| FEATURE ARTICLE, AUGUST 2006
TEXAS TAX REFORM: HOW WILL IT AFFECT YOUR BUSINESS?
A shift in tax burden may impact rental income for commercial real estate companies in Texas.
Kim Szarzynski and Kenneth Bezozo
After many years of debate about changing the Texas franchise tax system, legislators in the state were given little choice in the matter when the Texas Supreme Court held that the Texas school finance system was unconstitutional and gave the legislature until June 1 to correct the deficiencies.
Texas legislators addressed these issues by passing House Bills 1 through 5, all of which have been signed into law by Governor Rick Perry. Each of the bills will impact commercial real estate operations in Texas, but House Bill 2, which provides for a property tax reduction, and House Bill 3, which overhauls the Texas franchise tax system, are key.
Although commercial real estate owners in Texas should receive a reduction in their property taxes as a result of these changes, this benefit may be entirely offset by an increase in franchise taxes. For example, if a lease currently allows a landlord to pass through property taxes but not franchise taxes, the amount that can be passed through to the tenant will be reduced, while the landlord’s tax burden will be increased. It will be important for businesses heavily engaged in leasing to review all current and future leases to determine how this shift in tax burden (from property taxes to franchise taxes) will impact rental income going forward.
House Bill 2 – Property Tax Reduction
Under current law, the school property tax rate is typically $1.50 per $100 of real property value. Under House Bill 2, the school property tax will be reduced in 2006 through 2007 to 88.67 percent of the former amount. This will typically be $1.33 per $100 of real property value. In 2007 through 2008, the rate will be further reduced to 66.67 percent of the rate prior to the passage of House Bill 2. This will typically equal $1.00 per $100 of real property value. After the initial decrease, any rate increase in excess of 4 cents will require voter approval.
These property tax cuts should provide some relief for businesses owning real property, but those businesses may now be subject to the newly created margin tax.
House Bill 3 – The New Margin Tax
In an effort to raise revenue lost as a result of the property tax cuts, the Texas legislature passed House Bill 3, which abolishes the old franchise tax system and replaces it with what most practitioners are calling the margin tax. Under the new system, taxable entities that do business in Texas or are organized or chartered in Texas will be subject to the new margin tax, which is effective for tax periods for which reports are due on or after January 1, 2008. This will include income earned in 2007, and in some cases, income earned in 2006.
The fact that limited partnerships will now be a taxable entity for purposes of the franchise tax is one of the biggest changes to the current system. Previously, many businesses were able to plan around the old franchise tax system by operating in Texas through a limited partnership. However, with the recent changes, this planning opportunity is no longer available.
Rather than stating which entities are taxable entities, the new law provides a list of entities that are not taxable entities, such as sole proprietorships and general partnerships that are wholly owned by natural persons.
Real estate investment trusts (REITs) and qualified REIT subsidiaries are on the list of entities excluded from the definition of taxable entity, but the exceptions to this rule illustrate the Texas legislature’s intent that this exemption only be used to prevent double taxation, not to exclude REITs from taxation altogether.
If a REIT or qualified REIT subsidiary holds any real property directly, other than real property it occupies for business purposes, it will be subject to the new margin tax. If a REIT or qualified REIT subsidiary holds real property indirectly through ownership in a limited partnership, the REIT or qualified REIT subsidiary will not be subject to the tax, but the limited partnership holding the real property will be subject to the tax. In other words, either the REIT will be taxed, or the limited partnership holding real property will be taxed — but not both.
Certain passive general or limited partnerships or trusts are not subject to the new margin tax, as long as 90 percent of the taxable entity’s income is passive and no more than 10 percent of the taxable entity’s income is from an active trade or business. Passive income, which specifically excludes rents from real property, includes dividends, interest and gains from the sale of real property.
A taxable entity will determine eligibility for this exclusion on a yearly basis. As a result, there may be planning opportunities that allow a business to specifically structure its transactions in a manner that will allow a business to take advantage of this exclusion. For example, an entity may attempt to isolate gains from the sale of real property in one entity, such as a passive entity, while collecting rents from other property in a different entity, such as a non-passive entity.
Limited liability companies cannot take advantage of the passive entity exclusion, even if taxed as partnerships or as disregarded entities for federal income tax purposes. Although many businesses use single-member limited liability companies to hold real property in other states in order to avoid the transactional and administrative fees involved in setting up a partnership, businesses may choose to continue using limited partnerships in Texas, provided that the tax savings are significant when compared to the cost of forming a limited partnership.
Many real estate businesses may be concerned about the new margin tax if they operate through a structure that includes tiered partnership or other pass-through entities. However, House Bill 3 contains a provision allowing a lower tier entity (owning entity) to elect to report and pay the tax on the taxable margin of certain pass-through entities in which it owns an interest (upper tier entities). This should prevent double taxation for structures to which this rule applies.
Further Developments
There are still many areas of the new margin tax that need to be clarified. Taxpayers can anticipate receiving additional guidance from the Texas Comptroller, which will be issuing interpretive rules published in the Texas Administrative Code. In addition, the Texas legislature will begin a new session on January 1, 2007, during which it is anticipated that the margin tax will be further refined.
Kim Szarzynski is an associate in Haynes and Boone’s Richardson, Texas, office. Kenneth Bezozo is a partner in the firm’s New York City office.
©2006 France Publications, Inc. Duplication
or reproduction of this article not permitted without authorization
from France Publications, Inc. For information on reprints of
this article contact Barbara
Sherer at (630) 554-6054.
|
