The Texas "Not-An-Income-Tax" Income Tax

When is an income tax not an income tax?  Apparently when you decide to give it a different name, like "Franchise Tax".  Because it is written in our state's constitution that we cannot have an "income tax", we instead have a tax that defies logical calculation and is punitive for businesses that have high costs of rent, sales, or administrative costs.  But make no mistake about it, this is a tax that is income based.

Yes, it's that time of year when our CPA sends us our annual Texas Franchise Tax return and I rant about how the law was rewritten.  But I figure if nobody complains, how does anyone know there's a problem?

But, you might think, the tax rate is only like 1 percent, what is the big deal?  (Actually for retaillers like restaurants, groceries, yogurt stores, the rate is only one-half a percent.)   Because that rate applies to a company's gross margin (sales less production costs), and does not allow a company to also deduct other important operation costs.

Let's take a restaurant as an example, restaurants need space; space for people to sit, space for people to drink, space for people to sit on a patio.  Space is good, it generates rent for the owners and property taxes for the community.   Space costs money - but this expenditure for space is Franchise taxable, yes it is.

Or let's look at other taxes.  Like those property taxes on the space, which we pay with our rent.  Property taxes are good, they go back to the city, the county and the schools.  Taxable.  Or the Gross Receipts tax we pay (14%) on all alcoholic beverage sales.  Gross Receipts taxes go to the city and state, and help pay for important things like police.  But while GR taxes are assessed and paid to the Comptroller of the State of Texas, insultingly, we must also pay Franchise tax on these taxes.  Yes, we are taxed on taxes because they are not a deductible expense.

Or waiters.  It's tough to have a full-service restaurant without waiters.  They deliver the food.  And their best buddies, the bussers help too, hopefully to make the guest's experience ever-so-much nicer.  And having these people employed, earning wages so they can feed, clothe and house their families is a good thing, right?  We were very pleased that in 2009 we did not have to lay off one single person even though guests were spending significantly less and corporate catering dropped.  But, those wages (along with federal and state wage-based taxes) are taxable for the Franchise Tax calculation.

But hey, you might say, isn't it only for companies that make over $1 million buckaroos?  Well yes, but that is based on total sales, not on what you end up with on the bottom line.   So lets say I have a "company" that writes downloadable software (think apps), I operate out of my home with no employees (no state employment taxes paid either), pay no rent (or property taxes) and because there are some specific uses for my software, I sell $999,999 worth.  All mine, zero Franchise taxes.

Compare that to a restaurant, with higher overhead and labor costs $2 million in sales would typically only generate about $120-$150,000 on the bottom line, but their taxes would be about $6,000 - $7,000 depending on their production costs.   Well gollee, you might say, even after taxes that's a pretty nice chunk of change, whatcha' complaining about?   But let's say your restaurant cost $1.5 million to build and start up, this is the money that's used to pay back the investors or the bank loan.  And both want and expect payback, they are not in the lending-money-to-lose-money business - or else they stop lending to those types of businesses completely.

There was a drop in income from 2008 to 2009 in our industry while many costs went up (minimum wage increases, employment tax increases, liability insurance increases, property tax increases), most of us saw minimal drops in franchise taxes.  Or another way to look at it, our Texas "Not-An-Income-Tax" Franchise Tax came to a whopping  24% of our net income for 2009* compared to a more manageable 7% in 2008 .  So much for being a non-income tax state, if you ask me.

So what, you say, that's just part of the cost of having a restaurant in Texas.  Well, yes you are right.  And ultimately this tax burden is paid by the guests, driving up costs to eat out.  But here's the side that damages our economy because of how this has been written.  Businesses like restaurants (or other industries with high costs like renting space, employing people and paying taxes) are being disincentivized by the state to grow because the returns have been significantly lowered.  It means that businesses that don't rent space, or pay property taxes, or other taxes, or employ fellow Texans are incentivized to grow. 

Now which do you think is better for our fair state?

*  Net income before adjustments for federal income taxes.