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July 2010 TAX POLICY NEWS
a monthly newsletter about Texas tax policy

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FRANCHISE TAX

Service Industry Entities Generally Do Not Qualify for the Cost of Goods Sold Deduction

Franchise tax audits for report years 2008 and 2009 are now in full swing, and we've noticed that many entities in the service industry are incorrectly electing to use the cost of goods sold deduction to determine margin.

Section 171.1012 of the Texas Tax Code specifically provides that, in determining the cost of goods sold, the term “goods” means real or tangible personal property sold in the ordinary course of business and does not include services. The Tax Code does not allow a cost of goods sold deduction for entities that provide services such as dry cleaners, law firms, parking facilities, rental services, towing companies, etc.

Franchise Tax Rule 3.588(c)(8) does allow a cost of goods deduction for transactions that contain elements of both a sale of tangible personal property and a service; however, an entity may only subtract as cost of goods sold the costs otherwise allowed in relation to the tangible personal property sold.

For example, an auto body shop offers the service of car repair and in the process of the repair, replaces some of the car's parts. If the auto body shop elects to use the cost of goods sold to determine margin, the shop can only deduct the cost of the car parts. The labor related to the repair of the car is not allowed as a cost of goods sold.

If an entity that is not eligible for the cost of goods sold deduction elected to use this method for prior years' reports, the entity must amend the reports. The compensation deduction, however, is not available for the prior years' reports. The election language in Tax Code Section 171.101(d) does not allow a change in the method of computing margin to a cost of goods sold or compensation deduction after the due date of the report.

These entities that originally elected to use the cost of goods sold method must amend and use the 70 percent method to determine margin or, if total revenue is not more than $10 million, may use the E-Z Computation to determine tax due. The E-Z Computation does not allow a cost of goods sold or compensation deduction in computing margin but instead applies a lower tax rate of 0.575 percent directly to apportioned total revenue.

In future years, entities that do not sell real or tangible personal property in the ordinary course of business may choose the compensation deduction over the 70 percent method or the E-Z computation. The compensation deduction, detailed in Franchise Tax Rule 3.589, includes W-2 wages and cash compensation paid, net distributive income reported to natural persons and employee benefits provided. (Note: Internal Revenue Service Form 1099 wages cannot be included in the compensation deduction.)

If you have questions regarding eligibility for the cost of goods sold method to determine margin, please contact our office at tax.help@cpa.state.tx.us.

FRANCHISE TAX

Use of the Multistate Tax Compact (MTC) Apportionment Formula is Prohibited for Texas Franchise Tax

The Texas franchise tax is apportioned to Texas using a single-factor apportionment formula based on gross receipts as specifically provided in Texas Tax Code Section 171.105. The apportionment provision in Texas Tax Code Chapter 141, related to the Multistate Tax Compact (MTC), does not apply to the revised Texas franchise tax and entities may not elect to use the MTC's three-factor apportionment formula in lieu of the formula specified in Texas Tax Code Chapter 171.

HOTEL OCCUPANCY TAX

Good Faith Acceptance of Hotel Tax Exemption Certificates

Editor's note: This is the fifth in a five-part series of articles on hotel occupancy tax exemptions. The first article in the May 2009 Tax Policy News defined a permanent resident and discussed the basics of the exemption; the second article in the August 2009 Tax Policy News covered the rental of a range of hotel rooms; the third article in the November 2009 Tax Policy News described government exemptions; the fourth article in the February 2010 Tax Policy News explained the exemption for charitable, educational and religious organizations.

A Texas Hotel Occupancy Tax Exemption Certificate (Form 12-302) (PDF, 66k) may be accepted in good faith when presented with support documentation required by the Comptroller. Good faith acceptance means a hotel owner or operator may be assured the exemption, with the proper proof, cannot be disallowed during an audit. The hotel owner or operator must be aware of the available exemptions.

State hotel tax law, in Tax Code Section 156.104(a), provides that the right to use or possess a room or space in a hotel is exempt from tax if the person required to collect the tax receives, in good faith from a guest, a properly completed exemption certificate stating the guest is qualified for an exemption under Tax Code Sections 156.102 or 156.103. An exemption certificate must be supported by the documentation required under rules adopted by the Comptroller.

Section 156.102 exempts charitable, educational and religious organizations. Section 156.103 exempts the United States government, its officers or employees and designated Texas state officials.

Municipal and county hotel tax law also provides good faith acceptance of exemption certificates, but only for guests who qualify for exemption under Tax Code Section 156.103(d). This section exempts designated Texas state officials. See Tax Code Sections 351.006(g) and 352.007(g), respectively.

