Lawsuit Alleges "Margins Tax" is Unconstitutional State Income Tax

The business tax overhaul that Gov. Rick Perry and fellow GOP leaders championed in 2006 as a fix for the school finance system is now under attack in the Texas Supreme Court — as an unconstitutional state income tax.

An insurance claims adjustment company from the San Antonio area, Boerne-based Allstate Claims Service, L.P., filed the lawsuit a few days ago. It’s too early to gauge how far it will go, and the state of Texas — sure to vigorously defend the tax — hasn't given the court its official answer yet.

But the case has the potential to throw a wrench into state and perhaps even national politics: If the allegations aren't quickly tossed out by the all-Republican court, Perry could be forced to deal with a thorny tax issue just as he’s trying to win a presidential nominating contest. And the Legislature would be faced with a big new revenue shortfall if it's declared unconstitutional.

"Perry is very good when he is on solid ideological ground, job creation and balancing the budget with no new taxes," said Cal Jillson, political scientist at Southern Methodist University. "But if he has to explain in paragraph length, rather than bumper sticker length, a complicated issue like taxation, or even cuts to public schools, he is in much more difficulty."

Perry spokeswoman Catherine Frazier said the Texas Franchise Tax, also known as the "margins tax," is not an income tax and was supported by the Texas Association of Business and other groups as part of necessary tax swap legislation that reduced property taxes. She also noted that under more recently passed exemptions, taxpayers making less than $1 million don't have to pay.

The office of State Comptroller Susan Combs, named in the lawsuit, referred questions to Attorney General Greg Abbott. A spokesman for Abbott, whose office has to defend the state in such matters, declined to comment on pending litigation. Calls placed to the plaintiff and the company's lawyer also went unreturned.

Nikki Laing, a CPA and third-year Baylor law student, studied the structure of the tax for a Baylor Law Review article titled "An Income Tax By Any Other Name is Still an Income Tax." She believes it's just what the plaintiffs say it is: an income tax.

“Despite the name being a margins tax, if you look at it closely, it is in effect an income tax. You start with your gross revenue and you deduct certain statutory deductions,” Laing said. “It fits the comprehensive definition of an income tax, which is revenue less expenses.”

Rep. Jim Keffer, R-Eastland, said it's not an income tax because businesses can get hit with it even in years when they don't have net income (one of the chief complaints critics leveled at the tax when it was created).

“This is not an income tax per se; this is a gross receipts with deduction capabilities," Keffer said. "And you’re taxed whether you have income or not, or profits so to speak.”

It's not an academic proposition. Under a provision in the Texas Constitution, known as the "Bullock Amendment" because it was championed by the legendary former Lt. Gov. Bob Bullock, no income tax can be passed in Texas without voter approval. The 2006 overhaul was not submitted for approval by Texas voters.

That's the basic contention in the lawsuit — that the Legislature passed an income tax without getting the necessary voter approval. The lawsuit asks that the state stop all "attempts to enforce, collect, and assess this unconstitutional tax."

Texas lawmakers revamped the porous franchise tax after the state's school finance system was declared unconstitutional in late 2005 (on legal ground different from the new challenge before the court). The old tax was so full of loopholes that some business owners essentially considered it an optional tax: Hire some accountants and lawyers and it was easy to get around.

Lawmakers were searching for something that would keep the state out of court over how it finances public schools. Specifically, they wanted to lower local school property taxes. But they needed new state revenue to do it.

Perry assembled a blue-ribbon business panel headed by former Comptroller John Sharp, which proposed the new state business tax and a list of other measures that could offset lowered local property taxes, keep the school finance lawyers at bay and not raise objections from professional and amateur tax protesters. They even got anti-tax activist Grover Norquist to say it wasn’t a new tax if it didn’t ultimately increase government income.

The big rub in recent years is that after it finally passed, it has raised much less than its supporters projected — as Perry's chief critic, then-Comptroller Carole Keeton Strayhorn, said at the time. It brings in about $4 billion in revenue per year.

Earlier this year a deputy in Combs' comptroller's office said the shaky business tax and the costs to the state of lowered property taxes has actually produced a so-called structural deficit — an ongoing hole costing the state about $10 billion every two years. About half of the shortfall comes from the tax relief it provided and about half for the increased spending on schools that got thrown in to sweeten the package in 2006.

What surprises some tax experts is that it has taken so long for someone to sue on the ground that it's an income tax. Perry angered many fellow conservatives when he signed the "margins tax" into law, but he fought for exemptions in the law and resisted all attempts to raise taxes to deal with a huge budget shortfall earlier this year.

“I think all the tax practitioners in the state have been waiting for this shoe to drop,” said tax attorney William Grimsinger, who blogged about the lawsuit in a recent column. "The ability [to sue] has has been out there for a while. This is really the first time anybody has done it.”

Osler McCarthy, a spokesman for the Texas Supreme Court, said that under special provisions in the 2006 law, any challenge of its constitutionality goes straight to the high court. He said the court will be required to render a ruling by late November, almost six years to the day after the court ruled that the current school finance system was unconstitutional.

"The filing is direct in the Supreme Court, so you bypass the trial court and the courts of appeal," McCarthy said. "That makes this one different.”