Avoiding 99% of Texas franchise tax
Karl Irvin
by the Texas Society of CPA's) has an article which
describes the following approach to reducing the Texas
franchise tax.
1. Convert the existing corporation to a limited partnership
(under state law.) which is not subject to franchise tax.
2. Elect to tax the converted entity as a corporation under
the check the box regulations. Keep the same EIN and report
all income on one Federal return.
The author claims that there is not liquidation for Federal
tax purposes. I checked with the state comptrollers office
today and they said if the entity was registered with the
thee secretary of state as a partnership, then no franchise
tax would be due regardless of the Federal election to be
taxed as a corporation.
I have never seen this done before and it sounds too good to
be true. What are your thoughts or experiences with this?
Ed Zollars
> I have never seen this done before and it sounds too good to
> be true. What are your thoughts or experiences with this?
I'm not a Texas CPA <grin>, but I don't see any reason on
the federal end while you couldn't create such a structure.
I assume the structure would look like this this:
A - the current Texas corporation, taxed as a C corporation
B - a Texas LLC that will be the general partner. It elects
to be treated as a proprietorship. This LLC is owned by the
shareholders of A. Alternatively, we could use a Texas
corporation.
P - the new limited partnership, that files a check the box
election to be a C corporation for federal tax purposes.
We form P with B as the general partner. If state law
allows, we merge A into P, giving A's shareholders limited
partnership interests. If we cannot merge, we make use of
one of the other statutory tax free reorganization
provisions.
I believe there could be a problem with trying to make this
entity an S corporation, since arguably there are two
classes of "stock" (using that term loosely <grin>) in the
limited partnership with different rights--the shares held
by B and the shares held by the limited partners.
Also, getting a general partner in place seems a potential
snag, though I believe it's not going to be a big issue. Of
course, we want that general partner to be some entity with
limited liability.
In any event, I think you have to find a snag in one of
those steps to create a problem for federal law (which would
be the deemed liquidation).
---
Ed Zollars, CPA (AZ)
ezo...@primenet.com
Katie Jaques
> The November/December 1998 Today's CPA magazine (published
> by the Texas Society of CPA's) has an article which
> describes the following approach to reducing the Texas
> franchise tax.
>
> 1. Convert the existing corporation to a limited partnership
> (under state law.) which is not subject to franchise tax.
>
> 2. Elect to tax the converted entity as a corporation under
> the check the box regulations. Keep the same EIN and report
> all income on one Federal return.
>
> The author claims that there is not liquidation for Federal
> tax purposes. I checked with the state comptrollers office
> today and they said if the entity was registered with the
> thee secretary of state as a partnership, then no franchise
> tax would be due regardless of the Federal election to be
> taxed as a corporation.
>
> I have never seen this done before and it sounds too good to
> be true. What are your thoughts or experiences with this?
Karl, this is just a new twist on a Texas franchise tax
planning technique that has been used successfully for many
years. It derives from three principles of Texas franchise
tax law:
1. Partnerships, general or limited, are not subject to the
Texas franchise tax.
2. A corporated limited partner in a partnership doing
business in Texas does not have nexus for Texas franchise
tax purposes, as long as that is its only connection with
the state.
3. Texas does not follow the federal "check-the-box" rules,
but imposes the franchise tax on all LLCs as if they were
corporations.
What you do is organize a limited partnership (LP) under
Texas law. It's a good idea also to organize a new
corporation (Newco) under the law of some other state -
Nevada or Delaware, perhaps. The reason is that you want
the 99% limited partner in this partnership to be absolutely
"clean, " i.e., have no Texas ties other than its interest
in the partnership. Newco needs to be very careful to do
everything it does OUTSIDE of Texas. The old corporation is
already a Texas taxpayer (and may be organized in Texas, in
which case it's subject to the franchise tax no matter what
it does) and it is easier to organize a Newco than to clean
up the old corporation.
Oldco then transfers all of its Texas assets and activity to
Newco in exchange for Newco stock (a tax-free transaction
under IRC Sec. 351). Then Newco in turn transfers those
assets to LP in exchange for a 99% limited partner interest,
also a tax-free transfer under Subchapter K (I forget the
code section). Oldco contributes cash in exchange for the
1% general partner interest.
Now 99% of the Texas activity escapes the franchise tax,
because it is not taxable at the partnership level, and the
limited partner is not a Texas taxpayer and therefore not
taxed on the flowthrough income. (I call this the Texas
Two-Step, because it creates two new entities.)
The new wrinkle is the third principle - that Texas doesn't
follow check-the-box. That gives us the flexibility, if we
would rather have that activity in a C corporation for
federal purposes, to elect federal C status without
affecting the Texas structure.
Of course the Texas Comptroller and the legislature are
thoroughly aware of this planning technique. A few years
ago when the state was in financial trouble, the legislature
came within inches of enacting legislation imposing the
franchise tax on limited partnerships, which would have
negated all this structuring. Since states in general, and
Texas in particular, are not short of revenue these days,
the pressure to close the loophole is off. No doubt it will
come up again, though, the next time there is a revenue
shortfall. So it may be a relatively short-term fix. But
for now, it works.
One thing to watch out for is that Newco, the 99% limited
partner, maintains its office, bank accounts, etc. outside
Texas, never holds stockholder or director meetings in
Texas, etc. Carelessness can result in the Comptroller
determining that Newco's commercial domicile is in Texas and
it is therefore a Texas taxpayer. Then the 99% flowthrough
income would be subject to franchise tax.
