Texas Court Showdown Likely for Margin Tax

"The odds that it will be challenged in court are certain," Bryan Dunklin of Bryan Dunklin & Associates LLC in Dallas, tells GlobeSt.com. And that challenge of themargin tax, by virtue of the statute, will be played out before the Texas Supreme Court.

Attorneys, in state and out of state, have been huddling for weeks to decipher HB 3's far-reaching implications on the commercial sector. Some legislators prefer to call it a revised franchise tax, but the reality is a new tax has been created in Texas.

Dunklin's recent analysis of HB3, just one of many to surface since the legislation was signed in May, was the focus of a Dallas Area Real Estate Lawyers' study group meeting, which usually attracts about 30 attorneys and this time drew a standing room only crowd that overflowed into the hall. This week, the Dallas Bar Association is planning to hold an HB3 teleconference seminar.

If accounting giant Deloitte is correct in its interpretation, the law is an income tax. And in Texas, that's illegal. Lawmakers, though, knowing the public whipping they'd take for that kind of stance inserted a provision specifying that it's not an income tax.

"We don't expect that section to deter the challengers," co-authors Cindy Ohlenforst of Hughes & Luce and Geoffrey R. Polma of Locke, Liddell & Sapp wrote in their copyrighted paper to their Dallas peers about hot-button issues demanding further definition by the court and lawmakers. The 22-page Ohlenforst-Polma report cites 40 issues. "Listing all the issues that have already been identified would make this outline longer than the bill [which is 105 pages] so we've settled for focusing on issues that we hope this audience will find interesting," the co-authors footnoted.

Aaron Johnston with Munsch Hardt Kopf & Harr is becoming that firm's point man for the bill's interpretation. "It's definitely a substitute for real estate taxes," he says. "I don't think anybody questions that. But, what is it? Is it an income tax or a net profits tax? People don't know what it is. It can't be an income tax because that's unconstitutional in this state. It's something in between, with some attributes of an income tax and some not."

The language of leases, rents, pass-through items and expense stops are just some of the nebulous areas as are issues like what happens in the event of a death that effectively alters the ownership status. But of primary concern is the fate of the real estate owners' coveted use of limited partnerships, particularly single-purpose structuring with Delaware incorporation, to dance around previous taxing dilemmas. "That is now being taken away from us," Dunklin says. "From this point on, unless it's a passive investment, there's no reason to use an LP going forward. The LLC will be the favored entity because it has a pass-through federal income tax provision."

With "passive" and "active" as the determining factors for who pays and who doesn't, the new law sets up a scenario that side-by-side buildings could be taxed differently due to the ownership structuring. Management companies and tenant-in-commons join limited partnerships as being new taxing fodder.

"The most problematic aspect of the statute that I see," Dunklin says, "relates to affiliate entities. There are going to be some incredible messes with people who have affiliate businesses."

As the legal profession drills down into the law, the plot thickens because corporations need to start preparing for their first report based on what's in hand although it's commonly believed revisions are sure to come. If upheld, HB 3 levies a 1% for up to 70% of the annual taxable margin except for retail and wholesale operations, which will be taxed at 0.5%.