2007 Legislative Compendium: Franchise Tax Reform

The effort to revise Texas' franchise tax began in 1996, driven by concerns that Texas was overly dependent on sales and property taxes. The existing franchise tax was easy to avoid. It was often characterized as "optional" - even for large businesses.

For years, Texas was heavily dependent on the oil and gas industry for tax revenue. However, that sector is shrinking. Growth in Texas' economy now is driven by "service-sector industries," such as health care. Legislators had to develop a new tax system that would grow with the state's economy. After eight years, four regular legislative sessions, and numerous special sessions, the state still had not resolved the issue. In 2004, a state court declared the school finance system unconstitutional, and the governor appointed a special commission headed by John Sharp to resolve the problem.

The Texas Tax Reform Commission devised an innovative method for levying a franchise tax, which was passed virtually unchanged by the 2005 legislature in a third special session. The new and unusual tax is levied only on business types that have some protection for owners from personal liability. Thus, sole proprietors and general partnerships with no corporate owners are not subject to the tax. The new tax is levied on gross receipts minus either cost of goods sold or employee compensation and benefit cost.

The revised franchise tax was designed to treat all businesses equally because any appearance of favoritism would render the bill impossible to pass. The legislature was careful not to carve out exceptions or special treatment for any industry, so almost all tax credits and exceptions were removed from the bill.   

As a result of TMA's lobbying efforts, special exclusions for health care businesses were added to the tax bill virtually on the eve of its passage. Physicians and other health care businesses can exclude all revenues from Medicare, Medicaid, the Children's Health Insurance Program (CHIP), workers' compensation plans, and the TRICARE military benefits program. Health care facilities are permitted to exclude half of those revenues. Health care businesses who keep auditable records also can shelter a portion of their revenues from taxation to allow for the cost of uncompensated care.

Because the total franchise tax revenues will increase dramatically as a result of the tax bill, the legislature was able to mandate roll-backs of up to one-third in local school property taxes and boost the state's share of funding for local schools. Physicians with business or personal real estate holdings will benefit to some degree from these tax cuts.

In 2007, the legislature passed multiple technical revisions to the bill language. Legislators were careful to avoid any substantive revisions until the impact of the tax can be assessed after the initial tax returns are filed in May 2008.

TMA also focused its efforts on defending the existing health care revenue exclusions. One proposal to cut the exclusions in half was identified quickly and stopped; TMA's grassroots action caused the author to withdraw his proposed amendment. Because the tax exclusion for health care is unusual, it will continue to be a target for revision or removal from the tax bill. Rulemaking and implementation for the tax are likely to be difficult and problem-filled because of the lack of experience or precedents in this or any other state.

Taxes TMA Staff Team:

Legislative: Greg Herzog
Policy: Rich Johnson and Donna Kinney
Legal: Lee Spangler, JD

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