November 2006

To: TSCPA Members and Other Interested Parties

The 79th Texas Legislature passed House Bill 3 repealing the existing Texas Franchise tax and replacing it with a new margin tax. The new Texas margin tax is unlike any other state franchise tax in the nation. Not surprisingly, many CPAs and all business and professional entities in Texas are anxious to understand the new tax and how it will affect their clients or businesses.

We received inquiries from members and others that demonstrated that some parts of the bill were difficult to understand while others may present unintended consequences. I appointed a Special Task Force of experienced CPAs to study the bill and to suggest any changes to the bill that would improve the bill’s technical correctness, clarity and fairness.

The task force has completed its work and the Society has approved the release of that report to you and the public. We hope the report will be helpful to you and to the legislature as they consider any appropriate revisions to the margin tax during the upcoming 80th Texas Legislature.

Sincerely,

Jerry L. Love, CPA

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Notice to Readers

This analysis of the new Texas Margin Tax (House Bill 3, Third Special Session, 79th Texas Legislature) is educational and reference material for the members of the Texas Society of Certified Public Accountant and others interested in the subject. It is also published in an attempt to be helpful to those that will be considering changes to the Margin Tax during the 80th Texas Legislature. The report is distributed with the understanding that the TSCPA is not rendering any tax or legal advice.

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The Texas Society of Certified Public Accountants (www.tscpa.org) is a 27,000 member, professional organization representing Texas CPAs. The Society is committed to serving the public interest and promoting the highest standard of ethics and practice within the CPA profession.

This report was prepared in response to numerous inquires from CPAs across the state, including public practitioners and CPAs serving business and industry, about the provisions and consequences of the new Texas Margin Tax (HB 3). From these inquiries and subsequent analysis, TSCPA believes certain provisions of HB 3 should be revised to make technical corrections, improve clarity, fairness and avoid unintended consequences.

The recommendations included in this report are intended to be helpful to CPAs, legislators and legislative staffs as future changes to HB 3 are considered. The report makes recommendations that are consistent with TSCPA’s best understanding of the legislative intent of HB 3. The goal of our recommendations is to make HB 3 more technically correct, easier to understand and consistent for taxpayers.

Representatives of TSCPA are available to respond to questions or engage in dialogue about the report or other issues related to HB 3.

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TSCPA gratefully acknowledges the extensive efforts of the members of the Special Task Force on House Bill 3 for their study and deliberations. As the primary authors of the report, these individual CPAs are due special recognition.

The Task Force presented their report to TSCPA’s Legislative Advisory Committee and their review and consideration of the issues is also appreciated.

The TSCPA Executive Board received the Task Force Report and authorized its release to TSCPA members and the public.

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Table Of Contents

Headings are links - click to jump directly to each chapter.

Executive Summary

Management Company Definition

Taxable Entity

Clarifying Changes Relating to References to Partnerships

Passive Entities – Section 171.0003

Total Revenue

Cost of Goods Sold

Compensation

Combined Group

Temporary Credit on Taxable Margin – Section 171.111

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The TSCPA recommended improvements to House Bill 3 in several areas.

Management Company Definitions - Sections 171.001(11), 171.101(m-1) and 171.1013(f)

Changes clarify that management companies can perform partial services to clients, including back-office operations only, may or may not charge a management fee and clarifies the costs that are deductible and reimbursable.

Taxable Entities - Sections 171.0002(b)(2), 171.0002(c), 171.0002(a) and 171.0003(a)(1)

Partnerships

Total Revenue - Sections 171.1011(c)(2)(A) and 171.1011(g)

Cost of Goods Sold - Sections 171.1012(f), 171.1012(e)(12),171.101(l), 171.1012(g) and 171.1012(i)

Compensation - Section 171.1013

Combined Group - Section 171.1014

Temporary Credit on Taxable Margin - Section 171.111

The Act provides a temporary credit against the taxable margin, apparently based on the business loss carry forward available to a current franchise taxpayer. The wording of this section of the Act is vague and ambiguous and tax professionals themselves are befuddled as to the meaning and calculation of the credit. The proposed change makes the credit intelligible. However, because the original wording is so unclear, the proposed change may or may not reflect what the legislature intended. The change proposed is logical and consistent with preserving benefits that would have accrued to taxpayers under the historical Texas franchise tax.

