activity, which receives a much lower rate under the new tax. Thus, the company argued, it should be subject to the lesser rate.
Again, the Texas Supreme Court ultimately sided with the state, holding that the Legislature could consider the company’s non-Texas business activity in determining which tax rate to apply.
While the Allcat and Nestlé cases ultimately had little impact on the new margin tax, it still faces numerous pending legal challenges, touching on everything from how the state calculates the portion of a company’s activity that occurs in Texas to which expenses can be deducted from a firm’s total revenue. These cases could affect the revenues brought in under the franchise tax.
Nearly 100 bills and resolutions relating to the franchise tax were filed in the 2015 legislative session, 13 of which would repeal it entirely. Clearly, Texas’ franchise tax will continue to be subject to legislative changes and court challenges for the foreseeable future. FN
Read more about the Texas franchise tax.
For an in-depth look at the sources of state revenues, visit Texas Transparency.