Update on Rule Changes for the Texas Passive
Entity Exemption
Summary
On December 25, 2009, the Texas Comptroller of Public Accounts adopted final amendments to Rule 3.582 (34 Tex. Admin. Code § 3.582).1 These amendments did not include certain proposed changes that would have restricted taxpayers’ ability to qualify for passive entity treatment. With these lingering uncertainties resolved, taxpayers may now implement passive entity planning with increased confidence (at least until the next legislative session). By properly utilizing the passive entity exemption, taxpayers may be able to significantly reduce their Texas franchise tax liability.
Passive entities, as defined by Tex. Tax Code § 171.0003, are not subject to Texas franchise tax.2 In general, an entity qualifies as a passive entity if (1) the entity is a partnership or trust (other than a business trust); (2) at least 90 percent of the entity’s federal gross income for the tax period includes certain types of passive income (e.g., dividends, interest, distributive shares of partnership income, gain from the sale of securities); and (3) not more than 10 percent of the entity’s federal gross income is derived from conducting an active trade or business.
Uncertainties Resolved
- Treatment of Passive Income Earned in “Operations” or through Controlled Subsidiaries
To qualify as a passive entity, an entity must not receive more than 10 percent of its federal gross income from conducting an active trade or business.3 Income classified as passive income, however, may not be treated as active trade or business income.4 Despite this prohibition against passive income being treated as active income, the Comptroller’s October 2009 proposed margin tax rules introduced a requirement that income could not be passive unless the income was “not part of the receiving entity’s operations and is merely an investment.”5 The proposed rules also provided that income from an investment in another entity would not be passive income “if the investing entity or an affiliated entity or individual [controlled] the investee.”6
If implemented, these proposed rules could have been used to prevent an entity from qualifying as passive even if its only activities were making investments. The proposed rules also called into question the passive characterization of flow-through income from subsidiaries. During the 30-day public comment period, the State Tax Committee of the Texas State Bar—chaired by Baker Botts partner Matt Larsen—issued comments to the Comptroller arguing that these rule amendments conflicted with Tex. Tax Code § 171.0003(a-1), in addition to being undesirable policy. Citing these comments, the Comptroller agreed and withdrew the proposed rule amendment.7 The Comptroller’s apparent capitulation on the issue of whether passive income can also be active income is the first written acknowledgment by the Comptroller of something that many practitioners have suspected since the margin tax was implemented—that the active business provisions in Tex. Tax Code § 171.0003(a) have little practical significance.
- Treatment of Pass-through Rental Income
Passive income includes “distributive shares of partnership income.”8 Passive income, however, does not include rent.9 In November 2008, the Comptroller proposed an amendment to Rule 3.582, which provided that a distributive share of partnership income would not be considered passive income to the extent it constituted rent income in the hands of the lower-tier partnership.10 During the 30-day public comment period, the State Bar State Tax Committee issued comments to the Comptroller highlighting structural flaws to this policy and explaining that this new policy would result in unanticipated tax on taxpayers who consolidated assets producing passive income with interests in real estate partnerships.
Recognizing that her policy would unduly surprise some taxpayers, the Comptroller temporarily withdrew her amendment, stating that if the Legislature did not address the issue, she would re-propose her rule amendment for prospective application. During the interim, we advised clients to segregate interests in partnerships producing rental income from assets producing passive income.
As expected, the Comptroller re-proposed her rule on October 30, 2009 for reports due in or after 2010.11 During the 30-day comment period, the State Tax Committee and other commentators renewed their objections to this amendment, leading the Comptroller to withdraw it in the final rule.12 As a result, distributive shares of rental income should qualify as passive income.
- Reporting Requirements for Passive Entities
Under prior law, a passive entity was required to file information each year to verify that it met the passive entity qualifications.13 On December 25, 2009, the Comptroller adopted final amendments to Rule 3.582 clarifying passive entities’ filing requirements.14 The rule amendments provide that only passive entities registered with the Comptroller or Texas Secretary of State are required to file reports, and that they are only required to file a report for the first year that they qualify as a passive entity.15 When a previously passive entity becomes taxable, it must resume filing Texas franchise tax reports.16 If the Comptroller writes to a passive entity asking whether it is taxable, the entity must reply to the Comptroller within 30 days.17
Please contact Renn Neilson, Matt Larsen or Matt Hunsaker with any questions regarding applying these final rules, planning to take advantage of the passive entity exemption or franchise tax issues in general.
1 34 Tex. Reg. 9464 (December 25, 2009).
2 Tex. Tax Code § 171.0002(b)(3).
3 Tex. Tax Code § 171.0003(a)(3).
4 Tex. Tax Code § 171.0003(a-1).
5 34 Tex. Reg. 7559 (October 30, 2009).
6 Id.
7 34 Tex. Reg. 9464 (December 25, 2009).
8 Tex. Tax Code § 171.0003(a)(2)(B).
9 Tex. Tax Code § 171.0003(b)(1).
10 33 Tex. Reg. 9053 (November 7, 2008).
11 34 Tex. Reg. 7557 (October 30, 2009).
12 34 Tex. Reg. 9464 (December 25, 2009).
13 34 Tex. Admin. Code § 3.582(g); 32 Tex. Reg. 10015 (December 28, 2007).
14 34 Tex. Reg. 9464 (December 25, 2009).
15 34 Tex. Admin. Code § 3.582(g)(1), (2).
16 34 Tex. Admin. Code § 3.582(g)(3).
17 34 Tex. Admin. Code § 3.582(g)(4).
IRS Circular 230 Disclaimer: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.
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