Triple Net Lease Implications for Texas Franchise Tax

Triple Net Leases: Implications for Texas Franchise Tax

The state of Texas imposes a franchise tax (also known as the “margin tax”) based on total revenue less an adjustment on taxable entities. Taxable entities include partnerships (both general and limited, but not general if all partners are natural persons), LLPs, corporations, banking corporations, savings and loan associations, LLCs, business trusts, professional associations, and other legal entities. The adjustment to total revenue to arrive at taxable margin is a subtraction for the greater of cost of goods sold, compensation, 30% of total revenue (in other words, the taxable margin is 70% of total revenue), or $1 million. An entity’s taxable margin which exists after the adjustment to total revenue is taxed at a 0.75% rate for most taxable entities.

For purposes of the Texas franchise tax, confusion often arises around the issue of lessors of real estate involved in triple net lease agreements with tenants. A triple net lease provides that a tenant is responsible for each of the costs related to the leased asset which includes, in addition to rent and utilities, net real estate taxes, building insurance, and common area maintenance. The main question created by the triple net lease for purposes of the Texas franchise tax is whether or not the payment of lessor expenses by the tenant should be included in the total revenue of the lessor.

The Texas Administrative Code (TAC) outlines how total revenue is calculated for purposes of the franchise tax. Specifically, the TAC along with Texas Tax Code §171.1011 indicate total revenue for the franchise tax is calculated based upon the federal income tax rules which apply to the particular entity being taxed. According to the Internal Revenue Service (IRS) in Treasury Regulation §1.61-8(c), “As a general rule, if a lessee pays any of the expenses of his lessor such payments are additional rental income to the lessor.” As a result, based on federal income tax rules a tenant paying real property taxes or other expenses which would otherwise the obligation of the lessor under a triple net lease would require the landlord to include the amounts as additional rental income thus increasing taxable margin for purposes of the Texas franchise tax. The following example illustrates the application of the Texas franchise tax and federal income tax rules to triple net leases.

Example: Office Space Partners L.P., a limited partnership, leases commercial real estate properties around the San Antonio, TX area. The partnership leases several properties to tenants under triple net lease agreements. Among all the properties under triple net lease agreements the tenants pay a total amount of $100,000 in net rental real estate taxes, building insurance, and common area maintenance which Office Space otherwise would be legally obligated to pay. Total revenue for federal income taxes without considering the lessor expenses paid by the tenants is $2.5 million. There are no cost of goods sold or compensation as they are generally nonexistent in a rental real estate context.

Based on the above set of facts, for the purposes of Texas franchise tax, total revenue would be $2.6 million ($2.5 million in total revenue prior to inclusion of lesser expenses paid by tenant plus the $100,000 in triple net lease expenses otherwise legally obligated to be paid by the partnership). The taxable margin for purposes of the franchise tax in the state of Texas is the lesser of the following amounts:

Total Revenue less Cost of Goods Sold
$2,600,000 – $0 = $2,600,000

Total Revenue less Compensation
$2,600,000 – $0 = $2,600,000

70% of Total Revenue
$2,600,000 × 70% = $1,820,000

Total Revenue less $1 million
$ 2,600,000 – $1,000,000 = $1,600,000

The above calculations result in a taxable margin for Texas franchise tax purposes of $1,600,000. Applying 0.75% tax rate results in a Texas franchise tax obligation of $12,000 ($1,600,000 × 0.75%) for Office Space Partners.

For more information on the Texas franchise tax, triple net leases, and the treatment of these expenses paid by tenants please contact a tax professional.

About The Author

Daniel Quintana

Daniel Quintana of Kurtz & Company, P.C. in Dallas Texas.