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Management Company Definition: Sections 171.0001(11), 171.1011(m-1), 171.1013(f)

As passed in HB 3:

Section 171.1011(m-1) currently provides that a taxable entity that is a management company shall exclude from its total revenue reimbursements of specified costs incurred in its conduct of the active trade or business of a managed entity, including "wages and cash compensation" as determined under Sections 171.1013(a) and (b).

Section 171.1013(f) provides that a taxable entity that is a management company (1) may not include as wages or cash compensation any amounts reimbursed by a managed entity; and shall determine compensation as provided by this section for only those wage and compensation payments that are not reimbursed by a managed entity.

Section 171.0001(11) provides that a "management company" means a corporation, limited liability company, or other limited liability entity that conducts all or part of the active trade or business of another entity (the "managed entity") in exchange for (A) a management fee; and (b) reimbursement of specified costs incurred in the conduct of the active trade or business of the managed entity, including "wages and cash compensation" as determined under Sections 171.1013(a) and (b).

Issue:

The term “specified costs” is not defined. There is also a lack of clarity concerning how a management company performs the active conduct of a trade or business for another managed entity. For example, if a managed entity consists of a group of physicians, one could infer from the current version of the statute that the management company would have to conduct some form of physician services to be considered as conducting “all or part of the active trade or business” of the managed entity. This type of activity by the management company may be subject to restrictions or prohibited under medical rules and regulations.

Issue:

The current version of Section 171.0001(11) appears to apply only if a management fee is paid with the reimbursement. It is unclear if the Legislature intended to exclude application of the statute to managed entities that reimbursement expenses only (and do not pay a management fee). If the Legislature did not intend to limit application of the statute in this manner, a clarifying change is set forth below.

TSCPA-Proposed Solutions:

Edit Section 171.0001(11) to read as follows:

(11) "Management company" means a corporation, limited liability company, or other limited liability entity that provides managerial or operational services for another entity that is engaged in the active conduct of a trade or business conducts all or part of the active trade or business of another entity (the "managed entity") in exchange for either or both of the following:
(A) a management fee; and
(B) reimbursement of the following costs (the “Service Costs”) (i) direct costs of specified costs incurred in rendering such managerial or operational services, including “wages and compensation” (as determined under Sections 171.1013(a) and (b)) attributable to employees involved in the performance of such services and materials and supplies consumed or made available in rendering such services, and (ii) other costs reasonably allocable to the rendering of such services.

Edit Section 171.1011(m-1) to read as follows:

(m-1) A taxable entity that is a management company shall exclude from its total revenue reimbursements of Service Costs.

Edit Section 171.1013(f) and (g) to read as follows:

(f) A taxable entity that is a management company:
(1) may not include as wages or cash compensation any amounts reimbursed by a managed entity; and
(2) shall determine compensation as provided by this section for only those wage and compensation payments that are not reimbursed by a managed entity.
(g) A taxable entity that is a managed entity shall include reimbursements made to the management company for wages and compensation as if the reimbursed amounts had been paid to employees of the managed entity

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Taxable Entity: Sections 171.0002(b)(2), 171.0002(c), 171.0002(a) and 171.0003(a)(1)

As passed in HB 3:

Section 171.0002(b)(2) provides that a taxable entity does not include a general partnership the direct ownership of which is entirely composed of natural persons.

Issue:

If the Legislature intended to subject limited liability partnerships consisting of entirely natural persons to the margin tax, the statute should be amended to eliminate any ambiguity as to the taxation of such entities.

Issue:

A general partnership consisting entirely of partners that are natural persons presumably becomes a taxable entity if a natural person dies and the interest passes to his estate. The statute should be amended to clarify that such a partnership does not become a taxable entity during the period a deceased partner’s interest is held by his or her estate.