Exemption certificates can be accepted in good faith when presented with the following support documentation required by Rule 3.162(c)(2):

  • United States federal government employees traveling on official business — a valid government identification card;
  • Designated Texas state officials (mostly judicial officials, heads of agencies, members of state boards and commissions and members of the Texas Legislature) — a special hotel tax exemption photo ID or card that states the holder is exempt from hotel tax;
  • Foreign diplomats — a tax exemption card issued by the U.S. Department of State that exempts the diplomat or mission from hotel occupancy tax;
  • Persons traveling on official business of a charitable, educational or religious organization or organization exempt by law other than the hotel tax law — a Texas Comptroller of Public Accounts letter of hotel tax exemption or verification the organization is on the Comptroller's list of exempt entities, such as a printed copy of the Comptroller's website listing the organization as exempt from hotel tax.

Exemption verifications can be printed from the Comptroller's Texas Tax-Exempt Entity Search which lists organizations that are exempt from sales, franchise and hotel occupancy taxes. The search includes categories of exemption that cover like entities and group exemptions that cover subordinates. Entities that are exempt by law and are not required to apply for exemption, such as government agencies, will not normally be included in the search.

United States law (Title 18, US Code Part I, Chapter 33, Section 701) prohibits a person from making a copy of a U.S. government identification card. Verification of the exemption can be written on the exemption certificate, guest folio or other hotel record that indicates who stayed in the room. For example, the hotel clerk can write on the exemption certificate, “ID card verified” or similar wording with a date and the clerk's signature or initials.

INSURANCE TAX

Assessments and Retaliatory Tax Computation

The exclusion or inclusion of assessments for retaliatory tax calculation purposes varies by type and purpose.

The Comptroller interprets a special purpose assessment as an assessment that applies to insurers for insurance-related purposes only, and only for losses or deficits. They are paid for the benefit of policyholders and are excluded from either side of the retaliatory tax comparison.

Examples of special purpose assessments are:

  • guaranty association assessments;
  • high-risk health pool assessments;
  • Joint Underwriting Association assessments; and
  • Texas Windstorm Association assessments or other similar assessments.

The ability of an insurer to recoup fees paid, whether or not it actually does, determines that fee's exclusion from the retaliatory comparison. For example, assessments for the Texas Automobile Burglary and Theft Prevention Authority and the Texas Volunteer Fire Department Assistance Fund are excluded from the Texas side of the comparison because these funds may be recouped, directly or indirectly, from policyholders.

Some states have Second Injury Funds that are typically used to relieve employers from the burden of paying for disabilities that were unrelated to the injured worker's employment and to encourage the hiring of partially disabled employees who might not otherwise be hired due to an employer's fear of a potential liability to compensate for a total disability. Since these funds are not used for insurance-related purposes, they do not qualify as a special purpose assessment in Texas and they should be included in the retaliatory comparison.

The Texas Subsequent Injury Fund is funded with death benefits in those cases where a beneficiary does not exist. Therefore, because it is not funded by insurers, it would not be considered part of the overall Texas burden.

Some states levy a workers' compensation administrative assessment as well as an insurance fraud fee. These two fees are included in the aggregate burden on the state of incorporation's side of the retaliatory tax comparison because the fees collected provide financial support for specific funds or programs and are not special purpose assessments.

Although these examples represent a small sample of the total types of assessments made by all states, Texas requires an assessment to be included in the retaliatory tax comparison unless the assessment may be recouped directly or indirectly from policyholders or if the assessment meets the qualifications of a special purpose assessment.

SALES TAX

Reminder: Sales Tax Holiday is August 20, 21 and 22!

The 12th annual sales tax holiday begins at 12:01 a.m. on Friday, August 20th this year and ends at midnight on Sunday, August 22nd. During this three-day period, Texas shoppers get a break from state and local sales taxes on purchases of school supplies, clothing and most backpacks priced under $100.

SALES TAX

Fundraisers and Collecting Sales Tax

Generally, sales tax is due on the sale of tangible personal property and taxable services in Texas.

There is an exception for religious, educational and charitable organizations qualifying for sales tax exemption, and for organizations exempt under Internal Revenue Code Section 501 (c)(3), (4), (8), (10) or (19).These organizations can hold two one-day, tax-free sales or auctions each calendar year. During each one-day sale, the organization does not need to collect sales tax. See Tax Code Section 151.310(c) and Rule 3.322(h)(2).

But, when an exempt organization contracts with a for-profit fundraising firm to sell taxable items, the fundraising firm is considered the seller, and the sales are taxable.

Our office has consistently held that nonprofit organizations receiving compensation (such as a commission or share of the proceeds) for taking orders through a fundraising firm's brochures and sales forms are representatives of that firm. The fundraising firm is the actual seller of the items and is responsible for reporting and remitting the sales tax on the items sold. We formalized this policy effective July 11, 2010, in Rule 3.286 (related to seller's and purchaser's responsibilities).

