Must a Texas PLLC taxed as a partnership pay franchise tax, and are guaranteed payments deductible in computing earned surplus?

Plain-English summary

A professional limited liability company (PLLC) with two or more members, taxed as a general partnership for federal income tax, asked (1) whether it must file and pay the (pre-2008) Texas franchise tax and (2) whether guaranteed payments are deductible as compensation in figuring the tax. The Comptroller's answers: yes, it owes franchise tax, and guaranteed payments are deductible only within limits.

• The PLLC owes franchise tax. Tax Code Sec. 171.001(a)(2) imposes the franchise tax on every LLC doing business in Texas or organized under Texas law. Legal formation controls: a PLLC is subject to franchise tax regardless of being treated as a partnership federally.
• Earned surplus starting point. An LLC's reportable federal taxable income for earned-surplus purposes is its ordinary income (loss) from trade or business plus the separately stated items of income, loss, deduction, or credit reported to members on Form 1065, Schedule K.
• Profit shares are not compensation. A partner/member's share of LLC profits is not deductible as compensation in computing earned surplus.
• Guaranteed payments may be deductible. Payments that qualify as guaranteed payments under IRC Section 707(c) and are ordinary and necessary business expenses under IRC Section 162 (and not subject to IRC Section 263 capitalization) are deductible in computing net taxable earned surplus (Rule 3.562(e)(6)).
• Add-back for large or subsidiary LLCs. An LLC with more than 35 members, or that is a subsidiary of a corporation or other LLC with more than 35 shareholders or members, must add back the guaranteed payments to managers under Tax Code Secs. 171.110(a)(1), (b)(1), and (c).

Currency note: This describes the pre-2008 franchise tax and its earned-surplus computation. The 2007 legislation (House Bills 3 and 3928) replaced the tax with the current margin tax effective January 1, 2008, which computes the base differently. Treat this as historical.

What this means for you

PLLC and professional-practice owners

Choosing partnership tax treatment federally did not get a Texas PLLC out of the franchise tax - the entity's legal form as an LLC controlled. Members' distributive shares of profit were not deductible as pay, but true IRC 707(c) guaranteed payments generally were, subject to the large/subsidiary add-back.

Accountants and tax professionals

Test guaranteed payments against IRC 707(c), 162, and 263 before deducting, and apply the more-than-35-member and subsidiary add-back rules in Sec. 171.110. See Rules 3.562 and 3.558 for LLC treatment and officer/director compensation. Because the earned-surplus regime ended in 2008, this is pre-margin-tax guidance.

Common questions

Q: Our PLLC is taxed as a partnership federally - do we still owe Texas franchise tax?
A: Yes. Under Sec. 171.001(a)(2), the LLC's legal formation makes it subject to franchise tax regardless of federal partnership treatment.

Q: Are guaranteed payments deductible in computing earned surplus?
A: Generally yes, if they qualify under IRC 707(c) as ordinary and necessary business expenses under IRC 162 and are not subject to IRC 263 - but LLCs with more than 35 members, or that are subsidiaries of large corporations/LLCs, must add back guaranteed payments to managers.

Q: Can we deduct a member's share of the profits as compensation?
A: No. A member's share of LLC profits is not deductible as compensation.

Citations and references

Statutes and rules:

• Tex. Tax Code Sec. 171.001(a)(2) (franchise tax on LLCs)
• Tex. Tax Code Secs. 171.110(a)(1), (b)(1), (c) (net taxable earned surplus; manager guaranteed-payment add-back)
• IRC Section 707(c) (guaranteed payments); IRC Section 162; IRC Section 263
• 34 Tex. Admin. Code Secs. 3.562, 3.558

Source

• STAR search: https://star.comptroller.texas.gov/search?doc_type_code=L&tax_type_code=FIT
• Opinion: https://star.comptroller.texas.gov/view/200411919L

Original ruling text

November 24, 2004

To: ** <**>

Dear **:

Thank you for your Tax Help inquiry concerning Texas franchise tax.

You ask if a professional limited liability corporation (PLLC) with two or more
members that is taxed as a general partnership for federal income tax purposes,
must file and pay Texas franchise tax. You also ask if guaranteed payments are
deductible as compensation against the partnership's profits for calculating
the franchise tax.

The statutes, rules, forms and publications I mention below, as well as other
related information, are available online at
http://www.window.state.tx.us/taxinfo/franchise/index.html.

Texas Tax Code Sec. 171.001(a)(2) imposes a franchise tax on each limited
liability company (LLC) that does business in this state or that is organized
under the laws of this state. In determining an entity's responsibility for
filing Texas franchise tax, we consider the legal formation of an entity. If
legally formed as a PLLC, the PLLC will be subject to franchise tax regardless
of its treatment as a partnership for federal income tax.

An LLC's reportable federal taxable income for earned surplus purposes is the
amount of ordinary income (loss) from trade or business activities, as well as
the amount of items of income, loss, deduction, or credit of the LLC that are
separately stated to its members on Form 1065, Schedule K.

A partner/member's share of the LLC's profits, are not deductible as
compensation in computing earned surplus. However, payments to members that
qualify as guaranteed payments under Internal Revenue Code (IRC) Section 707(c)
and which constitute ordinary and necessary business expenses under IRC Section
162, but are not subject to IRC Section 263, are deductible in computing net
taxable earned surplus. See Comptroller's Rule 3.562(e)(6).

LLCs which have more than 35 members or which are subsidiaries of corporations
or other LLCs with more than 35 shareholders or members must add-back the
guaranteed payments to managers in computing net taxable earned surplus. See
Tax Code Sec. 171.110(a)(1), 171.110(b)(1) and 171.110(c).

Comptroller's Rule 3.562 addresses the franchise tax treatment of LLCs
including an LLC that is treated as a partnership for federal income tax. Also
see Rule 3.558 for additional information regarding officer and director
compensation.

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

Our goal is to provide you with prompt, professional service. Please take a
moment to complete our on-line survey at
http://aixtcp.cpa.state.tx.us/surveys/tpsurv/.

If you have questions about this, my internet address is
[email protected], or you may call toll-free at 1-800-531-5441,
extension 59952.

Sincerely,

Teresa Bostick
Tax Policy Division