Did Texas pass a law letting a corporation convert to a partnership to avoid franchise tax, and what are the franchise-tax consequences of such a conversion?

Plain-English summary

A CPA e-mailed the Comptroller after a client claimed to have heard "that Texas has recently passed a law allowing corporations to elect to be treated as partnerships and avoid paying franchise taxes." The Comptroller explained what the 1997 law actually did.

• What the law was. Senate Bill 555 (1997) amended the Texas Business Corporation Act (TBCA) and the Texas Limited Liability Company Act to allow a new transaction called a "conversion" — an additional way for certain business entities to change their organizational form. The bill did not change the franchise tax law itself, but the amendments affect franchise tax "to the extent that they affect the legal organization and/or termination of entities subject to the tax."
• The practical result. A Texas corporation can convert to a Texas limited partnership, and the resulting partnership is not subject to Texas franchise tax — but the converting corporation must file a final Texas franchise tax report as of the date of conversion. (The Comptroller pointed to a November 1998 Today's CPA article by James Hopson discussing the mechanics.)
• Corporate partners still pay. A foreign corporation acting as general partner of a limited partnership doing business in Texas is subject to the tax; a Texas corporation acting as general partner or limited partner is also subject; but a foreign corporation whose only Texas contact is as a limited partner is not (Tex. Tax Code § 171.001(a); Rule 3.546(c)(12)).

So the client's rumor was only half-right: the conversion route existed and did take the partnership out of franchise tax, but it was not a magic "elect and avoid everything" — a final report was due and corporate general partners stayed taxable.

Important currency note: This 1998 letter reflects the franchise tax before the 2008 overhaul. The premise that the converted partnership escapes franchise tax is exactly what changed — under the current margin-based franchise tax, partnerships are generally taxable entities, and STAR marks this document partially superseded on the taxation of partnerships. Treat the "partnership avoids the tax" conclusion as historical.

What this means for you

Businesses that heard about "converting to avoid franchise tax"

This letter is a good antidote to a persistent myth. Even in 1998, conversion did not let you simply elect out of all franchise tax: the converting corporation owed a final report, and any corporate general partner stayed on the hook. Today the premise is gone entirely, because limited partnerships are generally taxable entities under the margin tax.

Accountants advising on entity form

The durable point is that a change in legal organizational form drives Texas franchise-tax consequences (organization and termination), even when the tax statute itself is unchanged. Map any conversion to its filing consequences (final reports, who becomes/stops being a taxable entity), and re-check under current law.

Common questions

Q: Did Texas pass a law letting corporations elect partnership treatment to avoid franchise tax?
A: Not exactly. Senate Bill 555 (1997) created a "conversion" transaction. A corporation could convert to a limited partnership, and the partnership was not subject to franchise tax — but the converting corporation had to file a final report, and corporate general partners remained taxable.

Q: Does the converting corporation still owe anything?
A: Yes — it must file a final Texas franchise tax report as of the date of conversion.

Q: Is a corporate general partner of the new partnership taxable?
A: Yes. A foreign or Texas corporation acting as general partner of a Texas-active limited partnership is subject to franchise tax (§ 171.001(a); Rule 3.546(c)(12)).

Q: Is this still current?
A: No. It predates the 2008 margin tax, under which partnerships are generally taxable entities. STAR marks it partially superseded on the taxation of partnerships.

Citations and references

Statutes and authorities:

• Tex. Tax Code § 171.001(a) (franchise tax on corporations doing business in Texas)
• Franchise Tax Rule 3.546(c)(12) (corporate general/limited partner nexus)
• Senate Bill 555 (1997), amending the Texas Business Corporation Act and Texas Limited Liability Company Act to allow "conversion"

Source

• STAR search: https://star.comptroller.texas.gov/search?doc_type_code=L&tax_type_code=FIT
• Opinion: https://star.comptroller.texas.gov/view/9812326L

Original ruling text

STAR SUPERSED INFORMATION
Accession No. —
Supersede type - Partial
Document superseded on - 12/15/14
Issue(s) that caused the document to be superseded — Taxation of partnerships
Reason(s): The Franchise Tax Code was amended by House Bill 3 and House Bill 3928,
Acts 2007, 80th Legislative Session, effective January 1, 2008 and affected Franchise
tax reports due on or after January 1, 2008. One of the many changes to this Tax Code
subjected partnerships (previously not required to file) to the franchise tax reporting
requirement.

December 14, 1998

To: **

Thank you for your email concerning the Texas franchise tax.

Senate Bill 555, regarding conversions, was passed during the 1997 legislative
session. This bill amended the Texas Business Corporation Act (TBCA) and the
Texas Limited Liability Company Act regarding a new transaction called a
"conversion." A conversion will allow certain business entities an additional
option by which to effect a change in their organizational form.

This bill did not make any changes to the Texas franchise tax law. However,
the amendments to the TBCA and Limited Liability Company Act impact franchise
tax to the extent that they affect the legal organization and/or termination of
entities subject to the tax.

An article, written by Mr. James Hopson, was published in the November 1998
issue of Today's CPA. This article discusses the conversion of a Texas
corporation to a Texas Limited Partnership. This transaction is allowed under
the amendments to the laws cited above and the resulting partnership will not
be subject to the Texas franchise tax. However, a final Texas franchise tax
report must be filed by the converting corporation as of the date of
conversion.

I must also note that if a corporation acting as the general partner in the
limited partnership is a foreign corporation, it would be subject to the Texas
franchise tax if the limited partnership is doing business in Texas. If the
corporation acting as the general partner or as a limited partner is a Texas
corporation, it would also be subject to the franchise tax. A foreign
corporation, whose only contact with Texas is as a limited partner in a limited
partnership doing business in Texas, is not subject to Texas franchise tax.
See Texas Tax Code section 171.001(a) and Rule 3.546(c)(12).

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

If you have any questions about this or any other franchise tax matter, you
may call me at 1-800-531-5441, extension 3-4612, or e-mail me at the address
below.

Sincerely,

Janet Spies
[email protected]

We have a client who claims to have heard that Texas has recently passed a law
allowing corporations to elect to be treated as partnerships and avoid paying
franchise taxes. I have not heard of such a law, and would assume that since
LLCs and LCs must pay franchise taxes, that such a law would not be passed in
Texas. Please clarify this for me.

Thanks,

**, CPA