Corporate Tax Law
Every business is responsible for paying a variety of local, state, and federal taxes, depending in part on how the business is organized, the services the business provides, and the products it sells. In general, businesses are liable for federal and state income or franchise taxes, state sales tax, Social Security and Medicare tax, federal unemployment tax, and state unemployment tax. Businesses involved in the sale of alcohol, tobacco, or fuel, and those that generate hazardous waste, are subject to additional taxes. Texas does not have a state income tax but does have a franchise tax that operates as a sort of income tax for corporations. Firms that do business both inside and outside of Texas are assessed a franchise tax based on a formula that takes into account the percentage of capital and gross receipts attributable to the business’ Texas operations. Businesses that have employees are responsible for withholding taxes from the employees’ pay. This chapter discusses some of these liabilities and responsibilities.
Taxes and the Form of Organization
Texas businesses are responsible for different types of federal and state taxes depending on the way they are organized. The three common forms of business organization–sole proprietorships, partnerships, and corporations–are discussed here. A limited liability company in Texas is generally subject to the state franchise tax even if it is treated as a partnership for federal tax purposes. For more information on the forms of business organization, see the Closely Held Business Law Chapter and the Publicly Held Corporations Law Chapter.
Under a sole proprietorship, the owner is the taxpayer. Thus, the individual tax rate applies, rather than the higher corporate rate. The owner reports income and expenses from the business on his or her individual federal income tax return, using federal Schedule C with Form 1040. Generally, a sole proprietor cannot claim personal insurance costs, such as health, dental, and life insurance, as a business expense, but health insurance costs may be deductible as an adjustment to income. Most sole proprietors are liable for self-employment tax, discussed below, which is filed using federal Form SE. Usually, sole proprietors make estimated tax payments in quarterly installments during the year, using federal Form 1040-ES. Because Texas does not have an income tax for individuals, sole proprietors are not subject to a state tax on income.
A partnership itself does not pay taxes; each partner reports his or her income and deductions individually on federal Form 1040, Schedule E. Thus, the individual tax rate rather than the higher corporate rate applies to each partner. Generally, benefits such as health, dental, and life insurance are not deductible by individual partners as business expenses, but health insurance costs may be deductible as an adjustment to income. Partners usually are liable for self-employment tax, and generally they make quarterly estimated tax payments toward their year-end tax liability, using federal Form 1040-ES.
Even though it does not pay taxes directly, a partnership is required to file a federal “information return” (Form 1065) that reports partnership income and distributions to the partners. Other forms and schedules may also be required. Partnerships are not subject to the Texas franchise tax, and because Texas does not have an income tax, individual partners are not liable for state income tax.
As mentioned, a limited liability company is usually treated as a partnership for federal tax purposes. However, it is subject to the Texas franchise tax and must file appropriate forms. Some methods for calculating the franchise tax are unique to limited liability companies, and an attorney experienced in this area of law should be consulted.
A corporation is an association of shareholders created under law and regarded by the courts as an artificial person with its own legal identity. There are two kinds of corporations, C corporations and S corporations, and each is subject to different tax laws.
At the federal level, a C corporation is taxed under the provisions of Subchapter C of the Internal Revenue Code, and it is subject to a tax rate that is higher than the individual rate. For 1993, the corporate tax rate ranged from 15 percent for a corporation with an income of $50,000 or less, to 35 percent for a corporation with an income over $10 million. Corporations use federal Form 1120 or Form 1120-A to report income, deductions, and credits, and to compute tax. Other federal forms also may be required.
The taxable income of a C corporation is determined prior to distribution of shareholder dividends. Each shareholder also reports dividend income from a C corporation on his or her individual Form 1040. Thus, profits distributed as dividends are taxed twice–once on the C corporation’s tax return and again on an individual shareholder’s tax return. Shareholders may not use a corporation’s losses for their individual tax purposes. However, dividends may be accumulated by the corporation–up to certain limits–to postpone the double taxation. Texas does not have an income tax, but corporations are required to pay a franchise tax that operates as a form of income tax. A C corporation uses Texas Form 05-144 to file an initial franchise tax report and Form 05-146 thereafter for its annual franchise tax report. Annual reports are due on or before May 15. An information report must be filed even if no tax is due. In Texas, limited liability companies are subject to the state franchise tax whether treated as a corporation or a partnership for federal tax purposes.
Deductions allowed under federal income tax law are factored into the calculation of a Texas corporation’s franchise tax, and some additional deductions are also permitted. An attorney experienced in tax law can advise a corporation regarding allowable deductions.
C corporations generally must make estimated federal tax payments. Federal estimated tax payments are made quarterly to an authorized financial institution or Federal Reserve Bank, using Form 1120-W. Penalties may be assessed for failure to pay estimated taxes promptly.
