The Corporate Franchise Tax: Is there a way around it?

There is a way to eliminate the franchise tax in the State of Texas on an entity taxed as a corporation at the federal and state level.

If an entity is a corporation or a limited liability company in Texas, the entity can adopt a plan of conversion and restructure its organization so that its business is done by another type of entity such as a limited partnership. This type of conversion is authorized by the Texas Business Corporation Act, the Texas Limited Liability Company Act, the Texas Revised Limited Partnership Act, and the Texas Revised Partnership Act.

The conversion can effectively eliminate the franchise tax at the state level while not incurring any tax at the federal level from the conversion. Another added benefit is that after the conversion, the old corporation’s stock will become limited partnership interests subject to valuation discounts for estate and gift tax planning.

When the conversion is complete, all the rights and title of the property owned by the old corporation are owned by the new limited partnership. Also, all the liabilities of the old corporation become liabilities of the new limited partnership, and the shares of the old corporation are converted into interests of the new limited partnership.

The taxing consequences at the federal level will not change because of the "check the box" regulations. The new limited partnership can file IRS Form 8832 Entity Classification Election, and elect to be taxed as a corporation. If the new limited partnerhsip does this it will be deemed a domestic corporation because it will be classified as an association taxable as a corporation. If the new limited partnership does not make such an election then there will be tax imposed because the old corporation will be deemed to have distributed its assets and liabilities at fair market value which is a taxable event.

When the new limited partnership elects to be treated as a corporation at the federal tax level, this will qualify as a mere change in identity of the old corporation and shall be considered a tax free reorganization of the old corporation’s assets and liabilities.

This type of tax free reorganization means that the old corporation’s taxable year does not end on the date of the distribution to the new limited partnership. The new limited partnership shall continue with the old corporation’s tax year. No short tax year will exist and no short period return shall be due for the old corporation. Additionally, if the old corporation has any net operating losses, these losses will not disappear. They will still be able to be carried back to the pre-acquisition years.

If the LLC is taxed as a partnership, then the new limited partnership will be taxed as the same. This means that no change in the federal filing status of the partnership will take place.

When the old corporation converts into a new limited partnership, a new proper name should be obtained for the limited partnership. However, the same corporate employer identification number of the old corporation can be used by the new limited partnership.

There are other special considerations to be aware of when attempting this type of conversion, especially if the old corporation is an S corporation. With an S corporation, the new limited partnership must have a single member limited liability company as a general partner in order for the shareholders to qualify as S corporation shareholders. This is due to the disregarded entity status of the limited liability company ("LLC") which disregards the entity of the LLC and looks straight through to the owner.

The reason why the disregarded entity LLC needs to be utilized is because a corporation in which any shareholder is a corporation or a partnership does not qualify as a small business corporation. The internal revenue code defines a small business corporation to be a domestic corporation that does not have as a shareholder a person who is not an individual.

Additionally, any partnership agreement for the new limited partnership must be designed with no special allocations due to the S corporation election, and no indication of a separate type of stock can be created, except for a non-voting interest. Also, once an S election has been made, it does not need to be made again. The new entity can continue with the S corporation’s election.