Did federal tax deferral for an I.R.C. Section 1031 exchange also defer the exchange gain in the earned-surplus component of the former Texas franchise tax?

Plain-English summary

A corporation's federal Section 1031 deferral flowed into the earned-surplus component of the former Texas franchise tax because that component began with federal net taxable income.

The letter first distinguished Texas's former corporate franchise tax from an individual income tax. A corporation paid the greater of:

• 0.25% of net taxable capital for each privilege year; or
• 4.5% of net taxable earned surplus.

Taxable capital generally consisted of stated capital plus surplus. Earned surplus generally began with federal net taxable income and added compensation paid to corporate officers and directors.

Because a qualifying Section 1031 exchange deferred gain for federal income-tax purposes, the earned-surplus calculation reflected that deferral. The Comptroller added that the franchise-tax provisions did not otherwise address Section 1031 exchanges.

Currency note: Texas replaced this two-component franchise tax with the margin tax effective January 1, 2008. Confirm current Texas treatment and current federal Section 1031 requirements.

What this means for you

Corporations completing deferred exchanges

Under the former earned-surplus system, the federal taxable-income result carried into the Texas calculation. The letter did not create a separate Texas exchange rule.

Tax professionals

The holding addresses earned surplus, not an exemption from the separate taxable-capital component. The corporation still paid whichever former component produced the greater tax.

Common questions

Q: Did Texas impose an individual income tax on the exchange?
A: The letter says Texas did not impose a state income tax on individuals.

Q: Did federal Section 1031 deferral carry into earned surplus?
A: Yes, because earned surplus used federal net taxable income as its starting point.

Q: Did the letter establish any other Texas Section 1031 rule?
A: No. It says the franchise-tax provisions did not otherwise address the exchange.

Citations and references

• I.R.C. Sec. 1031 - federal tax-deferred exchange treatment

Source

• STAR search: https://star.comptroller.texas.gov/search?doc_type_code=L&tax_type_code=FIT
• Opinion: https://star.comptroller.texas.gov/view/9911330L

Original ruling text

November 19, 1999

Dear **:

We have your recent letter requesting information about the income tax
treatment of an Internal Revenue Code Section 1031 tax deferred exchange under
Texas law.

Texas does not impose a state income tax on individuals. Texas law does
provide for a corporate franchise tax; however, the tax is not a corporate
income tax per se.

Under the franchise tax law, a corporation pays the greater of the tax on net
taxable capital or net taxable earned surplus. The tax rate on taxable capital
is 0.25 percent per year of privilege period and the tax rate on earned surplus
is 4.5 percent.

Taxable capital is a corporation's stated capital (capital stock) plus surplus.
In general, surplus is the net assets of the corporation without deduction for
estimated liabilities and asset writedowns. Certain accounting methods are
required in computing surplus.

The earned surplus component basically includes a corporation's federal net
taxable income, plus compensation paid to officers and directors of the
corporation. Consequently, if the corporation has a Section 1031 tax deferred
exchange for federal income tax, the earned surplus component for franchise tax
will reflect the deferral.

The franchise tax provisions do not otherwise address the matter of a Section
1031 exchange.

The information provided by you and current franchise tax law form the basis
for this response. Different or additional information may result in a
different response.

If you have any questions, please call me toll free at 1-800-531-5441,
extension 3-4931, or directly at 512/463-4931.

Sincerely yours,

William E. York
Tax Policy Division