Subchapter S of the Internal Revenue Code applies to an S corporation, which generally is not directly liable for federal income tax. Instead, each shareholder pays tax on his or her share of the S corporation’s income and deductions by including it on federal Form 1040. However, an S corporation is required to file federal Form 1120-S with supporting schedules. S corporations are required to pay estimated federal tax on any income that is not passed to shareholders.
Because Texas does not have an income tax, shareholders in an S corporation are not liable for state tax on the income generated by the corporation. However, S corporations, like all other Texas corporations, are subject to the state franchise tax. A corporation recognized as an S corporation for federal tax purposes may file as an S corporation for the state franchise tax. Otherwise, an S corporation must calculate the taxable capital component of its franchise tax in the same manner as any other corporation.
Various federal tax credits are available to certain businesses. Some examples of these tax credits include:
Businesses with 30 or fewer full-time employees or $1 million or less in gross receipts may credit expenses related to complying with the Americans with Disabilities Act.
Employers of persons from targeted groups with particu larly high unemployment rates or special employment needs may credit wages paid to members of the targeted groups.
Some businesses that increase their research activities over a base amount may credit about 20 percent of the amount of increase.
Texas also allows some deductions to businesses in calculating the franchise tax to encourage them to engage in socially beneficial endeavors. For example, a corporation that has been designated as an enterprise project by the Texas Enterprise Zone Act may deduct five percent of its capital investment in the enterprise zone in which the project is located. Corporations may also deduct ten percent of the amortized cost of certain solar energy devices. The Comptroller’s Office can provide additional information on these credits.
Taxpayer Identification Numbers
There are generally two types of taxpayer identification numbers that apply to Texas businesses: the Federal Employer Identifica tion Number (EIN) and the Texas Employment Commission (TEC) Account Number. An EIN is required for all businesses. A sole proprietor generally uses his or her personal Social Security Number as the EIN. However, certain sole proprietors and all partnerships and corporations must apply for an EIN from the Internal Revenue Service (IRS) using Form SS-4. Additionally, sole proprietors must obtain an EIN if they have employees or a retirement plan, or if they are liable for federal excise taxes, such as for alcohol, tobacco, or firearms. The Texas Employment Commission issues a TEC Account Number to all employers required to register with the TEC. This number is assigned when the business registers.
Selecting the Tax Year
A tax return is based on an accounting period called a tax year. A tax year may be either a calendar year or a fiscal year. A calendar year is 12 consecutive months from January 1st through December 31st. A fiscal year is composed of any other 12 consecutive months. Once a tax year is established, a business needs IRS approval to change it. Businesses use the same tax year for federal and state tax returns.
Sole proprietorships usually use a calendar tax year. A partnership generally must use the same tax year as the partners who own a majority interest. If the majority partners’ years differ, the business must use the same tax year as the principal partners–those with a five percent or greater interest in partnership profits or capital. If the principal partners’ years conflict, a partnership generally uses a calendar tax year. A fiscal tax year can be used if the IRS agrees that there is a business purpose for using a fiscal year, or if the partnership files IRS Form 8716, Election to Have a Tax Year Other than a Required Tax Year, also known as a “Section-444 election.” In the latter case, a business may have to pay a fee that represents the amount of tax deferral benefit that results from using a fiscal, rather than calendar, year.
A C corporation’s first income tax return establishes its tax year. The first tax year must not be greater than 12 months from the date of incorporation. A C corporation that provides personal services must use a calendar tax year unless it has IRS approval to use a fiscal year or it makes a Section-444 election.
An S corporation must use a calendar tax year unless it gets IRS approval. In some cases, S corporations may make a Section-444 election.
Businesses with employees must also be aware of a number of other taxes.
The taxes discussed here usually are referred to as payroll taxes because employers are responsible for deducting an employee’s share of tax from his or her earnings before the employee is paid.
Taxes under the Federal Insurance Contributions Act (FICA) help pay for Social Security and Medicare benefits. Businesses without employees do not pay FICA tax. Most sole proprietors and partners in partnerships without employees pay a self-employment tax, which is discussed later in this chapter. Businesses that have employees contribute half of the total FICA tax, and are responsible for collecting the other half from employees through payroll deductions. For 1995, the tax rate for the Social Security portion of FICA tax was 6.2 percent each for employers and employees (a total of 12.4 percent). The maximum wage subject to the tax changes annually. The 1995 tax rate for the Medicare portion of FICA tax was 1.45 percent each for employers and employees (2.9 percent total). Special rules apply to employees who receive tips, to persons who receive both wages and self-employment income, and to employees receiving non-wage payments for items such as meals, lodging, clothing, and some services. The employer’s share of FICA taxes is deductible as a business expense.
