For the Texas franchise tax, can a leveraged ESOP's unpaid-shares contra account be netted against surplus, and is an ESOP counted as one shareholder for the officer/director compensation add-back?

Plain-English summary

A corporation with a leveraged ESOP asked how to report its ESOP stock for franchise-tax stated capital and surplus (Schedule A). In its equity section it carried the par value of outstanding ESOP-owned stock and a contra account reducing equity by the unpaid ESOP shares.

• Netting unpaid ESOP shares against surplus - only if it's debt. If the ESOP-related obligation is a debt under Sec. 171.109(a)(3) - a legally enforceable obligation for a certain amount of money payable within an ascertainable period or on demand - the contra account can be netted against surplus. If it is not such a debt, it cannot.
• ESOP as one shareholder. For the officer-and-director compensation add-back in computing earned surplus, the ESOP is counted as one shareholder as long as the shares are held in the ESOP's name. (The add-back generally does not apply to corporations with few shareholders, so counting matters.)
• Report mechanics confirmed. The Comptroller also confirmed the corporation's initial-report accounting periods and privilege period, the tax rates (0.312% taxable capital, 4.5% earned surplus), and that a second franchise tax report was due May 15, 2000.

Currency note: This 2000 letter applies the pre-2008 franchise tax and its taxable-capital/earned-surplus components (replaced by the margin tax effective January 1, 2008 under House Bills 3 and 3928). The margin tax uses a different base and rates and lacks the same add-back; confirm current law.

What this means for you

Corporations with a leveraged ESOP

Whether you could reduce surplus by the unpaid ESOP shares turned on the debt test: only a fixed, legally enforceable, time-certain obligation qualified. And for the compensation add-back, an ESOP holding shares in its own name counted as a single shareholder - which could keep a closely held corporation under the shareholder threshold that triggers (or avoids) the add-back.

Tax professionals

Two ESOP-specific points: (1) the contra/unpaid-shares account nets against surplus only if it satisfies Sec. 171.109(a)(3)'s debt definition; (2) an ESOP is one shareholder for the officer/director add-back when shares are titled in the ESOP. The report-date and rate confirmations are entity-specific. All pre-2008; the margin tax has no comparable add-back, so re-verify.

Common questions

Q: Can I net the unpaid leveraged-ESOP shares against surplus?
A: Only if the ESOP-related obligation is a debt under Sec. 171.109(a)(3) - a certain-amount obligation payable within an ascertainable period or on demand.

Q: Is an ESOP counted as one shareholder for the officer/director compensation add-back?
A: Yes, as long as the shares are held in the name of the ESOP.

Q: Does this still apply?
A: No. The pre-2008 franchise tax and its add-back were replaced by the margin tax effective January 1, 2008. Confirm current law.

Citations and references

Statute:

• Texas Tax Code Sec. 171.109(a)(3) - debt definition; a leveraged-ESOP obligation may be netted against surplus only if it meets this test

Source

• STAR search: https://star.comptroller.texas.gov/search?doc_type_code=L&tax_type_code=FIT
• Opinion: https://star.comptroller.texas.gov/view/200003332L

Original ruling text

March 31, 2000

RE: **
Texas Taxpayer Number: **

Dear **:

Thank you for your correspondence regarding the corporation named above. I
apologize for the delay in responding to your inquiry.

You stated in your correspondence that your corporation received a Certificate
of Authority (COA) to transact business in Texas on October 2, 1997. Our
records indicate that the COA was issued on October 2, 1998. The corporation's
normal accounting year end is March 31. You are correct that the accounting
year end to be used for the taxable capital component on the initial report is
September 30, 1999 and the accounting period for the earned surplus component
is October 2, 1998 through March 31,1999. The privilege period covered by this
report is October 2, 1998 through December 31, 1999. The tax rate for the
taxable capital component is .312% (.00312). The tax rate for the earned
surplus component is 4.5% (.045).

You also asked in your correspondence about the correct treatment "of leveraged
ESOP shares of stock and the amounts to be reported on Schedule A for stated
capital and surplus." You stated that in the equity section of the
corporation, you have the par value of all outstanding stock owned and
leveraged by the ESOP. Also in the equity section of the balance sheet is a
contra account which reduces equity by the amount of the unpaid ESOP shares.
You ask if the stated capital should be reported net of the unpaid ESOP shares
or if the unpaid ESOP should be netted against surplus.

If the ESOP related obligation is a debt pursuant to Sec. 171.109(a)(3) of the
Texas Tax Code (TTC), the account can be netted against the corporation's
surplus. The statutory debt test is met if the corporation is legally
obligated to make payments that are for a certain amount of money and must be
paid within an ascertainable period of time or on demand.

Your next question concerns the add back of officer and director compensation
for the earned surplus component of the franchise tax. You asked if the ESOP
is considered to be one shareholder. As long as the shares are held in the
name of the ESOP, it will be counted as one shareholder.

Finally, you asked for confirmation that your corporation will have a second
franchise tax report due on May 15, 2000, that the accounting period to be used
for the taxable capital component will be March 31, 1999, and the period for
the earned surplus component will be April 1, 1999 through March 31, 1999.
These dates are correct.

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, please
call me at 1-800-531-5441, extension 34612. My direct number is (512)
463-4612. You may write me at Tax Policy Division, Comptroller of Public
Accounts, Austin, Texas 78774.

Sincerely,

Janet Spies
Tax Policy Division