The fundraising firm should provide to the nonprofit organization instructions and information regarding the proper collection of tax. For example, the fundraising firm may advertise in the sales brochure or state on each invoice that tax is included, or require that tax be calculated and collected based on the selling price of each taxable item.

Because the nonprofit organization is not the seller, it will not issue resale or exemption certificates and will not need to use one of its two tax-free sale days. The qualifying exempt organization's two tax-free sale days can be used for other events such as holding an auction.

Regarding local sales tax, the primary location of the nonprofit organization determines the tax rate that should be collected from customers and which local taxing jurisdictions are entitled to revenue from those sales. Under this scenario, the nonprofit organization is operating on behalf of the seller a place of business as that term is defined in Tax Code Section 321.002.

SALES TAX

Garage Sales and the Occasional Sale Exemption

In general, sales tax applies to the sale of taxable items in Texas regardless of the price of the item, or the number of sales made by the seller. Texas sales tax is a “transaction tax” imposed on the sale, lease or rental of taxable items. A sale occurs when title or possession of a taxable item transfers for consideration. Each time an item is sold for consideration, sales tax is due. See Texas Tax Code Sections 151.005, 151.051(a), 151.006, 151.151 and 151.154.

Certain transactions, however, such as the sale of one or two taxable items during a 12-month period by a person (or company) who does not habitually engage in the business of selling taxable items, or the sale of the entire operating assets of a business in a single transaction, may qualify for exemption from tax as an “occasional sale” under Texas Tax Code Section 151.304. A new category of occasional sale, (151.304(b)(5), that affects the taxability of used items sold by individuals, became effective July 1, 2007, under House Bill 373 (80th Legislative Session, 2007).

Garage-type sales frequently fall under this new occasional sale provision. As a result of the enactment of 151.304(b)(5), sales tax is not due on the sale of items at a garage sale if:

  • the items being sold were originally acquired for personal use by the person or a family member of the person selling them; and
  • if the total receipts from sales of the individual's property in the calendar year the garage sale is made do not exceed $3,000.

The rules for occasional sales do not apply to leases or rentals, or to sales made by persons engaged in the business of selling taxable items, including persons who sell at flea markets, antique malls and similar events or facilities and, persons who hold, or are required to hold, a Texas sales and use tax permit or a similar permit or license issued by another state.

A person may also be considered engaged in the business of selling taxable items if that person routinely operates a location where sales of taxable items occur and sells taxable items purchased from other parties, and not used by that person or a family member prior to being offered for sale. For example, a person who has a “garage sale” every weekend may be considered to be engaged in business if the items being sold were not originally bought for the personal use of that person or a family member.

The exemption applies only to sales made by individuals and does not extend to similar sales that may be made by groups or organizations (such as student groups or church groups) who collect items to sell at a garage sale type event; or to “community-wide” type events that are coordinated or produced by a third-party if the seller is required to pay a fee or commission in order to participate in the event (i.e., booth or space rental fees). In these situations, sales tax is required to be collected unless other exemptions apply.

This exemption applies only to the first $3,000 in total receipts that an individual earns from the sale of items that were originally acquired for personal use by the person, or a family member of the person, selling them. Once the $3,000 threshold is reached, the individual must obtain a sales tax permit and begin collecting state and local sales and use taxes beginning with the first sale after the $3,000 threshold was exceeded, and must continue to collect tax on all sales of taxable items for the remainder of the calendar year.

As with all exemptions, the seller is required to maintain records to document that the exemption applies.

RECENTLY ADOPTED RULES

State Sales and Use Tax

The following rule adoption was filed with the Secretary of State on July 7, 2010. The publication date was July 30, 2010, effective 20 days after filing.

Section 3.326 Carbon Dioxide Capture and Sequestration

RECENTLY PROPOSED RULES

State Sales and Use Tax

The following rule was submitted for filing with the Secretary of State. The publication date was July 2, 2010. The comment period is 30 days after publication.

Section 3.369 Sales Tax Holiday — Certain Energy Star Products

ABOUT THE NEWSLETTER

The Comptroller's office publishes this newsletter to keep you informed about state taxes. Tax questions can be complicated, so please use these summaries as guidelines only.

For a Copy of a Proposed Rule

For a copy of a proposed rule or information about a proposed rule, write to Bryant Lomax, Tax Policy Division, 1700 North Congress Avenue, Austin, Texas, 78701-1436, or submit a request via Texas Tax Help.

For Publications, Rules or Other Tax Information

For a wealth of tax information sorted by tax type or by subject matter, please visit the Texas Taxes section of our website.

Contributors to This Month's Issue

Teresa Bostick, Robin Corrigan, Lisa Davis, Don Dillard, Jody Frierson, Gary Johnson, Carol McAnnally, Stefanie Medack, Jerry Oxford, Viki Smith, Karen Snyder, Jennifer Specchio and Steve White

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