Income Tax Withholding
Along with the employee’s share of FICA tax, employers generally must withhold federal and state income tax from the employee’s pay. The amount to withhold is determined by the amount of the employee’s pay and by the number of withholding allowances that the employee claims on federal Form W-4, Withholding Allowance Certificate. Employees are required to complete Form W-4 when hired, and generally the employer retains the form. However, the form must be filed with the IRS if the employee claims more than ten withholding allowances, or if the employee claims exemption from withholding and his or her wages normally exceed $200 per week.
Employers must furnish a statement of wages and taxes (federal Form W-2) to employees by January 31st of each year or, if requested by the employee, within 30 days of termination. The federal copy of Form W-2 must be submitted to the IRS, accompanied by federal Form M-3, Transmittal of Income and Tax Statements. Because Texas does not have an income tax, there is no comparable withholding for state tax purposes.
Payroll Tax Return
Generally, employers report FICA taxes and withheld federal income tax together on federal Form 941, Employer’s Quarterly Federal Tax Return, which is filed at the end of each calendar quarter. There are different forms to be used for agricultural and household workers and for employees who are not subject to FICA taxes. Most employers are required to make deposits for payroll taxes before returns are actually due. How often deposits must be made is determined in part by how much tax liability a business has accrued in the past. For example, a business that owed $50,000 or less in payroll taxes during a specific previous 12-month period may be designated a monthly depositor; a business that owed $50,000 to $100,000 during the specific period may be designated a semi-weekly depositor. The depositor designation is reevaluated annually. A business’ actual tax liability at the end of each deposit period determines whether it actually must make a deposit. If the amount of accumulated undeposited liability reaches $100,000 in any period, taxes must be deposited the day after that volume is reached, and if the business’ deposit status was monthly, it is immediately changed to semi-weekly.
Self-employment tax is a Social Security and Medicare tax for individuals who work for themselves. This includes sole proprietors and most partners in partnerships without employees. Net earnings of $400 or more are subject to self-employment tax, and in some tax years there are ceilings on the amount of earnings subject to the tax. In 1995, there was a ceiling of $61,200 for the Social Security portion of the tax, but no ceiling for the Medicare portion. The Social Security portion was assessed at 12.4 percent of earnings, and Medicare was assessed at 2.9 percent, for a total self-employment tax of 15.3 percent. Federal Schedule SE is used to calculate self-employment tax, which then is added to one’s total tax liability on Form 1040. One-half of the self-employment tax is deductible as an adjustment to gross income on Form 1040.
Federal and state governments have programs to help support able workers who lose their jobs. Tax under the Federal Unemployment Tax Act (FUTA) is reported by eligible employers once per year on federal Form 940 or 940-EZ. The form usually is due one month after the end of the calendar year. However, deposits toward the annual payment are required at the end of any quarter in which the employer accrues $100 or more in FUTA tax liability. Penalties may be imposed for late filing and late deposits. Most employers, even those with part-time employees, are responsible for paying FUTA tax. The general rule is that a business is subject to FUTA tax if the business pays wages of $1500 or more in any calendar quarter, or the business had a least one part-time employee in each of 20 different (not necessarily consecutive) calendar weeks. In addition, FUTA tax is due on cash wages of $1000 or more paid in any calendar quarter to domestic workers who work in a private home, local college club, or local fraternity or sorority house.
A business that employs farm workers is subject to FUTA tax on their wages if the wages total $20,000 or more in any calendar quarter, or if there was at least one day in each of 20 different calendar weeks when the business had 10 or more at least part-time farm workers. The tax is figured at a rate of 6.2 percent of the wages paid to the employee up to $7000. Tip income reported by an employee to an employer for FICA tax purposes is considered wages for calculating FUTA tax. However, the tax does not apply to some payments, such as workers’ compensation payments, nor does it apply to certain types of employment, such as earnings paid to cooperative education students. A business is credited for up to 5.4 percent of the amount it pays for state unemployment tax, which can reduce the actual tax liability to 0.8 percent. The IRS administers the FUTA tax.
The state has its own unemployment program and corresponding taxes. Almost all employers in Texas are required to pay contributions to the Texas Unemployment Compensation Fund. New employers pay unemployment tax at any entry level rate of 2.7 percent for approximately 18 months. Thereafter, the employer’s tax rate is computed based on a formula that measures the amount of unemployment benefits charged by the employer in a ratio to the amount charged statewide. This experience tax rate or general rate ranges between zero percent and six percent. All experience rated employers are also subject to a replenishment tax based on ineffectively charged benefits, and the Texas Employment Commission has authority to levy an addition interest tax of up to 0.2 percent.
