Does a single-member LLC, wholly owned by a tax-exempt IRC Section 401(a) trust and disregarded for federal income tax purposes, still owe Texas franchise tax?

Plain-English summary

Two single-member LLCs — limited partners in Texas real estate partnerships — are wholly owned by a tax-exempt trust organized under IRC Section 401(a) (the kind of trust that typically holds retirement or employee benefit plan assets). Because the LLCs are disregarded for federal income tax purposes, they never file their own federal returns; only the parent trust files (IRS Form 5500 and Form 990-T for any unrelated business income). The LLCs asked whether they have any Texas franchise tax filing obligation given this disregarded status.

The Comptroller ruled the LLCs do have to file — and their exempt owner's tax-exempt status does not carry over to them:

• Texas franchise tax looks at legal formation, not federal tax treatment. Section 171.0002(a) makes LLCs taxable entities regardless of whether they're disregarded federally. Being invisible to the IRS doesn't make an LLC invisible to Texas.
• The parent trust's tax exemption is personal to the trust. IRC Section 401(a) trusts are excluded from Texas franchise tax, but that exclusion doesn't extend to legally separate entities the trust owns — even wholly-owned ones.
• The LLCs have Texas nexus because they do business in the state (as limited partners in Texas real estate partnerships), so they're subject to the tax.
• Total revenue is computed via the trust's Form 990-T. Since the LLCs don't file their own federal return, Rule 3.587(d)(6) lets them determine total revenue by looking to a "substantially equivalent" form — here, the unrelated business income the parent trust reports on Form 990-T that's attributable to the LLCs' activities becomes the basis for the LLCs' own total revenue calculation. Each LLC must prepare a separate pro forma federal return as if it were taxable.
• Combined reporting applies. Since the trust owns more than 50% of both LLCs, they form an affiliated group and, if their business is unitary, must file a combined Texas franchise tax report together.

What this means for you

Tax-exempt organizations (trusts, retirement plans, nonprofits) using single-member LLCs to hold Texas real estate or other assets

Don't assume that because your LLC is disregarded for federal purposes (and generates no separate federal filing), it escapes Texas franchise tax too. The LLC is its own taxable entity under Texas law, has its own filing obligation once it has Texas nexus, and needs a mechanism (like a pro forma federal return keyed to the parent's Form 990-T unrelated business income) to compute total revenue.

Real estate investment structures using LLC layers

If your ownership chain runs through a disregarded LLC to a tax-exempt parent, check whether the LLC itself does business in Texas (has nexus) — that alone triggers a Texas filing obligation independent of your parent entity's tax-exempt status.

Accountants and tax professionals

Rule 3.587(d)(6)'s "substantially equivalent forms" mechanism is the key tool here for entities that don't file a federal return in their own name — worth flagging for any disregarded-entity client whose parent's Form 990-T (or another substantially equivalent form) can source the entity-level total revenue calculation.

Common questions

Q: If an LLC is disregarded for federal tax purposes, is it also disregarded for Texas franchise tax?
A: No — Texas franchise tax is based on an entity's legal formation, and LLCs are taxable entities under Section 171.0002(a) regardless of their federal tax treatment.

Q: Does a parent trust's federal tax-exempt status protect a wholly-owned LLC from Texas franchise tax?
A: No — the trust's exclusion under Section 171.0002(c)(7) is specific to the trust itself and doesn't extend to a legally separate LLC it owns, even a wholly-owned one.

Q: How does a disregarded LLC compute "total revenue" if it files no federal return of its own?
A: Under Rule 3.587(d)(6), it can look to a substantially equivalent form — here, the unrelated business income the parent trust reports on IRS Form 990-T attributable to the LLC's activities — and must prepare its own pro forma federal return as if it were taxable.

Q: Do multiple LLCs owned by the same tax-exempt parent need to file separately?
A: Not necessarily separately — if the parent owns more than 50% of each and their business is unitary, they form an affiliated group that must file a combined Texas franchise tax report.

Citations and references

Statutes and rules:

• Tex. Tax Code § 171.0002(a) (Definition of a Taxable Entity — includes limited liability companies)
• Tex. Tax Code § 171.0002(c)(7) (exclusion for certain trusts, including IRC § 401(a) trusts)
• Tex. Tax Code § 171.001(a) (Tax Imposed)
• Tex. Tax Code § 171.1011(c)(3) (Determination of Total Revenue — substantially equivalent forms)
• Tex. Tax Code § 171.1014 (Combined Reporting; Affiliated Group Engaged in Unitary Business)
• 34 Tex. Admin. Code Rule 3.587(c)(3), (d)(6) (Margin: Total Revenue)
• 34 Tex. Admin. Code Rule 3.590 (Margin: Combined Reporting)
• 26 U.S.C. § 401(a) (tax-exempt trust)

Source

• STAR search: https://star.comptroller.texas.gov/search?doc_type_code=L&tax_type_code=MAR
• Opinion: https://star.comptroller.texas.gov/view/201803028L

Original ruling text

March 26, 2018

RE: Private Letter Ruling No. 2017010155

Dear **:

We issue this private letter ruling in accordance with Rule 3.1, Private Letter Rulings and General Information Letters. [ENDNOTE 1] We are responding to your request dated December 21, 2016. Detrimental reliance relief is provided in accordance with Rule 3.10, Taxpayer Bill of Rights.

