By: Mike Peterson
The Texas Franchise Tax (Chapter 171 of the Texas Tax Code) is a tax on gross receipts and these gross receipts must exceed $1,110,000. This is the amount for 2016 and 2017 – such number is adjusted for inflation under Section 171.0006 before franchise tax is owed. The franchise tax applies to all “Taxable Entities” under Section 171.0002. Section 171.0002 does generally apply to all types of business entities, but it specifically excludes (1) sole proprietorships, (2) general partnerships owned entirely by natural persons and not otherwise protected by limited liability protections, such as limited liability partnerships, (3) passive entities, and (4) exempt entities, such as charitable non-profit corporations. While limited partnerships used to be the favorite type of entity, that has now been replaced by limited liability companies.
What tends to get overlooked by investors is the passive entity exemption – but not without reason. That exemption applies only to partnerships (including limited partnerships) and trusts and it only applies for any year of such partnership or trust with at least 90% of such partnership or trust’s income being passive and no more than 10% of such income being active. Since a limited partnership costs more to form and requires two entities to give liability protection (with one entity acting as the general partner, which otherwise doesn’t have liability protection), it is hard to incur the extra expense, because of the difficulty to know in advance if the entity income will meet the 90% test. Few entities would turn down income despite its form and the definition of passive specifically doesn’t include rents, which you would otherwise think of as passive, particularly under the Internal Revenue Code.
Passive income is defined under Section 171.0003 as:
A) 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;
(B) distributive shares of partnership income to the extent that those distributive shares of income are greater than zero;
(C) 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
(D) royalties, bonuses, or delay rental income from mineral properties and income from other nonoperating mineral interests.
So there are some planning opportunities available to investors, particularly those investing in stocks and bonds, undeveloped land, or non-operating mineral interests where it is unlikely that the type of investment will change. The ownership of rental property or operating and non-operating mineral interests or mixes of investments involving some active type, makes it much harder to predict whether or not in any particular year an investor will be able to avoid franchise tax. But where an investor can separate the types of investments, and maintain that separation, it may be worthwhile to put passive assets in a limited partnership for liability protection or family asset protection, or even to discount the value of partnership interests in the event of a gift or transfer at death. Of course, small investments will not matter anyway, as the $1,110,000 threshold will likely not be met – but small investments held for a long period could jump over that threshold in the year of sale, so give future value appropriate consideration when deciding on the type of entity to use.
The above rules apply generally to individuals, but you may want to discuss these issues with your tax advisor before proceeding. Certain activities or relationships can turn passive income into active, so an active business can’t drop down its patents and trademarks into a limited partnership and avoid franchise tax on the otherwise passive royalty income from those patents and trademarks. Similarly, an operating mineral interest holder can’t create passive income from a non-operating interest in the same operating property, if the non-operating interest is held by an affiliate of the operator.