Texas requires that businesses pay unemployment taxes and file wage reports quarterly. The employer’s quarterly report must show the total amount of wages paid during the quarter and the total amount of taxable wages paid. The first $9000 paid to each employee by an employer during a calendar year constitutes taxable wages. There are penalties and fines that can be imposed on businesses that fail to file on time, do not pay the necessary unemployment taxes, or fail to keep accurate employment records.
A Texas firm that acquires an existing business that has been subject to unemployment tax may be eligible for a transfer of the previous employer’s experience in calculating the general tax rate. An employer’s experience is transferred to a successor employer when all of the organization or business is acquired, the operation of the organization or business is continued, and certain relationships exist between the previous employer and the successor. Without these conditions, there cannot be a total transfer of experience. However, a partial transfer is permitted when the two employers apply for the transfer, the acquired portion of the business is identifiable and segregable, and the application is approved by the Employment Commission.
Sales and Use Taxes
Texas sales and use taxes must be paid for most sales and taxable purchases for which tax has not yet been paid. Sales tax is imposed on the sale, lease, or rental of taxable tangible personal property within the state; use tax is imposed on the storage or use of taxable items obtained outside the state and shipped or brought into the state for use. Either sales tax or use tax may be imposed on a particular transaction, but not both.
A wide variety of persons, entities, items and transactions are exempt from the sales tax. Some common exemptions include:
Food and food products normally sold by grocery stores
Drugs, medicines and medical devices prescribed or dispensed by a licensed practitioner
Seeds and annual plants
Machinery and equipment used in agriculture
Wrapping, packing and packaging supplies used by manufacturers
Other items and transactions are also exempted from either sales or use tax. In most cases, a business is required to obtain an exemption certificate from the purchaser when a tax-free purchase is made. An attorney experienced in tax or business law can assist a business in determining when sales and use tax must be paid or whether a particular business or sale is exempt.
The Texas sales tax rate ranges between 6.25 percent and 8.25 percent, based on a 6.25 percent state tax and additional local taxes. Businesses must pay their sales and use taxes monthly, quarterly, or yearly, depending on how much tax they pay. Tax returns include information on total sales, taxable sales, and the cost of items bought for use.
Certain Texas taxpayers also may be required to pay additional sales and use taxes for transit services and other special purposes. These taxes are discussed in the next section.
Local and Sales Taxes
In addition to the sales and use taxes imposed by the state, all Texas cities and certain counties impose sales and use taxes. These taxes are collected, reported and paid to the Comptroller’s Office at the same time as the state tax. Taxpayers in certain cities are also subject to a transit sales and use tax. The transit tax rates ranges between 0.25 percent and 1 percent for San Antonio, Houston, Dallas, Fort Worth, Austin, Corpus Christi, Laredo, El Paso and the surrounding cities. Some local districts also impose a special purpose local sales and use tax to fund activities such as health services, emergency services and crime control.
The amount of local sales and use taxes for any transaction may not exceed 2 percent. Local taxes are collected in the following order: all local sales taxes, city use tax, county use tax, special purpose district use tax, transit use tax.
Business owners should be aware of a variety of miscellaneous taxes. For example, the federal government assesses various excise taxes. Excise taxes are imposed on the sale, use, or lease of the following articles by the manufacturer, producer, or importer: sport fishing equipment, electric outboard motors and certain sonar devices, bows and arrows, highway-type tires, gas-guzzling automobiles, certain vaccines, coal, and alcohol sold as fuel but not used as fuel. There are environmental excise taxes, such as taxes on the sale or manufacturing use of certain ozone-depleting chemicals, and there are luxury taxes, such as a tax on the sale of passenger vehicles that cost over $30,000.
Many of these taxes are reported using federal Form 720, Quarterly Federal Excise Tax Return. Although the return is filed quarterly, the taxes generally must be deposited before the return is due. There are additional excise taxes that are reported separately from those described above. For example, certain heavy vehicles, including buses, truck tractors, and trucks with gross vehicle weights of 55,000 pounds or more are subject to a federal highway use tax. Pickup and panel trucks are not subject to the tax. Generally, the vehicles must be used on public roads more than 5000 miles per year. This tax is reported on IRS Form 2290, Heavy Vehicle Use Tax Return. There also are taxes on alcohol, tobacco, and firearms that are filed with the Bureau of Alcohol, Tobacco, and Firearms.
For Texas tax information, contact the Texas Comptroller of Public Accounts, 111 E. 17th Street, Austin, TX 78711, (800) 252-5555. The Comptroller’s Office also has booklets and other publications discussing specific taxes and tax rules.
Businesses with employees should contact the Texas Employment Commission, 101 E. 15th Street, Austin, TX 78778, (512) 463-2800, TDD (800) 735-2989, for information on unemployment taxes and other issues.
For federal forms, including the Employer’s Tax Guide (Circular E, Pub. 15), contact the Internal Revenue Service,(800) TAX-FORM.