TSCPA-Proposed Solution:

Edit Section 171.0002(b)(2) to read as follows:

(2) a general partnership (other than a registered limited liability partnership or a foreign limited liability partnership) the direct ownership of which is entirely composed of partners that are natural persons, or the estates(within the meaning of Section 171.0002(c)(2) or trusts of deceased partners) or charitable entities as described in Section 501( c) (3)

As Passed in HB 3:

Section 171.0002(c)(1) currently provides that a taxable entity does not include a grantor trust as defined by Sections 671 and 7701(a)(30)(E) of the Internal Revenue Code, all of the grantors and beneficiaries of which are natural persons or charitable entities as described in Section 501(c)(3), Internal Revenue Code, excluding a trust taxable as a business entity pursuant to Treasury Regulation Section 301.7701-4(b).
Section 171.0002(c)(7) currently provides that a taxable entity does not include a trust that is a passive entity and that meets certain requirements, including that all of the beneficiaries of which are natural persons or charitable entities as defined in Section 501(c)(3), Internal Revenue Code.

Issue:

In the current statute, the grantor and all of the beneficiaries of a grantor trust must be natural persons in order for such trust to be excluded from the definition of a taxable entity. Thus, if a grantor or any of the beneficiaries dies and the beneficial interest passes to the decedent’s estate, the grantor trust would become a taxable entity. The statute should be amended to clarify that such a grantor trust does not become a taxable entity during the period a beneficial interest is held by the estate of a decedent grantor or beneficiary. A similar clarification should be made to Section 171.0002(c)(7) so that the death of a trust beneficiary does not result in an otherwise nontaxable trust becoming a taxable entity.

TSCPA-Proposed Solution:

Edit Section 171.0002(c) to read as follows:

(c) "Taxable entity" does not include an entity that is:
(1) a grantor trust as defined by Sections 671 and 7701(a)(30)(E), Internal Revenue Code, all of the grantors and beneficiaries of which are natural persons, the estates (within the meaning of Section 171.0002(c)(2)) of a deceased grantor and trusts of any deceased beneficiaries, or charitable entities as described in Section 501(c)(3), Internal Revenue Code, excluding a trust taxable as a business entity pursuant to Treasury Regulation Section 301.7701-4(b);
* * *
(7) a trust that is a passive entity:
(A) that is taxable as a trust under Section 641, Internal Revenue Code;
(B) all of the beneficiaries of which are natural persons, estates (within the meaning of Section 171.0002(c)(2)) and trusts of deceased beneficiaries, or charitable entities as defined in Section 501(c)(3), Internal Revenue Code;
(C) that is not a trust taxable as a business entity pursuant to Treasury Regulation Section 301.7701-4(b); and
(D) that is organized as a trust and is described in Section 7701(a)(30)(E), Internal Revenue Code;

As Passed in HB 3:

The definition of “taxable entity” in Section 171.0002(a) includes a business trust. The definition of a passive entity under Section 171.0003(a)(1) defines an entity is a passive entity only if the entity is a general or limited partnership or a trust, other than a business trust.

Issue:

HB 3 does not define the term “business trust” as used in Sections 171.0002(a) and 171.0003(a)(1). It does not appear that the term “business trust” is used in any other section of the law. If the Legislature intended that trusts taxable as business entities pursuant to Treasury Regulation Section 301.7701-4(b) should be the type of trust subject to the margin tax, Sections 171.0002(a) and 171.0003(a)(1) should be amended to clarify the ambiguity. In particular, Section 171.0002(a) should be amended to remove any inference that ordinary trusts described in Treasury Regulation Section 301.7701-4(a) are subject to the margin tax.

TSCPA-Proposed Solutions:

Edit Section 171.0002 to read as follows:

(a) Except as otherwise provided by this section, "taxable entity" means a partnership, corporation, banking corporation, savings and loan association, limited liability company, trust taxable as a business entity pursuant to Treasury Regulation Section 301.7701-4(b), professional association, business association, joint venture, joint stock company, holding company, or other legal entity. Notwithstanding anything to the contrary in the immediately preceding sentence, an ordinary trust described in Treasury Regulation Section 301.7701-4(a) is not a taxable entity.

