Red Flags Rising Over Texas' New Tax

Haynes and Boone LLP partner Kenneth Bezozo in New York City and associate Kim Szarzynski in Richardson say the best advice at this point is to schedule meetings ASAP with tax advisers to begin running pro formas to determine financial onus from legislation signed six days ago in Austin. Property owners might relish their real estate tax cut, but red flags are rising for leases, particularly triple net, and rental income as part of the trickle-down effect on the commercial sector from a newly structured franchise tax based on taxable margins.

"There are no loopholes," Bezozo told participants in yesterday's web conference. "Get ready to write a check. And just because it's disregarded for federal tax doesn't mean you're going to be disregarded for state."

Many corporate structures that didn't pay a franchise tax before will be doing so now. The new list includes partnerships, corporations, banking corporations, savings and loan corporations, limited liability companies, business trusts, professional associations, business associations, joint ventures, joint stock companies and holding companies.

"A substantial amount of business in Texas has been run through LPs," Bezozo points out to GlobeSt.com. "The franchise tax before was more or less voluntary. Now, it will no longer be voluntary. This is a very significant change and it will have ripples and the ripples are industry concentric."

So what's left? Not subject to the tax are sole proprietorships, general partnerships owned entirely by individuals, escrows and "certain" entities classified as tax-exempts, grantor trusts, estates, REITS, real estate mortgage investment conduits, family partnerships in which at least 80% are directly or indirectly held by one family and passive investments of LPs, general partnerships and trusts. The key word is "certain," Bezozo stresses. "Rent is not passive. For me, that's a big one. Raw land could be passive, but apartment buildings or office buildings won't qualify because rent's not passive."

Of equal concern is the impact on leases, particularly existing long-term, triple-net agreements. The legislation gift wraps a property tax reduction for triple-net holders while property owners must include rents in calculating taxable margins. "The lessors of the world are going to be thinking very quickly how to re-dress leases," Bezozo predicts. "For those with a bunch of 10-year leases or longer, it could be bad. Real estate companies need to rethink leases very soon with respect to the pass-through."

Bezozo sees the franchise tax winners as oil and gas production companies, manufacturers, wholesalers and retailers. The losers, he says, are service business professionals and transportation companies.

The state legislature met its June 1 deadline imposed by the Supreme Court, but the end result could jeopardize Texas' pro-business standing in the US and abroad, the attorneys say. "It will take time for issues to play out," Bezozo says. "We're not even at the point where the law is affecting someone. The tax savings compared to the cost of the new margin tax might not be a big deal. But, what it does do is it leaves a lot of relationships out of balance."

Entities have until March 1, 2007 to elect to continue deducting loss carryovers to help offset taxable margins, which is based on gross revenues adjusted by either 30% of the taxable entity's total revenue, cost of goods sold or compensation and benefits. The Catch-22 is loss carryovers are only allowable if the entity previously paid the franchise tax. The other stickling points are loss carryovers can't be transferred to another entity and can only be exercised for 20 consecutive reporting periods.

The first report is due on or after Jan. 1, 2008. "But be careful," Bezozo warns, "it reflects income from Jan. 1, 2007. You should be running pro formas to know what to expect before 2007."

A company can reduce its taxable margin by increasing compensation and benefits for employees, but only for "employees." Independent contractors and temporary help aren't deductible. On the bright side, the deduction for benefits is "unlimited so that could be a planning opportunity," Bezozo says. Meanwhile, he says there are "special rules" in motion for staff leasing and management.

"Until there's more interpretation with respect to the statute, there are going to be some issues that are unclear," Szarzynski says. "A lot of questions I get are from real estate companies who have each of their pieces of property in individual partnerships. It's kind of a waiting game at this point."