As noted in a prior post, the Texas franchise tax is a tax imposed on any “taxable entity” that does business in Texas or that is chartered or organized in Texas. [1] This begs the question – “Which entities are taxable, and which are not?”
The term “taxable entity” is defined in an incredibly broad manner that, at first glance, appears to include virtually any type of Texas entity. The definition includes “a partnership, limited liability partnership, corporation, banking corporation, savings and loan association, limited liability company, business trust, professional association, business association, joint venture, joint stock company, holding company, or other legal entity.” [2] However, there are certain omissions from this list that are noted in subsection (b):
- Sole proprietorships
- General partnerships:
- The direct ownership of which is entirely composed of natural persons; and
- The liability of which is not limited under a statute of this state or another state, including by registration as a limited liability partnership
- Passive entities
- Entities that are exempt from taxation under Texas Tax Code Chapter 171, Subchapter B. [3]
There is also a separately laundry list of entities that are not “taxable entities” listed in subsection (c). This list includes, among others: (i) a grantor trust as defined by I.R.C. § 671, all of the grantors and beneficiaries of which are natural persons charities; (ii) an estate of a natural person; (iii) a REIT; and (iv) a trust qualified under I.R.C. § 401(a) (relating to qualified pension, profit-sharing, and stock bonus plans).
The exclusion for “passive entities” is also noted elsewhere in the Tax Code. Texas Tax Code § 171.001(c) states “The tax imposed under this section or Section 171.0011 is not imposed on an entity if, during the period on which the report is based, the entity qualifies as a passive entity as defined by Section 171.0003.” [4] However, the underlined language of this provision is important, as it makes clear an entity may be a taxable entity for some periods, and a passive entity for others.
Passive Entities
The term “passive entity” is defined in Texas Tax Code § 171.0003(a), and requires all of the following elements:
- The entity is a general or limited partnership or a trust, other than a business trust;
- During the period on which margin is based, the entity’s federal gross income consists of at least 90 percent of the following income:
- Dividends, interest, foreign currency exchange gain, periodic and nonperiodic payments with respect to notional principal contracts, option premiums, cash settlement or termination payments with respect to a financial instrument, and income from a limited liability company;
- Distributive shares of partnership income to the extent that those distributive shares of income are greater than zero;
- Capital gains from the sale of real property, gains from the sale of commodities traded on a commodities exchange, and gains from the sale of securities; and
- Royalties, bonuses, or delay rental income from mineral properties and income from other nonoperating mineral interests;
- The entity does not receive more than 10 percent of its federal gross income from conducting an active trade or business. [5]
The computation of income for purposes of the “90 percent” element above does not include (i) rent or (ii) income received by a nonoperator from mineral properties under a joint operating agreement if the nonoperator is a member of an affiliated group and another member of that group is the operator under the same joint operating agreement. [6]
Stated throughout these elements, is important to note that this determination is based on federal gross income, not just Texas-based income.
[1] Tex. Tax. Code § 171.001(a).
[2] Tex. Tax Code § 171.0002(a).
[3] Tex. Tax Code § 171.0002(b).
[4] Tex. Tax Code § 171.001(c) (emphasis added).
[5] Tex. Tax Code § 171.0003(a).
[6] Tex. Tax Code § 171.0003(b).
[View source.]
