Taxes in Texas for Small Business: The Basics
Texas is a popular place to conduct business. The state's job growth and unemployment numbers speak for themselves. As of August 2015, the Texas unemployment rate sits at 4.1%, a full percentage point lower than the national rate. Total payrolls and the labor participation rate have also been increasing at a healthy rate in Texas throughout the 2010s, unlike at the national level where payrolls are stagnant and labor participation has shrunk to its lowest rate since the 1970s. In fact, the business climate in Texas has been so pleasant during the 21st century that the state's former governor Rick Perry, who served from 2000 until January 2015, was known for storming through less business-friendly states, such as New York and California, and giving speeches to companies about why they should relocate to Texas. His successor, Greg Abbott, has made similar overtures.
One of the biggest reasons companies want to do business in Texas is its favorable tax climate. Compared to most states, business taxes are extremely low in Texas, and personal income tax is nonexistent. This gives companies two distinct competitive advantages in locating there. They keep more of the money they make as businesses, and they can recruit top talent more easily by touting the lack of personal income taxes.
On the business side, the news gets even better for small businesses . The business tax rate, which is already low, shrinks even more and, in some cases, drops to zero for businesses whose revenues do not exceed certain thresholds. For a small business starting out, this helps ease the already tenuous early years when it is trying to establish itself and grow.
The Franchise Tax
Texas calls its tax on businesses a franchise tax. The way it works is pretty simple. The state taxes most businesses at a rate of 1% on their taxable margins, which it defines as the lowest number of the following three figures: 70% of total revenue; 100% of revenue minus cost of goods sold (COGS); or 100% of revenue minus total compensation. Nearly all business types in the state are subject to the franchise tax; the only exceptions are sole proprietorships and certain types of general partnerships. Corporations, S corporations, limited liability companies (LLCs) and limited liability partnerships (LLPs) all pay the franchise tax.
For many small businesses, the 1% rate stated above is actually much lower. This is because many situations exist in which Texas reduces the franchise tax for certain businesses. For example, the franchise tax for retail and wholesale companies, regardless of the size of the business, is 0.5%. Businesses that earn less than $10 million in annual revenues and file taxes using the state's E-Z Computation form pay only 0.575% in franchise tax. However, the E-Z Computation form does not allow a business to deduct COGS or compensation, or to take any economic development or temporary credits. As of 2015, businesses that earn less than $1.08 million in annual revenue owe no franchise tax at all; this amount is known in Texas as the no-tax-due threshold.
Corporations
Though most small businesses are not corporations, they sometimes switch from LLCs and S corporations to C corporations when their growth reaches a certain level. Therefore, it is helpful to understand how corporations are taxed in Texas. Tax treatment for corporations is very cut and dry. Like most states, Texas subjects corporations to its standard business tax, meaning the franchise tax. As with all businesses, the no-tax-due threshold and E-Z Computation rules apply to corporations. At 1%, the tax rate on Texas corporations ranks very low nationally, making the state a popular place for businesses of all sizes.
S Corporations
The S corporation is a popular designation for small businesses. S corporations provide many of the benefits of incorporating, but unlike C corporations, they are not subject to separate federal income tax or, in most states, separate state income tax. Instead, shareholders are taxed on their equity in the company. Texas, however, still subjects S corporations to its franchise tax based on the business' annual revenue. Once again, the highest this tax can ever be is 1%. Individual shareholders in the company do not have to pay state taxes on their portions of the company's income. This benefit is especially attractive to small S corporations whose annual revenues do not exceed the no-tax-due threshold. They operate essentially tax-free, since tax is not assessed on the business itself nor on the individuals who earn income from the business.
Limited Liability Companies
LLC is the other highly popular designation for small businesses. In most states, LLCs are entities that protect business owners from certain legal liabilities but pass their incomes to those owners, who pay personal income tax on them rather than business income tax. As with S corporations, Texas bucks the national trend and charges the franchise tax to LLCs, with the same rules that apply to all business types. However, the income that passes to the owners as personal income is not subject to state income tax in Texas. Given the franchise tax is a maximum of 1%, LLC owners in Texas make out better financially than in most states.
Partnerships and Sole Proprietorships
Most Texas small businesses that are partnerships pay the franchise tax, while sole proprietorships do not. The litmus test in a partnership is whether the business is directly owned by natural persons, with the income from the business distributed directly to those persons. In those situations, Texas treats partnerships like sole proprietorships and does not impose the franchise tax. These business owners must pay federal income tax on this income but not state tax, since Texas does not tax personal income.