Edit Section 171.0003 to read as follows:

(a) An entity is a passive entity only if:
(1) the entity is a general or limited partnership or a trust, other than a trust taxable as a business entity pursuant to Treasury Regulation Section 301.7701-4(b)

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Clarifying Partnership Changes: Sections 171.0001(8), 171.1015, 171.0002(c)(4), 171.1011(c)(1)(B)(iii), 171.1013(a)(2)

As Passed in HB 3:

Certain sections of HB 3 use state law and federal income tax concepts to address the treatment of partnerships and limited liability companies.

In certain sections of HB 3, the use of state law and federal income tax concepts to address the treatment of partnerships and limited liability companies creates some ambiguity in the statute.

Issue:

References to Capital and Profits Interests. Certain sections of the Act refer to the “capital” and “profits” of a partnership, but do not describe how to determine the capital interest and the profits interest of a partner. We recommend that the Legislature clarify the meaning of capital and profits interests for purposes of the Act. For federal income tax purposes, neither the Internal Revenue Code nor the regulations clearly define capital interest and profits interest for federal income tax purposes. The U.S. Tax Court has adopted a liquidation-type analysis in determining whether a partnership interest is a capital interest or a profits interest. Under this analysis, the relevant inquiry in determining whether a partner’s interest in a partnership is a capital interest, rather than a mere profits interest, turns on whether that partner has the right to receive a share of the partnership’s assets upon a hypothetical winding up and liquidation immediately following acquisition of the interest, rather than the mere right to share in future partnership earnings or profits.

Consistent with the liquidation-type analysis adopted by the Tax Court, IRS Revenue Procedure 93-27 (which is an administrative pronouncement) defines a capital interest as an interest that would give the holder a share of the proceeds if the partnership’s assets were sold at fair market value and then the proceeds were distributed in a complete liquidation of the partnership. This determination generally is made at the time of receipt of the partnership interest. Rev. Proc. 93-27 defines a profits interest as a partnership interest other than a capital interest.

If the Legislature intended to adopt the federal income tax definition of a capital interest and a profits interest, we recommend the clarifications below.

TSCPA-Proposed Solutions:

Edit Section 171.0001(8) to read as follows:

“Controlling interest" means:
(B) for a partnership, association, trust, or other entity, 80 percent or more, owned directly or indirectly, of the capital or profits interest ( such interest as determined for federal income tax purposes) or beneficial interest, as the case may be, in the partnership, association, trust, or other entity.

Edit Section 171.1015 to read as follows:

(b) In addition to the tax it is required to pay under this chapter on its own taxable margin, a taxable entity that is a lower tier entity may pay the tax on the taxable margin of a higher tier partnership if the higher tier partnership submits a report to the comptroller showing the amount of taxable margin that each lower tier entity that owns it should include within the lower tier entity's own taxable margin, according to the profits interest (as determined for federal income tax purposes) of the lower tier entity. An upper tier partnership is not required to pay tax under this chapter on any taxable margin reported under this section.
***
(e) For a merger or consolidation of two or more partnerships, the resulting partnership is, for purposes of this Act, considered the continuation of any merging or consolidating partnership whose members own an interest of more than 50 percent in the capital and profits (as determined for federal income tax purposes) of the resulting partnership.
(f) For a division of a partnership into two or more partnerships, the resulting partnerships, other than any resulting partnership the members of which had an interest of 50 percent or less in the capital and profits (as determined for federal income tax purposes) of the prior partnership, are, for purposes of this Act, considered a continuation of the prior partnership.

Issue:

Family Limited Partnerships: Ambiguity Relating to Use of Reference to Passive Entity. Section 171.0002(b) provides that a taxable entity does not include a passive entity as defined by Section 171.0003. Section 171.0002(c) provides that a taxable entity does not include an entity that is (i) a family limited partnership that is a passive entity meeting certain ownership requirements; (ii) a passive investment limited partnership that is a passive entity; (iii) a passive investment general partnership that is a passive entity; and (iv) a trust that is a passive entity. If a passive entity is not included as a taxable entity, there is some question as to the necessity of the specific exclusions in Section 171.0002(c) described in the immediately preceding sentence.

