Choosing the right margin calculation method can significantly reduce your Texas franchise tax liability. The tax allows four different approaches, and selecting wisely requires understanding how each method applies to your specific business.
The cost of goods sold method works best for businesses with significant direct costs related to goods they produce or sell. COGS includes direct materials, direct labor, and certain overhead costs tied to production or acquisition of goods. Retailers, manufacturers, and distributors often benefit from this method. However, Texas defines COGS more narrowly than federal tax law in some respects, so not all costs that qualify federally will qualify for Texas purposes.
The compensation method suits businesses with substantial payroll costs. This deduction includes wages, salaries, bonuses, and certain benefits paid to employees and officers. Businesses can also include the cost of employer-provided health insurance. Service businesses with large workforces often find the compensation method produces the best result. Independent contractor payments don’t qualify, so businesses relying heavily on contractors see less benefit from this approach.
The 70% of total revenue method requires no calculation of actual costs. You simply deduct 70% of your total revenue and pay tax on the remaining 30%. This method appeals to businesses with low direct costs and low payroll relative to their revenue, or businesses that don’t want to maintain the detailed records required for COGS or compensation calculations.
The $1 million deduction provides a floor that benefits smaller businesses. If your total revenue is close to $1 million, subtracting $1 million may produce little or no taxable margin. This method is essentially automatic for businesses near or below the threshold.
You’re not locked into one method permanently. Each year, you can choose whichever method produces the lowest tax liability. However, amended returns changing your method after the fact face additional scrutiny.
The right method depends on your business structure, cost profile, and revenue level. Analyzing all four options before filing ensures you’re not paying more than necessary.
For help determining the best margin calculation method for your business, contact us to schedule a consultation.
