What is the Texas Franchise Tax?

February 22nd, 2012 | Author: Linda Silva

The Texas franchise tax is a privilege tax imposed on each taxable entity chartered/organized in Texas or doing business in Texas. It is a tax on corporations and other business entities that do business in Texas.

The tax is based solely on various types of income reported on the taxpayer’s federal income tax return. Furthermore, although the tax is called a franchise tax, it is a compensatory tax that operates as an income tax. The object of a franchise tax is to impose a tax for the privilege of doing business in the state, whereas the object of an income tax is to pay compensation for benefits that are provided by the state.

The critical distinction between the operation of a tax as a franchise tax or as an income tax is that a franchise tax is payable in advance for the privilege of exercising the right to do business in the future, whereas an income tax is compensatory for benefits received and is due even if the corporate entity ceases to exist and discontinues doing business in the state. Before a corporation doing business in Texas can dissolve, it must satisfy all of its tax liabilities. In other words, the corporation must pay the Texas franchise tax due even if it ceases doing business in the state.

What entities are subject to the franchise tax?
The revised franchise tax applies to partnerships (general, limited and limited liability), corporations, LLCs, business trusts, professional associations, business associations, joint ventures, incorporated political committees and other legal entities. Texas Tax Code 171.0002.

What entities are not subject to the revised franchise tax?

The revised franchise tax does not apply to:

sole proprietorships (except the tax does apply to single member LLCs filing as a sole proprietor for federal income tax purposes);
general partnerships directly and solely owned by natural persons (except the tax does apply to all limited liability partnerships);
entities exempt under Subchapter B of Chapter 171;
passive entities (as defined under Texas Tax Code 171.0003). Note that some passive entities have an annual reporting requirement to affirm their passive status.
unincorporated political committees organized under the Election Code or the provisions of the Federal Election Campaign Act of 1971 This provision is effective for reports originally due on or after Jan. 1, 2012.

What is a passive entity?

An entity is considered passive if it is a general, limited or limited liability partnership, or a non-business trust and the entity’s federal gross income during the period on which margin is based consists of at least 90% of the following income:

dividends, interest, foreign currency exchange gain, periodic and nonperiodic payments with respect to notional principal contracts, option premiums, cash settlement or termination payments with respect to a financial instrument, and income from a limited liability company;
distributive shares of partnership income to the extent that those distributive shares of income are greater than zero;
net capital gains from the sale of real property, net gains from the sale of commodities traded on a commodities exchange, and net gains from the sale of securities; and
royalties from mineral properties, bonuses from mineral properties, delay rental income from mineral properties and income from other non-operating mineral interests. Texas Tax Code 171.0003(a)(2).

Rent is not considered passive income for the Texas franchise tax. Texas Tax Code 171.0003(b).