For pre-2008 Texas franchise tax, could an LLC exclude contributed property with a $1,000 tax basis and $600,000 agreed value from taxable capital?

Plain-English summary

The LLC had to include the contributed property's agreed value in taxable capital; it could not use the property's much lower federal tax basis to remove that value.

A Texas corporation contributed property to an LLC in exchange for a membership interest. The property had a $1,000 cost basis, a $600,000 fair market value, and therefore a $599,000 built-in gain for purposes of I.R.C. Sec. 704(c). The LLC was taxed as a partnership for federal income tax.

The taxpayer asked either to exclude the Section 704(c) asset from total taxable capital or to use a GAAP method that would not include the asserted artificial asset in the capital account.

The Comptroller rejected both approaches. Although the LLC used partnership treatment federally, Texas Tax Code Sec. 171.001 subjected it to franchise tax as if it were a corporation. Rule 3.562(c) computed an LLC's taxable capital by adding members' contributions and surplus, and defined a noncash contribution using its agreed value. Federal carryover basis, GAAP, and federal accounting rules did not displace that specific Texas franchise-tax treatment.

Currency note: The taxable-capital system discussed here was replaced by the margin tax effective January 1, 2008. The present tax does not use this former taxable-capital base; confirm current treatment before applying the letter.

What this means for you

LLCs receiving appreciated property

For the former franchise tax, a large difference between federal tax basis and agreed contribution value did not keep the agreed value out of taxable capital.

Tax professionals

The letter separates federal Section 704(c) allocations from the Texas taxable-capital calculation. The controlling step was Rule 3.562(c)'s treatment of LLC member contributions, not the partnership's federal carryover basis.

Common questions

Q: What value did the LLC use for the contributed property?
A: The agreed value of the member's contribution.

Q: Did Section 704(c) allow the asset to be excluded?
A: No. Section 704(c)'s federal allocation rules did not override Texas's specific taxable-capital rules.

Q: Could the LLC select a GAAP method that omitted the value?
A: No. The letter says all pertinent franchise-tax provisions applied regardless of GAAP or federal requirements.

Citations and references

• Texas Tax Code Secs. 171.001, 171.109(b), and 171.113
• 34 Tex. Admin. Code Secs. 3.547(c)(1)-(2) and 3.562(c)(1)-(2)
• Texas Limited Liability Company Act art. 5.01A
• I.R.C. Sec. 704(c)

Source

• STAR search: https://star.comptroller.texas.gov/search?doc_type_code=L&tax_type_code=FIT
• Opinion: https://star.comptroller.texas.gov/view/200001284L

Original ruling text

January 18, 2000

Dear **:

We respond to your letter concerning the franchise consequences of certain
circumstances that you describe which we summarize in the following paragraph.
I regret the delay in responding to your inquiry.

A Texas corporation contributes property to a limited liability company (LLC),
taxed as a partnership for federal income tax, in exchange for an interest in
the LLC. At the time the property is contributed to the LLC, it has a cost
basis of $1,000 and a fair market value of $600,000. The contributed property
is subject to the provisions of Internal Revenue Code (IRC) 704(c) concerning
"built-in gain or loss" given that it has a built-in gain of $599,000.

Section 704(c) and the underlying regulations require a partnership to allocate
tax items with respect to property contributed by a partner so as to take into
account any variation between the adjusted tax basis of the property and its
fair market value at the time of the contribution. The purpose of the Section
704(c) allocations is to prevent the shifting of tax consequences among
partners respecting the precontribution gain or loss.

For federal income tax, the adjusted basis of the contributed property to the
partnership is generally the same as that of the contributing partner at the
time of contribution despite the Section 704(c) provisions. Accordingly, items
of income, deduction, or gain to the partnership respecting the property are
made using the carryover adjusted basis.

You ask "that either: A) the [Section] 704(c) asset be excluded from the
calculation of total taxable capital; or, B) [t]he LLC be permitted to file on
the GAAP method, which would not include this artificial asset in the capital
account."

The following discussion presumes that the LLC is subject to the Texas
franchise tax. The statutes and rules that we mention in this response are
available through this agency's website as further explained below.

Although the LLC is taxed as a partnership for federal income tax, it is
subject to franchise tax as if it were a corporation except as the franchise
tax provisions otherwise provide. Tax Code Section 171.001. For franchise
tax, a corporation is generally required to use the same accounting method in
computing gross receipts as it uses in computing surplus. Franchise Tax Rule
3.547(c)(1).

Unless a corporation meets the qualifications for using the federal income tax
method under Section 171.113, it usually must report its taxable capital and
gross receipts according to generally accepted accounting principles (GAAP).
Section 171.109(b). Nonetheless, all pertinent franchise tax provisions apply
in determining the LLC's franchise tax regardless of any requirements or
allowances under GAAP or the IRC. Rule 3.547(c)(2).

Rule 3.562(c) specifically provides for the computation of an LLC's taxable
capital. That rule provides that an LLC's taxable capital is determined by
adding the company's members' contributions, as provided for under Article
5.01A of the Texas Limited Liability Company Act (Article 1528n, Vernon's Texas
Civil Statutes), and surplus. Article 5.01A provides that the contribution of
a member may be in cash, property or services rendered, or a promissory note or
other obligation to pay cash or transfer property to the limited liability
company. Rule 3.562(c)(1).

Rule 3.562(c)(2) further provides that "[a] member's contribution is the sum of
the cash contributed and the agreed value of any other contribution made plus
the amount of cash and the agreed value of any other contribution which the
member has agreed to make in the future as an additional contribution, provided
that the promise by a member to make a contribution to, or otherwise pay cash
or transfer property to, the limited liability company is set out in writing
and signed by the member."

Therefore, the LLC uses the agreed value of the contributed property in
computing its taxable capital.

You may access the foregoing statutes and rules, as well as certain other
information, through this agency's website at www.window.state.tx.us. At that
site, select Texas Taxes in the middle column of information. On the ensuing
screen, select The Texas Franchise Tax which provides access to the foregoing
information.

Chapter 171 of the Tax Code contains the franchise tax statutes.

Title 34, Part 1, Chapter 3, Subchapter V of the Texas Administrative Code
(TAC) contains the franchise tax rules.

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