Revised Texas franchise tax raises lease issues for tenants

Due to constitutional issues regarding public education funding in Texas, this year's special session produced a legislative package providing property tax relief, funded, in part, by a revised Texas franchise tax.


from Houston Business Journal


"At the same time, the package reduced school taxes by an estimated
$15.7 billion over the next three years with a 33.3% rate reduction over two years.


Now, in addition to corporations and LLCs (currently subject to the existing franchise tax), general partnerships and joint ventures which have at least one partner that is not a natural person, limited partnerships and other entities are subject to the Texas franchise tax.


Commercial leases 101


Most commercial leases require the tenant to pay, in addition to rent, some portion of the taxes assessed against the project.


Mechanisms include the tenant's paying a pro rata share of all the taxes (a net lease) or the landlord including certain base year taxes in the rent the tenant pays with the tenant obligated to pay its pro rata share of increases.


Taxes, from the landlord's perspective, are generally described broadly.
Sophisticated tenants exclude from the definition of taxes income taxes, estate taxes or inheritance taxes and sometimes franchise taxes.


Sophisticated landlords, on the other hand, recognize that in some jurisdictions income producing properties are taxed by a tax against the income generated by the property -- what better evidence of the value of a property than the income generated thereby?


Those landlords pass on to tenants any tax imposed on the rents paid by the landlord (either by way of substitution for, or in addition to, ad valorem taxation upon the real estate).


Combining these positions with the revised franchise tax raises the following issues for landlords and tenants with respect to existing Texas leases:


§ What taxes can the landlord legitimately pass through to its
tenants?


Is the tax definition broad enough that the entire franchise tax payable by a landlord can now be passed on to the tenants?


§ If there is a carve-out for income taxes (but not
franchise taxes), does the revised franchise tax count as a income tax which should be excluded? Note that an income tax is prohibited by the Texas Constitution.


§ If the revised franchise tax can be passed on to tenants,
how is it to be allocated among various tenants?


Some tenants require the determination to be based upon the income generated by the rents paid at that particular location without regard to other locations owned by the landlord or its affiliates.


§ Many landlords (e.g. limited partnerships) are now paying a
tax that they had never had to pay before.


Although their property taxes may be reduced by a third, they are able to pass those reduced property taxes on through to the tenants. Should they be able to pass a third of the revised franchise tax on to the tenants -- to keep things even?


Solutions


Existing leases where one or more of these types of issues (or variations thereof) are present, will have to be analyzed on a case-by-case basis by both landlords and tenants to determine -- from the landlord's perspective -- what the landlord can pass on to the tenant in the form of taxes and -- from the tenants perspective -- that the landlord is not passing on more than is permitted under the terms of the lease.


As for future leases, landlords may recognize that the revised franchise tax is a cost of doing business that needs to be factored into the determination of the base or minimum rent that the landlord charges a particular tenant.


Alternatively, a landlord could provide for the franchise tax to be passed on to the tenant (and in doing so, the landlord should make specific reference to the revised franchise tax and any future amendments thereof).


The landlord will still have to include a method for allocating the franchise tax to the particular tenants in a particular location.
Tenants, on the other hand, will resist inclusion of the franchise tax as a pass-through item believing that it really is an income type of tax that should be properly borne by the landlord.


As is usual in these types of cases, larger, more sophisticated tenants with significant bargaining power will be able to exclude any franchise tax pass-through while those with less bargaining power will be paying the landlord's franchise taxes.


With a new legislative session about to begin, there is no doubt that there will be even further revisions to the revised franchise tax law.
In addition, we can be sure of judicial challenges to the existing law based on the Texas constitutional prohibition against an income tax.


While resolution of these issues has considerable economic impact on both landlords and tenants, there is no telling where it may end up -- stay tuned!" for more information see: www.houstonrealtyadvisors.com or www.houstonrealtyadvisors.net or www.houstonofficefinders.com