How did Texas treat nexus and cash distributions when a REIT placed partnership interests into two wholly owned single-member LLCs?

Plain-English summary

The LLCs were separate Texas taxpayers from their REIT owner, their cash payments were not dividends, and the passive non-Texas LLC avoided nexus only on a proved outside-Texas activity record.

A Texas corporation taxed federally as a REIT planned to split its 93% general-partnership interest in a Texas real-estate partnership into a 1% general interest and 92% limited interest. A non-Texas LLC would hold the limited interest and conduct no Texas activity; a Texas LLC would hold the general interest and conduct the partnership's Texas management and business.

The Comptroller answered four groups of issues:

• Non-Texas LLC nexus: no Texas tax if its only connection was the partnership interest, regardless of income source, but it had to prove that every activity it was capable of performing occurred outside Texas.
• Separate entities: both LLCs remained separate from the REIT owner for Texas franchise tax even though federal law treated them as one entity.
• Not dividends: state-law resolutions calling the payments dividends did not control. For franchise tax, a dividend meant a corporate payment to a shareholder; LLC distributions followed Rule 3.562(j).
• LLC1 distribution sourcing: accumulated earnings that were not return of capital were excluded from the REIT's Texas receipts for taxable capital under Rule 3.562(j)(1)(C). Previously taxable LLC1 income was excluded from taxable earned surplus and earned-surplus receipts under Rule 3.562(j)(2)(B).

Currency note: This is a pre-2008 separate-entity and distribution ruling. Texas replaced the former franchise tax with the margin tax effective January 1, 2008.

What this means for you

Owners of single-member LLCs

Federal disregarded status did not collapse the entities for the former Texas tax, and labels in LLC resolutions did not determine tax character.

Passive out-of-state LLCs

The no-nexus conclusion required more than intent. The LLC had to prove that all activities it could conduct were actually carried on outside Texas.

Common questions

Q: Were LLC payments to the owner dividends?
A: No.

Q: Were the LLCs separate from the REIT for Texas tax?
A: Yes.

Q: Did LLC1 automatically avoid nexus?
A: No. It had to prove its activities occurred outside Texas.

Citations and references

• 34 Tex. Admin. Code Sec. 3.562(j)(1)(C)
• 34 Tex. Admin. Code Sec. 3.562(j)(2)(B)

Source

• STAR search: https://star.comptroller.texas.gov/search?doc_type_code=L&tax_type_code=FIT
• Opinion: https://star.comptroller.texas.gov/view/9812306L

Original ruling text

December 29, 1998

Dear **:

In your letter of December 4, you requested a determination regarding the
franchise tax treatment of payments made by a single member limited liability
company (LLC) to its sole member.

You state that A is a Texas corporation which is classified as a real estate
investment trust (REIT) for federal income tax purposes. A is an approximately
93% general partner in a limited partnership, XYZLP. The remaining limited
partnership interest in XYZLP is owned by unrelated third parties (collectively
referred to as "B"). XYZLP owns Texas income producing real property assets and
has ownership interests in other partnerships and LLCs which also own and
operate Texas income producing real property assets.

In our telephone conversation, you indicated that the partnership agreement
will be changed so that the 93% general partnership interest becomes a 1%
general partnership interest and a 92% limited partnership interest. A
anticipates forming two wholly owned LLCs, LLC1 (a non-Texas LLC) and LLC2 (a
Texas LLC). A will transfer the limited partnership interest in XYZLP to LLC1
and the general partnership interest to LLC2 (in a tax free exchange for
federal income tax purposes). LLC1 will engage in no activities in Texas. LLC2
will conduct all Texas management and business activity of XYZLP.

You also state that earnings and cash distributions from XYZLP's Texas
operations will be allocable to LLC1, LLC2, and B pro rata to their ownership
interests. LLC1 and LLC2 will make cash payments to A based on the amounts
received by the LLCs from XYZLP. All payments from LLC1 and LLC2 to A will be
made pursuant to duly authorized LLC resolutions categorizing such payments as
dividends under state law.

I have restated the rulings you requested followed by a response.

1. Assuming LLC1 has no connection with Texas other than its partnership
   interest in XYZLP, LLC1 will not be subject to Texas franchise tax irrespective
   of the source of its income.

Response

Correct. However, LLC1 must prove that the activities which it is capable of
are carried on outside Texas.

2. LLC1 and LLC2 will be treated as entities separate from A for franchise tax
   purposes even though they are considered to be a single entity for federal
   income tax purposes.

Response

Correct.

3. (a) Cash distributions from LLC1 and LLC2 to A will be considered dividends
   for Texas franchise tax purposes by recipient A to the extent those
   distributions are properly denominated as dividends by actions of the payor
   LLCs.

Response

For franchise tax purposes, the cash distributions would not be considered
"dividends". The term "dividend" is limited to payments by corporations to
shareholders. The fact that an LLC is defined as a corporation for franchise
tax purposes does not affect the meaning of "dividend" for franchise tax
purposes. In addition, the characterization of a distribution for federal
income tax purposes is not controlling for franchise tax purposes.

(b) The cash distributions from LLC1 and LLC2 will be respected as dividends
for state franchise tax purposes even though they are considered to be
intracompany payments for federal income tax purposes.

Response

See response to 3(a). For franchise tax purposes, the distributions from the
LLCs to A will be treated as indicated in Rule 3.562(j)(1)(C) and 3.562(j)
(2)(B).

(c) Cash distributions from LLC1 and LLC2 to A will be respected as dividends
made from corporations for Texas franchise tax purposes even though LLCs are
not, strictly speaking, corporations for state law purposes.

Response

The cash distributions are not dividends as indicated in my response to 3 (a).

4. Cash dividend distributions received by A from LLC1 are non-Texas sourced
   pursuant to the location of the payor rule because they are payments from a
   payor (i.e., LLC1) formed pursuant to the laws of a jurisdiction other than
   Texas.

Response

For taxable capital purposes, distributions of accumulated earnings of LLC1
which are not a return of capital would not be included in A's Texas receipts
(see Rule 3.562(j)(1)(C)). For earned surplus purposes, distributions of
previously taxable income of LLC1 would not be included in either taxable
earned surplus or earned surplus receipts (see Rule 3.562(j)(2)(B)).

This response is based on the facts presented and current law. If there are
different or additional facts, the response may change.

If you have any questions, contact Tax Policy Division. You may call me at
463-4817. You may write me at Tax Policy Division, Comptroller of Public
Accounts.

Sincerely,

Bob Jeffcoat
Tax Policy Division