Texas “Margin Tax” Pass-Throughs

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Margins of Texas

It is strictly a business matter as to what a Tenant is willing to pay or unwilling to pay. In Texas, almost every Landlord seeks to pass the “Margin Tax” along to Tenants. The discussion below will explain that it is not a real estate tax and is not a tax only on rental income. It is a Franchise Tax and is payable, according to a formula, based on an entity’s (not just a landlord entity’s) gross income. A manufacturer would pay it. A law firm organized as a limited liability company or professional corporation would pay it.

The “Margin Tax” is an income tax. The enabling Texas legislation calls it a Franchise Tax. The “public” calls it the Margin Tax because of the way it is calculated. It is a taxable on a taxable entity’s “taxable margin.” Prior to its passage, the Texas Franchise Tax applied only to corporations and limited liability companies. Limited partnerships were not taxed. Most real estate in Texas was held in the name of a limited partnership to avoid the pre-2008 Texas Franchise Tax.

So, when the Franchise (“Margin”) Tax was extended to limited partnerships, landlords began to pass this income tax on to Tenants. It is not a tax on real estate or even real estate owners. It is a tax on entities that afford limited liability protection to their owners. That is why it is not imposed on proprietorships or general partnerships.

Texas does not have a state income tax for individuals, but it does tax the profits of business entities according to the “margin tax” which is found at Chapter 71 of the Texas Tax Code.

Sec. 171.002(a) of the Texas Tax Code provides that the statutory maximum margin tax rate applicable to a taxable entity not engaged in retail or wholesale business is 1%. However, the maximum amount of gross revenues that is subject to the tax is 70%; therefore, in practical effect, this tax rate is 0.7%. Deductions may also apply to the extent that deductible compensation and other items comprise at least 30% of this “standard deduction.” This standard deduction has not changed.

No tax is due if the total tax liability is less than $1,000 or if total revenue falls beneath the “small business exemption,” which has been raised from $300,000 to $1,000,000 for the years 2010 and 2011. In 2012, the exemption will fall to $600,000.

Taxable entities include: a partnership, limited liability partnership, corporation, banking corporation, savings and loan association, limited liability company, business trust, professional association, business association, joint venture, joint stock company, and a holding company. Not included are sole proprietorships, general partnerships composed entirely of natural persons that do not have limited liability, a “passive entity,” and certain other specified entities.

Certainly, Landlords organized as limited partnerships, as is very common in Texas, were surprised to learn in 2008 that they would be paying a Franchise Tax (similar in effect to a gross income tax) on their pre-existing rental income. Once the tax took effect, they should have quoted rents that would satisfy their after-tax income objectives. Many, however, chose to try to pass this tax along to their Tenants. This might be likened to Landlords insisting on a Lease provision passing along increases in mortgage interest if they refinance their property.

Now dem’s “fighting words” and are intended to be such. I’m looking to provoke a response from the other side of the issue.

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Comments

  1. Ira,
    Brilliantly put! We tenants echo your concerns and your challenge. Love the blog — keep up the good work.
    David

    DSW Designer Shoe Warehouse

  2. George Bernhardt says:

    Hi Ira,

    Nice summary of the topic. Most people out of state do not take the time to understand the details of the “margins” tax. I think that more often than not tenants are NOT paying the franchise tax in Texas, though it’s certainly still hotly negotiated. Probably non-Texas landlords are pushing harder for this than Texas landlords. As you note, it is really very similar to an income tax. The only reason it is not an income tax is that this would require an amendment to the Texas constitution and pretty much anyone voting for this in the legislature would be thrown out at the next election. State income tax is the 3rd rail of Texas politics. The franchise tax is crafted specifically to avoid the courts calling it an income tax.

    I recently dealt with this issue in Houston with a major national landlord, which leased several properties to us that were owned in SPV limited partneships when the franchise tax only applied to corporations and LLC’s. The leases provided that any new taxes enacted in substitution for property taxes would be payable by the tenant. Some of our positions were:

    1. The “Margin” tax is NOT a new tax. It is an expansion of the franchise tax to include new entities that were not previously taxes (among other revisions).
    2. Our particular lease specifically excluded income taxes and the franchise tax. As noted, this is the same franchise tax that was excluded from the original lease, just amended. If it was not a reimburseable tax before, it should not be now.
    3. While there was some discussion of increasing franchise tax revenues and decreasing property taxes, there is no direct substitution of franchise for property taxes in the legislative history.
    4. Although no one in Texas will admit it, this is really modified income tax. Income taxes should not be paid by tenants.

    They pushed pretty hard (this was over $100K in margin taxes per year), but I believe they have come around to our position (mainly because our particualr leases expressly excluded franchise taxes).

    George

  3. Ira:

    Very good article. I have represented landlords in Texas and this has always been a tough situation to negotiate with smart tenants.

    Also, I believe there is a typo that you may want to correct. In the second paragraph you state that limited liability companies were originally taxed, and then go on to say that they were not taxed… “…Prior to its passage, the Texas Franchise Tax applied only to corporations and limited liability companies. Limited Liability Companies and limited partnerships were not taxed….” I wish I could take credit, but a friend noticed it.

    Alan Betus
    The Law Office of Alan Betus

  4. Ira: Good post. In my experience, I have encountered the following. Most landlord lease forms have a very broad and inclusive definition of “Taxes” that not only includes traditional real estate taxes (including assessments for off-site improvements) but also attempts to include (i) taxes related to real estate, e.g. taxes imposed upon or measured by rent, and (ii) “other” taxes, whether or not related to real estate, but usually impose these latter taxes only in the circumstance where there occurs a change in the pre-existing method of real property taxation and a new tax is enacted therefor to make up for lost revenues resulting from the change in the former tax (“substitution tax”) . However, these same landlord drafted clauses almost universally exclude “income taxes” as going too far as they are a tax on the landlord’s profitability rather than gross receipts (which may not care whether the taxpayer experiences a profit or loss). With a few exceptions, this exclusion is honored whether or not a substitution event has occurred. In Texas the following occurred:

    1. The Texas Supreme court held in 2005 that the Texas system of funding schools violated the Texas constitutional prohibition of a state-wide property tax.

    2. Texas enacts a margin tax (HB#) in 2006 arguably as a result of the revenue effects of the Texas Supreme court opinion.

    My client’s standard lease with a major developer had permitted certain substitution taxes into the definition but expressly excluded “income or profit” taxes under any circumstances. In a new lease with that developer, the following clause appeared:

    Notwithstanding anything to the contrary contained in this Lease, Landlord and Tenant agree that any tax or fee imposed on Landlord pursuant to House Bill 3 signed by the Governor of Texas on May 16, 2006, as amended and/or supplemented (“Texas Margin Tax”) or any similar tax or fee shall be considered a part of Property Taxes for the purposes of Article 7 of this Lease as such Texas Margin Tax was imposed in partial substitution for real estate taxes as evidenced by the Governor of Texas also signing House Bill 1 which provides for a real property tax reduction.

    So while one might successfully argue that the Texas Margin Tax had been as a direct result of the Texas court decision and enacted in substitution to make up for any lost revenues therefrom (one would have to study the legislative history to determine that), the landlord could not charge my client because it was an income tax. Although their counsel argued vigorously that the Margin Tax was not an income tax, all accountants agree that it is.

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