Issue:

Family Limited Partnerships: Omission of Limited Liability Companies From Family Limited Partnership Section; Reference to Partnership Classification for Federal Income Tax Purposes in Section 171.0002(c)(4). Section 171.0002(c)(4) provides that a taxable entity does not include a family limited partnership meeting certain requirements “and that is a limited partnership (A) formed pursuant to the Texas Revised Limited Partnership Act (Article 6132a-1, Vernon's Texas Civil Statutes); (B) formed pursuant to the limited partnership law of any other state; or (C) treated as a partnership for federal income tax purposes.” Families also use limited liability companies and it is unclear if the omission of a reference to limited liability companies was intentional or inadvertent. If the omission was inadvertent, we recommend the clarifying amendment set forth below. Also, there is some lack of clarity regarding the usage of the word “or” immediately preceding subsection (C). The statute requires that a family limited partnership be formed pursuant to the limited partnership law of Texas or another state. It would appear that Subsection (C) of Section 171.0002(c)(4) would apply only to a limited partnership that is not formed pursuant to the laws of Texas or another state. We understand that such a case would be rare. The drafters may have intended that the entity be formed pursuant to the applicable law in Texas or another state and that it be taxed as partnership. If so, we recommend the clarifying amendment shown below.

TSCPA-Proposed Solution:

Edit Subsection (C) of Section 171.0002(c)(4) to read as follows:

(c) "Taxable entity" does not include an entity that is:
(4) a family limited partnership or limited liability company that is a passive entity in which at least 80 percent of the interests are held, directly or indirectly, by members of the same family, including an individual's ancestors, lineal descendants, spouse, and brothers and sisters by the whole or half blood, and the estate of any of these persons, and that is a limited partnership or limited liability company:
(A) formed pursuant to the Texas Business Organizations Code (or predecessor limited partnership or limited liability company law) or pursuant to the limited partnership or limited liability company law of any other state; and
(B) treated as a partnership for federal income tax purposes;

Issue:

Clarification Regarding References to Entities Taxable as S Corporations. In several sections of the Act, there is a reference to “limited liability companies” and corporations treated as S corporations for federal income tax purposes. If certain requirements are satisfied, a general partnership, including a limited liability partnership, may elect corporate treatment and be treated as an S corporation for federal income tax purposes. See, e.g., IRS PLR 200326024 (Mar. 14, 2003); IRS PLR 200226032 (Mar. 27, 2002). We recommend the following amendments to clarify that a partnership may be treated as an S corporation.

TSCPA-Proposed Solutions:

Edit Section 171.1011(c)(1)(B)(iii) to read as follows:

to the extent included in Subsection (c)(1)(A), net distributive income from partnerships and from trusts and limited liability companies treated as partnerships for federal income tax purposes and net distributive income from limited liability companies, partnerships and corporations treated as S corporations for federal income tax purposes;

Edit Section 171.1013(a)(2) to read as follows:

net distributive income from limited liability companies, partnerships and corporations treated as S corporations for federal income tax purposes, but only if the person receiving the distribution is a natural person;

Edit Section 171.1015 to read as follows:

REPORTING FOR CERTAIN PARTNERSHIPS IN TIERED PARTNERSHIP ARRANGEMENT. (a) In this section, "tiered partnership arrangement" means an ownership structure in which all of the interests in one partnership, trust, or limited liability company that is treated for federal income taxes as a partnership or a limited liability company or partnership treated as an S corporation for federal income tax purposes (a " lower-tier partnership") are owned by one or more other taxable entities (an " upper-tier entity"). A tiered partnership arrangement may have two or more tiers.

