Texas Comptroller Issues Guidance for Apportioning Receipts From the Sale of a Single Member Limited Liability Company

The current version of the Texas franchise tax was enacted effective for reports filed beginning in 2008. Although the tax base was changed dramatically for 2008, the method of apportioning the tax base was left largely untouched. One unusual sourcing rule for Texas deals with receipts from certain intangibles, including the sale of ownership interests in other entities. This rule is referred to as the Location of Payor rule and has been in existence since before the 2008 changes to the franchise tax. In a recently issued Tax Policy Memo, the Texas Comptroller of Public Accounts (Comptroller) confirmed that a sale of a single member limited liability company (SMLLC) by its sole owner created revenue from the sale of an intangible asset rather than revenue from the sale of the SMLLC’s assets. This distinction provides an opportunity for substantial tax savings in certain situations.

Background

Texas franchise tax is imposed on taxable entities that are conducting an active trade or business in Texas. Taxable entities include limited liability companies (LLCs) even if they are disregarded entities for federal income tax purposes. Texas uses a single receipts method to apportion taxable margin to the state. The sourcing method for receipts from the sale of an asset differs depending on whether the asset is tangible or intangible. Receipts resulting from the sale of a tangible asset are sourced based on the physical location of the asset. Alternatively, for receipts derived from the sale of an intangible asset, Texas uses the location of payor rule.

Under the location of payor rule, receipts are sourced based on the legal domicile of the payor. The legal domicile of a corporation or LLC is its state of formation, while a partnership’s legal domicile is the principal place of business, or commercial domicile, of the partnership.

Tax Policy Memo 201810001L

In October, the Texas Comptroller issued Tax Policy Memo 201810001L to the Director of the Audit Division, in which the Comptroller found that the sale of an SMLLC by its sole owner is treated as the sale of an intangible asset. The Comptroller made the distinction that for federal income tax purposes, an SMLLC may be viewed as a disregarded entity, but for Texas franchise tax purposes a limited liability company is a taxable entity. As a result, the sole owner of the SMLLC owns an interest in the SMLLC and not the SMLLC’s assets directly. Therefore, when the sole owner sells its interest in the SMLLC, the owner has receipts from the sale of an intangible asset and those receipts should be sourced based on the location of the payor. Although not mentioned in the letter ruling, the receipts are limited to the gain recognized from the sale of the SMLLC rather than the gross sales price.

The Takeaway

Under Tax Policy Memo 201810001L, Texas has confirmed that an intangible asset includes the sale of a membership interest in an SMLLC even if the entity is disregarded for federal income tax purposes. As a result, it is crucial that the seller of an entity know the legal domicile of the payor entity (buyer) and what effect it may have on its receipts for Texas franchise tax purposes. The impact of selling to a Texas versus a non-Texas entity for purposes of the location of payor rule can be material to a taxpayer’s Texas franchise tax liability. A seller may want to consider this impact when negotiating a purchase price with a buyer.

It is also important to note that Texas generally follows Internal Revenue Code Sec. 338(h)(10) elections for both C corporations and S corporations, meaning that gains related to a Sec. 338(h)(10) election are sourced based on the type and location of the underlying assets rather than the legal domicile of the purchaser of the stock. This does not mean that the location of payor rule would have no relevance for transactions treated as asset sales. For example, under a Sec. 338(h)(10) election, gains from the deemed sale of tangible assets such as land and equipment would be sourced based on their physical location whereas intangible assets such as goodwill would be sourced using the location of payor rule.

Andersen has the resources to assist clients in evaluating the Texas franchise tax impact of various scenarios related to mergers and acquisitions, as well as tax planning.