In March of 2014, a landmark case was decided that would change the landscape of Texas Margin Tax and the taxation of the Transportation Industry, hopefully forever. Before this case was decided, the Transportation Industry felt it was treated unfairly by the Secretary of State interpretation of the franchise tax law, thereby, forcing these companies to pay more taxes. Given the recent ruling, it may be prudent to examine your past franchise filings to determine if you have any refunds that you may claim. This case may have an impact on other industries in the future. A little background: In 2006, the legislation was passed that changed the way Texas taxed businesses. This new legislation included taxation upon partnerships and other business entities that were previously not taxed. The franchise tax was replaced with the margin tax for all returns that were due after January 1, 2008. Businesses were given a few options on how to report their “margin” tax. They would be required to report 100% of their gross revenues, have a few select exclusions/deductions from gross revenue, and then choose to deduct the following items from their gross revenue to arrive at taxable margin:
- Costs of Goods Sold (COGS)
- Compensation
- 30% of Total Revenue
The net margin tax was then multiplied by the apportionment factor and then multiplied by the state tax rate-.5% for retail/wholesale, and 1% for all other companies. With this method for determining margin tax, many companies had to pay margin tax even when they had a net loss for the full year. Here is how the Margin Tax applies to the transportation industry prior to this ruling: The Texas Comptroller initially determined that the Transportation industry is a service provider industry and issued a Tax Policy newsletter in August 2010 explaining this determination. Based on their assessment of the service related industry, they determined that transportation companies were not entitled to a COGS deduction. This meant that the Transportation Industry could only rely on the remaining two deduction categories, which are the compensation deduction and the 30% of total revenue deduction. The compensation deduction would allow the company to deduct payments made to employees as long as they didn’t exceed $300,000 per employee (adjusted to $350,000 in 2013 for inflation.) This is a great deduction, but what if you don’t have any employees; instead choosing to pay sub-contractors to do the transportation? Payments made to Form 1099 recipients are not included in this category. The answer is you do not get a deduction for any sub-contractor payments. If all your employees are sub-contractor labor, then you are left with the only remaining choice of the 70% of Total Revenue method. This created a very large amount of Margin Tax due on an Industry that normally runs on very tight margins. In some cases Margin Tax due was more than the Net Income produced for the year. For example, let’s assume your company grossed $15 million, paid mostly through sub-contractors, and was in the transportation industry. The result would be a state margin tax of $105,000 (15,000,000*70%*1% tax rate). We know from working with transportation companies that nearly 85-90% of their revenue is funneled to the sub-contractors and the business may make only 10-15% net revenue on these contracts. This in effect is taxation on gross revenue that the transportation companies never truly receive. $105,000 is a lot of money to pay the state in this example. This treatment has been in effect since 2008. In March 2014 a case, which was brought by a client of Akin, Doherty, Klein & Feuge, P.C. (ADKF), was settled favorably for the taxpayer. This ruling eliminated the disparity that exists within the Transportation Industry, which denied companies the ability to deduct and/or exclude sub-contractor payments. Titan Transportation, LP vs Susan Combs, Comptroller of Public Accounts was decided in appeals by the Texas Court of Appeals, Third District. Titan Transportation initially excluded the payments made to their transportation sub-contractors under the Franchise Tax Statute 171.1011(g)(3) that states the following:
A taxable entity shall exclude from its total revenue, to the extent [reported to the federal IRS as income] only the following flow-through funds that are mandated by contract or subcontract to be distributed to other entities….
(3) subcontracting payments made under a contract or subcontract entered into by the taxable entity to provide services, labor, or materials in connection with the actual or proposed design, construction, remodeling, remediation, or repair of improvements on real property or the location of the boundaries of real property.
The state of Texas initially denied the exclusion, stating, as a transportation company, Titan Transportation did not contribute any improvements to real property. Titan successfully countered that argument by proving the material they carry, aggregates and concrete materials, is essential to construction and impacts the real property as well as changes the topography of the property. Titan Transportation brought in experts, including a CPA from ADKF, who supported these claims. The State’s initial denial of the exclusion was reversed and Titan Transportation won the case for themselves and the industry. As a result of the success of this appeal, there will be a benefit for the entire Transportation Industry. Likewise, the Texas Margin Tax will no longer punish the transportation companies that choose to hire sub-contractors for hauling. Transportation companies need to revisit their franchise tax filings and determine if they need to amend any forms to take advantage of the recent changes. Remember, the statute of limitations for filing amended forms within Texas is four years, so, double check and see if you are leaving any money on the table! If we can help assist you with this project please feel free to contact your CPAs at ADKF, at 210-829-1300.