Margin Tax Update: Consider Restructuring Your LP Immediately
LIMITED PARTNERSHIPS will shortly become subject to a Texas franchise tax for the first time.
Businesses organized as limited partnerships may consider abandoning these structures in favor of other business forms. Based on a Technical Corrections Bill expected to be signed into law, it appears that for business owners wanting to restructure, a tax savings may be available if such restructuring occurs on or prior to June 30, 2007.
MARGIN TAX - OVERVIEW
The new Texas business tax – known as the “Margin Tax”– was signed into law in 2006. The Margin Tax revises and expands the existing franchise tax by changing the tax base, lowering the rate and extending coverage to all active businesses receiving state law liability protection. Under the new tax, limited partnerships will become subject to a franchise tax for the first time.
The Margin Tax assesses a tax on an entity’s “taxable margin,” which is the amount that equals the lesser of (A) 70% of the taxpayer’s total revenue or (B) the taxpayer’s total revenue minus either Cost of Goods Sold or employee compensation and benefits paid. The Margin Tax rate equals 0.5 percent for taxable entities primarily engaged in wholesale or retail trade and 1 percent for all others. The Margin Tax is effective for returns originally due on or after Jan. 1, 2008.
Depending on a taxpayer’s particular circumstances, there may be several non-tax reasons to merge out of a limited partnership (or LP) structure in favor of another business form, such as a corporation, an S corporation or a limited liability company (“Newco”). For example, popular LP structures – like the “Delaware sub” structure – use out-of-state entities to minimize the Texas franchise tax. However, these structures are cumbersome and costly to maintain as compared to conducting business through a Newco. Similarly, for wholly-owned businesses, an LLC presents the opportunity to have the Texas business be treated as a “disregarded entity” for U.S. federal income tax purposes, which reduces certain administrative and filing obligations. Finally, without the continuing benefit of franchise tax savings, a business owner may wish simply to use a more straight-forward business form in light of the change in law. The choice of the appropriate entity to conduct business may differ from taxpayer to taxpayer and should be individually reviewed.
A business operating through an LP structure has several options in response to the Margin Tax. Specifically, the business may (i) merge the LP into an LLC or a corporation, or liquidate the LP into its LLC or corporate partners (hereafter jointly referred to as merging; (ii) restructure during or after 2008 once the Margin Tax has become effective, or (iii) do nothing and simply begin paying the tax after Jan. 1, 2008. It may be beneficial to consider possible tax differences in timing when contemplating a restructuring.
OPTION 1: MERGE IN 2007
If a business chooses to abandon its LP structure in favor of an alternative structure prior to 2008, the business will become subject to the Margin Tax beginning on the merger date. If a merger takes place on or before June 30, 2007, the tax for the period through Dec. 31, 2008 is based on the total revenue for the period between the merger date and Dec. 31, 2007. In contrast, if the merger takes place after June 30, 2007, the tax for the period through Dec. 31, 2008 is based on the total revenue (including revenue of the LP) for all of 2007. This interpretation is not free from doubt and may be subject to legislative correction. For a calendar year taxpayer with annual taxable margin equal to $1 million per year that merges into an LLC on June 30, 2007, the taxes payable on its initial return for the period from the date of merger through Dec. 31, 2008 will be $5,000 (assuming such taxpayer’s gross receipts are earned ratably throughout the year).
OPTION 2: RESTRUCTURE ON OR AFTER JANUARY 1, 2008
On Jan. 1, 2008, the LP will become subject to the new Margin Tax. The tax for 2008 will be computed by reference to the entity’s total revenue in 2007. For a calendar year taxpayer with annual taxable margin equal to $1 million that restructures on or after Jan. 1, 2008, the taxes payable on its initial return for the period through Dec. 31, 2008 will be $10,000.
OPTION 3: DO NOTHING
If a business chooses to keep its LP structure in place, it will become subject to the Margin Tax on Jan. 1, 2008. Taxes for 2008 will be computed as described above under Option 2.
TIMING IS EVERYTHING
If a taxpayer determines that there are significant non-tax reasons to restructure its LP into an LLC (or other form of entity), the taxpayer should time its restructuring to minimize the detrimental impact of the tax. Based on the Options set forth above, it appears that the least amount of tax will be payable if the taxpayer merges its LP on June 30, 2007. Specifically, while merging by this time will trigger taxes beginning in 2007, the measurement period on which tax is based for the initial return appears to be shorter as compared to any other option. Of course, nontax reasons may dictate that merging at this time is undesirable. In that case, at least the taxpayer will have considered these timing implications in making an informed decision.
FEDERAL TAX IMPLICATIONS
Because the unique characteristics of a business may cause an otherwise tax-free merger to trigger Federal income tax, a business owner should evaluate the anticipated Federal income tax consequences of a merger before deciding to merge an LP. A discussion of the Federal tax issues is beyond the scope of this Alert.
As a general rule, the legal instruments necessary to consummate a merger are not complex. Nevertheless, there are several significant business issues that must be addressed before a merger. These include, but are not limited to, the effect of the merger on change of control restrictions in contracts and restrictive covenants in loan agreements. In addition, the effect on licenses and permits must be reviewed. Finally, issues relating to insurance and property transfers must be explored. These facts will differ from taxpayer to taxpayer and should be individually reviewed.