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Passive Entity: Section 171.0003

As Passed in HB 3:

Sec. 171.0003. Definition of Passive Entity

(a) An entity is a passive entity only if:

 

(1) the entity is a general or limited partnership or a trust, other than a business trust;

(2) during the period on which margin is based, the entity's federal gross income consists of at least 90 percent of the following income:

 

(A) dividends, interest, foreign currency exchange gain, periodic and nonperiodic payments with respect to notional principal contracts, option premiums, cash settlement or termination payments with respect to a financial instrument, and income from a limited liability company;

(B) distributive shares of partnership income to the extent that those distributive shares of income are greater than zero;

(C) gains from the sale of real property, commodities traded on a commodities exchange, and securities; and

(D) royalties, bonuses, or delay rental income from mineral properties and income from other nonoperating mineral interests; and

(3) the entity does not receive more than 10 percent of its federal gross income from conducting an active trade or business.

(a-1) In making the computation under Subsection (a)(3), income described by Subsection (a)(2) may not be treated as income from conducting an active trade or business.

(b) The income described by Subsection (a)(2) does not include:

 

(1) rent; or

(2) income received by a nonoperator from mineral properties under a joint operating agreement if the nonoperator is a member of an affiliated group and another member of that group is the operator under the same joint operating agreement.

Issue:

Income From a Limited Liability Company. Sec. 171.0003(a)(2)(A). It is unclear what the Act means by “income from a limited liability company.” Presumably the legislature intended it to mean “distributive shares of limited liability company income to the extent that those distributive shares are greater than zero” in order to be consistent with Sec. 171.0003(a)(2)(B), which includes as passive income “distributive shares of partnership income to the extent that those distributive shares of income are greater than zero.” This meaning would also be consistent with the rules of tiered partnership arrangements under Sec. 171.1015, under which a taxable entity does not report the taxable margin of an owned entity unless it so elects. A solution lies in changing “income from a limited liability company” to “distributive shares of limited liability company income to the extent that those distributive shares are greater than zero” as shown below.

TSCPA-Proposed Solution:

Edit Section 171.0003 to read as follows:

Definition of Passive Entity

(a) An entity is a passive entity only if:

 

(1) the entity is a general or limited partnership or a trust, other than a business trust;

(2) during the period on which margin is based, the entity's federal gross income consists of at least 90 percent of the following income:

 

(A) dividends, interest, foreign currency exchange gain, periodic and nonperiodic payments with respect to notional principal contracts, option premiums, cash settlement or termination payments with respect to a financial instrument, and distributive shares of limited liability company income to the extent that those distributive shares are greater than zero.

Issue:

Define “Securities.” Sec. 171.0003(a)(2)(C) – The Act does not define “securities” for the purpose of determining whether a gain from the sale thereof gives rise to passive income.

TSCPA-Proposed Solution:

Add “Securities” to the list of definitions contained in Sec. 171.0001 and define it as follows:

“Security” or “Securities” has the meaning assigned by Section 581-4, The Securities Act. Thus, it includes any limited partner interest in a limited partnership, share, stock, treasury stock, stock certificate under a voting trust agreement, collateral trust certificate, equipment trust certificate, preorganization certificate or receipt, subscription or reorganization certificate, note, bond, debenture, mortgage certificate or other evidence of indebtedness, any form of commercial paper, certificate in or under a profit sharing or participation agreement, certificate or any instrument representing any interest in or under an oil, gas or mining lease, fee or title, or any certificate or instrument representing or secured by an interest in any or all of the capital, property, assets, profits or earnings of any company, investment contract, or any other instrument commonly known as a security, whether similar to those herein referred to or not. The term applies regardless of whether the "security" or "securities" are evidenced by a written instrument. Provided, however, that this definition shall not apply to any insurance policy, endowment policy, annuity contract, optional annuity contract, or any contract or agreement in relation to and in consequence of any such policy or contract, issued by an insurance company subject to the supervision or control of the Texas Department of Insurance when the form of such policy or contract has been duly filed with the Department as now or hereafter required by law.”