You requested guidance on whether single-member limited liability companies (LLCs), wholly owned by a tax-exempt Internal Revenue Code (IRC) Section 401(a) trust and disregarded for federal income tax purposes, have reportable revenue for Texas franchise tax purposes.

Facts Presented

The facts presented are based on information provided by ** (Taxpayer’s Companies) in the initial request on December 21, 2016, and additional information provided by Taxpayer’s Companies on April 28, 2017 and June 02, 2017. Taxpayer’s Companies are single-member LLCs. They are limited partners in limited partnerships that own real estate in Texas. Taxpayer’s Companies are disregarded for federal income tax purposes, and, thus, do not file federal income tax returns.

Taxpayer’s Companies are wholly owned by ** (Trust), a tax- exempt IRC Section 401(a) trust that files Internal Revenue Service (IRS) Form 5500, Annual Return/Report of Employee Benefit Plan, and IRS Form 990-T, Exempt Organization Business Income Tax Return.

Question, Ruling, and Analysis

Our restatement of your question is shown below, followed by our response and analysis.

Question: Is Taxpayer’s Companies’ revenue includable in total revenue for Texas franchise tax purposes?

Ruling: For Texas franchise tax purposes, Taxpayer’s Companies are not exempt and must file franchise tax reports. Taxpayer’s Companies compute total revenue based on the unrelated business income reported by Trust related to Taxpayer’s Companies’ activities.

Analysis: The determination of responsibility for Texas franchise tax is based on the legal formation of an entity. Section 171.0002(a) identifies all entities that are taxable entities and specifically includes limited liability companies. Taxpayer’s Companies are regarded entities for Texas franchise tax, regardless of whether the LLCs are disregarded for federal tax purposes.

Taxpayer’s Companies are wholly owned by Trust, an IRC Section 401(a) trust. IRC Section 401(a) trusts are not taxable entities for Texas franchise tax. See Section 171.0002(c)(7). Taxpayer’s Companies are legal entities separate from Trust, and the exclusion of Trust from being a taxable entity for franchise tax purposes does not extend to Taxpayer’s Companies.

Taxpayer’s Companies have nexus in Texas because they do business in the state. See Section 171.001(a). Therefore, as taxable entities with nexus in this state, Taxpayer’s Companies are subject to Texas franchise tax. Rule 3.587(c)(3) provides that “A disregarded entity shall compute its total revenue as if it had filed a separate return for federal income tax…” Accordingly, the two entities must prepare separate pro forma federal income tax returns as if they were subject to federal income tax.

Under Section 171.1011(c)(3) and Rule 3.587(d)(6), in computing total revenue for a taxable entity other than a taxable entity treated for federal income tax purposes as a corporation, S corporation, partnership, trust, or single-member limited liability company filing as a sole proprietorship, the total revenue will be an amount determined in a manner substantially equivalent to the amount calculated for the entities listed in these sections. Pursuant to this rule, taxable entities such as Taxpayer’s Companies may determine total revenue by looking to substantially equivalent forms.

Taxpayer’s Companies’ parent, Trust, files IRS Form 990-T annually. IRS Form 990-T contains line numbers where an exempt entity reports unrelated business income. This form provides a mechanism to determine total revenue in a manner substantially equivalent to the amount calculated for the entities listed in Section 171.1011(c)(3) and Rule 3.587(d)(6).

Trust reports income derived from any unrelated trade or business regularly conducted by the exempt organization on IRS Form 990-T. Any unrelated business income reported by Trust on Form 990-T representing income derived from Taxpayer’s Companies is includable in Taxpayer’s Companies’ total revenue calculation.

Additionally, given that Trust owns more than 50 percent of the two entities, the two entities constitute an affiliated group for franchise tax and, if unitary, must file a combined group report. Section 171.1014 and Rule 3.590.

The Texas Tax Code, Texas Administrative Code, and the STAR system are accessible at www.comptroller.texas.gov/taxes/.

If you have questions about this private letter ruling, please email us through our website at https://comptroller.texas.gov/web-forms/tax-help/ and reference Private Letter Ruling No. 2017010155.

Sincerely,

Tax Policy Division – Direct Taxes

Texas Comptroller of Public Accounts

ENDNOTE

1 Unless otherwise indicated, all references to “Section” are to the Texas Tax Code, and all references to “Rule” are to Title 34 of the Texas Administrative Code.