Small Business Taxes in Texas: The Basics

Texas has the second-largest economy in the U.S., with a gross state product of $1.76 trillion in 2020. Much of that money is made in the oil and gas industry, though farming, steel, banking, and tourism were also big contributors. Part of the reason may be that Texas, in the 21st century, has a very pleasant business climate.

Compared to most states, business taxes are extremely low in Texas, and there is no personal income tax. This gives Texas two distinct competitive advantages over many other states—businesses keep more of the money they make, and they can recruit top talent by citing the lack of personal income taxes.

The news is even better for small businesses. The business tax rate, which is already low, shrinks or drops to zero for businesses whose revenues do not exceed certain thresholds. For a small business just starting out, this can ease the strain of those tenuous early years.

The Franchise Tax

Currently, there are six U.S. states that do not have a corporate income tax. However, apart from taxing business income through a corporate income tax or a personal income tax, many states impose a separate tax on at least some businesses.

Texas calls its tax on businesses a franchise tax. The difference between corporate income tax and a corporate franchise tax is that income taxes apply to profit while franchise taxes do not apply to profit. A corporate franchise tax is essentially a fee that a company must pay for the privilege of doing business in a city or state.

Businesses with $20 million or less in annual revenue pay 0.331%. They can file using an E-Z Computation form (and this form really is easy—it's a one-pager). The tax for wholesalers and retailers is 0.375%. The tax rate for businesses other than retail and wholesale is 0.75%.

It's worth emphasizing that this is a tax on gross receipts, not on net corporate income. Texas is one of only four states with this type of system. The others are Nevada, Ohio, and Washington.

The Zero-Tax Threshold

Small businesses with annual receipts below a certain level pay no franchise tax at all. This is known as the no-tax-due threshold. For the tax year 2020, that threshold is $1,180,000.

Taxes on Larger Businesses

The state taxes businesses that do not file the E-Z Computation form at a rate of 0.75% on their taxable margins (0.375% for retailers and wholesalers). It defines this as the lowest 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.

For many businesses, the actual tax rates are much lower than the stated rates. For example, the franchise tax for retail and wholesale companies, regardless of the size of the business, is 0.375%. Businesses that earn less than $20 million in annual revenues and file taxes using the state's E-Z Computation form pay 0.331% 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.

C Corporation Taxes

Most small businesses are not corporations, but 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.

Like most states, Texas subjects corporations to its standard business tax, the franchise tax. As with all businesses, the no-tax-due threshold and E-Z Computation rules apply to corporations.

S Corporation Taxes

The S Corporation is a popular designation for small businesses. It provides many of the benefits of incorporating but, unlike the C corporation, it is 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's 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 or on the individuals who earn income from the business.

Limited Liability Company Taxes

LLC is the other common 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 rather than business income tax on their proceeds.

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.

Partnership and Sole Proprietorship Taxes

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 individuals, with the business income distributed directly to those individuals. In these situations, Texas treats partnerships like sole proprietorships and does not impose the franchise tax.

In such cases, the 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 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 individual circumstances.