The majority of partnerships in Texas, including limited partnerships (LPs) and LLPs are subject to the franchise tax. For business owners in Texas considering forming a partnership, a qualified tax accountant can help determine how to structure the partnership for the most favorable tax treatment given the unique circumstances of the business and business owners.
One of the biggest reasons companies want to do business in Texas is its favorable tax climate. Compared to most states, business taxes are extremely low in Texas, and personal income tax is nonexistent. This gives companies two distinct competitive advantages in locating there. They keep more of the money they make as businesses, and they can recruit top talent more easily by touting the lack of personal income taxes.
On the business side, the news gets even better for small businesses . The business tax rate, which is already low, shrinks even more and, in some cases, drops to zero for businesses whose revenues do not exceed certain thresholds. For a small business starting out, this helps ease the already tenuous early years when it is trying to establish itself and grow.
The Franchise Tax
Texas calls its tax on businesses a franchise tax. The way it works is pretty simple. The state taxes most businesses at a rate of 1% on their taxable margins, which it defines as the lowest number of the following three figures: 70% of total revenue; 100% of revenue minus cost of goods sold (COGS); or 100% of revenue minus total compensation. Nearly all business types in the state are subject to the franchise tax; the only exceptions are sole proprietorships and certain types of general partnerships. Corporations, S corporations, limited liability companies (LLCs) and limited liability partnerships (LLPs) all pay the franchise tax.
For many small businesses, the 1% rate stated above is actually much lower. This is because many situations exist in which Texas reduces the franchise tax for certain businesses. For example, the franchise tax for retail and wholesale companies, regardless of the size of the business, is 0.5%. Businesses that earn less than $10 million in annual revenues and file taxes using the state's E-Z Computation form pay only 0.575% in franchise tax. However, the E-Z Computation form does not allow a business to deduct COGS or compensation, or to take any economic development or temporary credits. As of 2015, businesses that earn less than $1.08 million in annual revenue owe no franchise tax at all; this amount is known in Texas as the no-tax-due threshold.
Corporations
Though most small businesses are not corporations, they sometimes switch from LLCs and S corporations to C corporations when their growth reaches a certain level. Therefore, it is helpful to understand how corporations are taxed in Texas. Tax treatment for corporations is very cut and dry. Like most states, Texas subjects corporations to its standard business tax, meaning the franchise tax. As with all businesses, the no-tax-due threshold and E-Z Computation rules apply to corporations. At 1%, the tax rate on Texas corporations ranks very low nationally, making the state a popular place for businesses of all sizes.
S Corporations
The S corporation is a popular designation for small businesses. S corporations provide many of the benefits of incorporating, but unlike C corporations, they are not subject to separate federal income tax or, in most states, separate state income tax. Instead, shareholders are taxed on their equity in the company. Texas, however, still subjects S corporations to its franchise tax based on the business' annual revenue. Once again, the highest this tax can ever be is 1%. Individual shareholders in the company do not have to pay state taxes on their portions of the company's income. This benefit is especially attractive to small S corporations whose annual revenues do not exceed the no-tax-due threshold. They operate essentially tax-free, since tax is not assessed on the business itself nor on the individuals who earn income from the business.
Limited Liability Companies
LLC is the other highly popular designation for small businesses. In most states, LLCs are entities that protect business owners from certain legal liabilities but pass their incomes to those owners, who pay personal income tax on them rather than business income tax. As with S corporations, Texas bucks the national trend and charges the franchise tax to LLCs, with the same rules that apply to all business types. However, the income that passes to the owners as personal income is not subject to state income tax in Texas. Given the franchise tax is a maximum of 1%, LLC owners in Texas make out better financially than in most states.
Partnerships and Sole Proprietorships
Most Texas small businesses that are partnerships pay the franchise tax, while sole proprietorships do not. The litmus test in a partnership is whether the business is directly owned by natural persons, with the income from the business distributed directly to those persons. In those situations, Texas treats partnerships like sole proprietorships and does not impose the franchise tax. These business owners must pay federal income tax on this income but not state tax, since Texas does not tax personal income.
The majority of partnerships in Texas, including limited partnerships (LPs) and LLPs are subject to the franchise tax. For business owners in Texas considering forming a partnership, a qualified tax accountant can help determine how to structure the partnership for the most favorable tax treatment given the unique circumstances of the business and business owners.
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