By the way, the two-step technique used to work in
Tennessee, but for years beginning after June 30, 1999,
LLCs, LLPs, and limited partnerships are subject to the
Tennessee excise (income) tax the same as corporations.
Katie in San Diego
The foregoing is intended for educational purposes only and
does not constitute legal or professional advice. The views
expressed herein are those of the writer and are not
expressed on behalf of her employer.
parcpa
> The November/December 1998 Today's CPA magazine (published
> by the Texas Society of CPA's) has an article which
> describes the following approach to reducing the Texas
> franchise tax.
>
> 1. Convert the existing corporation to a limited partnership
> (under state law.) which is not subject to franchise tax.
>
> 2. Elect to tax the converted entity as a corporation under
> the check the box regulations. Keep the same EIN and report
> all income on one Federal return.
>
> The author claims that there is not liquidation for Federal
> tax purposes. I checked with the state comptrollers office
> today and they said if the entity was registered with the
> thee secretary of state as a partnership, then no franchise
> tax would be due regardless of the Federal election to be
> taxed as a corporation.
>
> I have never seen this done before and it sounds too good to
> be true. What are your thoughts or experiences with this?
It seems plausible that this is the case. A lot of the
states have not figured out all of the loopholes associated
with the federal check-the-box rules. I believe the same
holds true in Pennsylvania also (which has an onerous
franchise tax).
nero...@my-deja.com
when forming a corporation or LLC, especially for someone
new to business. I've been reading a book on incorporating,
and have been getting most of the main concepts and issues.
Now, I'm not claiming a MBA just yet, but is the process
straight-forward enough to attempt it on one's own? Do a lot
of small businesses do it without consultation?
Nemo
Katie Jaques
> It seems plausible that this is the case. A lot of the
> states have not figured out all of the loopholes associated
> with the federal check-the-box rules. I believe the same
> holds true in Pennsylvania also (which has an onerous
> franchise tax).
The PA franchise tax is imposed on LLCs and limited
partnerships - no matter what box they check.
The Tennessee franchise tax also applies to LLCs, LLPs and
limited partnerships, effective for years beginning on/after
July 1, 1999 (except in some cases, it applies for years
ENDING on/after that date).
Kansas also imposes its franchise (net worth) tax on LLCs
and LLPs.
John H. Fisher
I don't know about percentages. However, I do know that it
is not advisable for a novice to undertake such an important
step without the advice of a professional. When you have to
get into the nitty-gritty, reading a book would rarely do
it. Perhaps a genius could master the subject in a brief
period of time. Even then, if there were enough genius
he/she would likely engage a professional, in spite of that
genius.
"Jack" - John H. Fisher - TaxSe...@aol.com
Philadelphia, Pa - Atlantic City, NJ - West Wildwood, NJ
My Newsgroups & Boards at: http://members.aol.com/TaxService/index.html
Where Ignorance is bliss, 'tis folly to be wise!=:)
Ed Zollars
> Is is generally wise for one to seek private legal consel
> when forming a corporation or LLC, especially for someone
> new to business. I've been reading a book on incorporating,
> and have been getting most of the main concepts and issues.
> Now, I'm not claiming a MBA just yet, but is the process
> straight-forward enough to attempt it on one's own? Do a lot
> of small businesses do it without consultation?
Well, I would ask first one question--why are you
incorporating? There are many self-help books, articles,
etc. that will step through the *how* of incorporating but
give short shrift to the *why* and the possibilities of
alternatives. And the why has impacts all over the place,
on both tax and nontax issues. From an income tax
perspective, though, I'd put it this way--the further down
this list you go in selecting a structure for your business,
the more sure of your decision you have to be (because it
can be difficult and expensive from a tax standpoint to move
back up the list if you got it wrong):
Proprietorship (including LLC under check the box)
Partnership (including LLC under check the box)
Corporation (taxed as an S corporation)
Corporation (taxed as a C corporation)
You can easily move down that list without a tax
consequence--so if you start out as a proprietorship but
decide you should have been a C corporation, there would be
no tax consequence. But, if you decide the alternative (you
should have been a proprietorship, but you've already
incorporated), then it can be very costly from a tax
standpoint to fix the problem (all gains inside the
corporation would be taxed twice if a C, once if an S).
I suspect the attorneys, considering only legal issues,
would rearrange that list slightly (the partnership/LLC
would be the most complex device from a legal standpoint and
could be the biggest problem to unwind from a legal
standpoint).
I can tell you that I make *LOTS* of money on fees (and my
attorney friends even more) from dealing with entities that
were originally set up as the wrong entity but which now
would be prohibitively costly to fix from a tax standpoint.
We make significantly less over time from clients that
consulted with us first and got it right to start.
waynero...@gmail.com
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Alan
> I have a llc registered in New York. It is a family owned business started in 2011. My son like all my nephews own a small 2% of the stock. But play no active role in the business. He moved to Texas this year. Would his ownership of stock create nexus in Texas. Would all the sales across the country be subject to the franchise tax or just the sales made in the state of Texas?
>
only be subject to the tax if it does business in Texas. So, if you
previously determined that your LLC has not been doing business in Texas
(i.e., the sales you reference were orders placed by telephone, internet
or catalog and delivered by common carrier or USPS) then the mere change
of residency by a 2% owner (your son) would not create nexus unless your
son is an employee or acts as an agent of the company.