COVER STORY, MARCH 2012

WHO PAYS MARGIN TAX?
Since 2006, commercial landlords and tenants in Texas have had to negotiate who will pay the levy.
Lindsey Bragg

Lindsey Bragg

Texas does not have a state income tax for individuals, but it does tax the profits of business entities pursuant to the franchise tax which is set out in Chapter 171 of the Texas Tax Code. The franchise tax originally applied only to corporations and limited liability companies — it did not apply to limited partnerships. Accordingly, the majority of commercial real estate in Texas was owned and leased by limited partnerships with a view toward avoiding the franchise tax.

In 2006, however, the Texas legislature replaced the franchise tax with a revised business franchise tax — the so-called “margin tax” — in order to extend application of the franchise tax to limited partnerships, general partnerships, and joint ventures which have at least one partner that is not a natural person, and to accomplish various other objectives. A “natural person,” as defined in Section 171.0001 of the Texas Tax Code, is a “human being or the estate of a human being.” A purely legal entity given recognition as the possessor of rights, privileges, or responsibilities (such as a corporation, limited liability company, partnership or trust) does not constitute a natural person for margin tax purposes.

Since commercial landlords cannot avoid the margin tax, landlords and tenants are faced with negotiating (or arguing over) lease language in order to determine which party is or should be ultimately responsible for the payment of the margin tax assessed against the landlord.

In particular, landlords want the margin tax to be included in the definition of operating expenses that are to be passed through to and reimbursed by their tenants; while tenants, conversely, believe that the margin tax assessed against their landlord should be excluded from operating expenses. Both parties manage to see aspects of the margin tax which support their respective views. It is important to note that this negotiation (or argument) generally only takes place in the context of triple net leases. Landlords with net leases will no doubt pass the margin tax through to their tenants (who are paying a set, all-inclusive rate).

In the context of commercial leases (i.e. ground leases and leases for office, retail/restaurant, and industrial space), one of the following two situations will typically exist:

1. Leases that were entered into prior to the enactment of the legislation typically don’t specifically address the margin tax, and although the landlord will frequently attempt to amend the lease to address the issue in their favor, an argument will likely be had between landlord and tenant as to whether or not the margin tax can be passed through to tenant under the existing terms of the lease. If the language in the lease specifically and expressly excludes items such as “income taxes” or “franchise taxes” from the operating expenses that the landlord can pass through to the tenant, the landlord will have a difficult time winning the argument that the lease, as written, permits the landlord to pass the margin tax through to its tenants. The landlord may have better luck if the lease contains language that permits the landlord to pass through costs and/or expenses incurred “in lieu of” or in replacement or substitution of other property taxes. It can, however, be somewhat difficult to demonstrate how the margin tax payable by the landlord directly reduces the other property taxes payable by the landlord.

2. Where landlords and tenants are entering into new leases, they typically tend to (and no doubt should) specifically address the margin tax and how it will be treated in the written lease agreement. This process often begins as early as the letter of intent stage. Some of the more common arguments and positions asserted by landlords and tenants when discussing the margin tax are set forth below. These arguments apply and are frequently used not only in the negotiation of new leases, but in situations where existing lease terms are not clear on the matter as well. Notwithstanding the multitude of potential arguments and positions (in the context of new leases a little more so than in the context of interpreting existing leases), the reality is that the pass through of the margin tax assessed against the landlord is ultimately a business decision, not a legal issue, and (as with other business decisions) the result typically turns on the negotiating strength of the respective parties.

The margin tax discussion has evolved over time, but these days it is typical for one of the parties to win the battle outright (i.e. the tenant either pays its portion of the landlord’s margin tax or it doesn’t). In the absence of an outright victory, however, landlords and tenants will negotiate on the issue and will come up with some compromise whereby neither landlord nor tenant bears the burden of the entire margin tax. The most often used compromise is where the tenant pays only that portion of the margin tax that is attributable to the income earned by the landlord in connection with the tenant’s lease. This approach limits the margin tax to be essential a tax on rents earned from the tenant and addresses the tenant’s main concern that it not forced to absorb the landlord’s cost of doing business. Some of the other more common compromises are set forth in general terms below:

• Rather than passing though the entire margin tax assessed against the landlord to the tenants, the tenants pay their proportionate share of only the portion of the margin tax that represents an actual reduction in applicable school district maintenance and operations taxes (i.e. the amount equal to (a) the amount that such school district maintenance and operations tax expenses would have been if calculated based upon the applicable school district maintenance and operations tax rates for 2006, minus (b) the actual amount of school district maintenance and operations tax expenses that are assessed for such lease year).

• Rather than passing though the entire margin tax assessed against the landlord to the tenants, the tenants pay a stipulated sum based on current tax rates and typically determined by applying said tax rates to a portion of the base and any additional rent to be paid by the tenants pursuant to the terms of the lease.
• Rather than passing though the entire margin tax assessed against the landlord to the tenants, the tenants pay a stipulated percentage of the margin tax assessed against the landlord.

• The tenant will require that any portion of the margin tax attributable to the landlord’s sale or other conveyance of the property be excluded from the operating expenses and/or taxes passed through to the tenant.

— Lindsey Bragg, associate with Winstead Attorney’s Real Estate Development & Investments Practice Group in Dallas.

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