State and Local Tax: Entity Formation For Certain Texas Activity

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My colleague, Matthew Roberts, recently posted an article regarding choice-of-entity, “Starting a Business in Texas:  Choice of Entity.”   The article provided a summary of the tax and non-tax implications of each potential entity type.

We will discuss “passive entities” under Texas law.  Please note the definition of a passive entity under Texas law is not the same as the definition under the Internal Revenue Code.   Depending on the business being conducted in Texas, a certain type of entity may be more beneficial to reduce or eliminate your  Texas Margin Tax (the “Margin Tax”).

Under Texas law, “passive entities” are exempt from the Margin Tax.   Furthermore, “passive entities” are not included in a combined Margin Tax return.  What is a “passive entity under Texas law?”   In order to qualify as a passive entity under Texas law, passive entities must have at least 90% of their gross income for federal income tax purposes from partnership allocations from downstream non-controlled flow-through entities, dividends, interest, royalties, or capital gains from the sale of (i) real estate, (ii) securities, or (iii) commodities.

It is important to note that real estate rentals, as well as other rent and income from mineral interests, are not passive income sources unless they are classified as “royalties, bonuses, or delay rental income from mineral properties and income from other nonoperating mineral interests.”

Furthermore, only non-business trusts, general partnerships and limited partnerships can qualify as passive entities. LLCs and S-corps cannot qualify as passive entities, even if 90% of their income is from qualifying passive sources.

There may be 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 the Margin Tax. However, if an investor can separate the types of investments, and maintain that separation, it may be worthwhile to put passive assets in a limited partnership and other active assets in another entity type.

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DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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