Issue:

Income from an Active Trade or Business. Sec. 171.0003(a)(3) – It is not clear why an entity that has more than 90 percent of its federal gross income consisting of passive income under Sec. 171.0003(a)(2) must also not receive more than 10 percent of its federal gross income from conducting an active trade or business. That is, how could an entity that has at least 90 percent of its federal gross income from passive income also have more than 10 percent of its federal gross income from conducting an active trade or business? It appears that the 10 percent rule is superfluous, or at least confusing.

TSCPA-Proposed Solution:

Delete the 10 percent active business income requirement contained in Sec. 171.0003(a)(3), or explain its purpose with an example showing how an entity can have more than 90 percent of its “federal gross income” from passive sources and at the same time receive more than 10 percent of its ‘federal gross income’ from conducting an active trade or business.

Edit Section 171.0003 to read as follows:

Definition of Passive Entity

(a) An entity is a passive entity only if:

 

(1) the entity is a general or limited partnership or a trust, other than a business trust;

(2) during the period on which margin is based, the entity's federal gross income consists of at least 90 percent of the following income:

 

(A) dividends, interest, foreign currency exchange gain, periodic and nonperiodic payments with respect to notional principal contracts, option premiums, cash settlement or termination payments with respect to a financial instrument, and income from a limited liability company;

(B) distributive shares of partnership income to the extent that those distributive shares of income are greater than zero;

(C) gains from the sale of real property, commodities traded on a commodities exchange, and securities; and

(D) royalties, bonuses, or delay rental income from mineral properties and income from other nonoperating mineral interests; and

(3) the entity does not receive more than 10 percent of its federal gross income from conducting an active trade or business.

Issue:

Entities Allowed as Passive Entities. Sec. 171.0003(a)(1) – There appears to be no logical basis for excluding S corporations and LLCs from the list of passive entities if they otherwise meet the passive income tests. A passive S corporation is no different than a passive general or limited partnership or trust, which are included as passive entities in Sec. 171.0003(a)(1).

TSCPA-Proposed Solution:

Edit Section 171.0003 to read as follows:

Definition of Passive Entity

(a) An entity is a passive entity only if:

 

(1) the entity is a general or limited partnership, limited liability company, S corporation or a trust, other than a business trust;

Issue:

Clarify “Gains form the sale of real property”. Sec. 171.0003(a)(2)(C) – “Gains from the sale of real property” should be clarified for purposes of determining which gains are included as passive income. There are many varieties of gains from the sale of real property, such as ordinary income from various types of depreciation recapture and individual partner adjustments to gain or loss related to the transfer of a partnership interest or death of a partner.

TSCPA-Proposed Solution:

Add the following sentence to Sec. 171.0003(a)(2)(C): “Gains from the sale of real property include all taxable gains from real property, whether treated as ordinary income or capital gain, reported on the entity’s Schedule D or Form 4797” as follows:

Sec. 171.0003. Definition of Passive Entity

(a) An entity is a passive entity only if:

 

(1) the entity is a general or limited partnership or a trust, other than a business trust;

(2) during the period on which margin is based, the entity's federal gross income consists of at least 90 percent of the following income:

 

(A) dividends, interest, foreign currency exchange gain, periodic and nonperiodic payments with respect to notional principal contracts, option premiums, cash settlement or termination payments with respect to a financial instrument, and income from a limited liability company;

(B) distributive shares of partnership income to the extent that those distributive shares of income are greater than zero;

(C) gains from the sale of real property, commodities traded on a commodities exchange, and securities (gains from the sale of real property include all taxable gains from real property, whether treated as ordinary income or capital gain, reported on the entity’s Schedule D or Form 4797); and

(D) royalties, bonuses, or delay rental income from mineral properties and income from other nonoperating mineral interests; and

TSCPA-Proposed Solutions:

With all the changes recommended above, Sec. 171.0003 would read as follows:

Sec. 171.0003. Definition of Passive Entity

(a) An entity is a passive entity only if:

 

(1) the entity is a general or limited partnership, limited liability company, S corporation or a trust, other than a business trust;

(2) during the period on which margin is based, the entity's federal gross income consists of at least 90 percent of the following income: