What Defines a Passive Entity in the Texas Tax Code?
Understand the narrow Texas definition of a passive entity. Exemption from the state franchise tax depends on specific income sources, not federal rules.
The Texas Franchise Tax is a privilege tax on entities conducting business in the state. However, certain businesses can be exempt if they qualify as a “passive entity.” This designation is strictly defined and requires adherence to specific income and entity type requirements set by the Texas Comptroller of Public Accounts. To qualify, a business must first be an eligible entity type and then perform a detailed analysis of its income sources to ensure it meets a quantitative test. Only after meeting these standards can an entity proceed with the required reporting to claim its tax-exempt status.
Qualifying as a Passive Entity
To be recognized as a passive entity under Texas law, a business must satisfy two conditions. The first relates to its legal structure, as only specific types of entities are permitted to seek this classification. The Texas Tax Code limits passive entity qualification to general partnerships, limited partnerships, limited liability partnerships, and trusts, with the exception of business trusts. Other structures like corporations and LLCs are disqualified. An entity must maintain its qualifying structure for the entire accounting period to be eligible.
The second condition is the 90% passive income test, which mandates that at least 90% of the entity’s federal gross income must come from state-defined passive sources. Qualifying sources include:
- Dividends, interest, and foreign currency exchange gains
- Income from certain financial instruments like option premiums and notional principal contracts
- Distributive shares from partnerships and limited liability companies
- Net capital gains from the sale of securities and real property
- Royalties and bonuses from mineral properties
Conversely, income from an active trade or business is non-passive. This includes revenue from the sale of goods, performance of services, and rental income from real property. If more than 10% of the entity’s federal gross income comes from these active sources, it fails the test. For example, a partnership with $100,000 in total federal gross income, where $92,000 is from interest and dividends and $8,000 is from consulting fees, would meet the 90% test and qualify.
Required Documentation and Reporting
Entities that meet the passive status requirements must affirm this qualification on their annual franchise tax report. The requirement to file a separate No Tax Due Report has been eliminated; a qualifying passive entity must file either the EZ Computation Report or the Long Form Report.
On the report, the entity marks the designation that identifies it as a passive entity in the taxpayer information section. While no financial details are required on the form to affirm the status, the business must perform the 90% passive income test using figures from its federal income tax return to verify qualification.
The Filing Process
Once an entity determines it qualifies as passive, it must submit the appropriate franchise tax report to the Texas Comptroller by the May 15 deadline. Missing this deadline can result in penalties. The Comptroller encourages online filing through its WebFile system, which is the most efficient method. Alternatively, entities can mail a physical copy of the form. No franchise tax is due when filing as a passive entity.
Distinctions from Federal Passive Activity Rules
It is important to distinguish the Texas “passive entity” definition from the federal “passive activity” rules under the Internal Revenue Code, as they serve different purposes. The Texas definition is an entity-level test used solely to determine if a qualifying partnership or trust is exempt from the state’s franchise tax.
In contrast, the federal passive activity rules apply at the individual taxpayer level, not to the entity itself. These IRS regulations are designed to limit the ability of individuals, estates, and trusts to deduct losses from passive activities against their other, non-passive income, such as wages or portfolio income. The federal rules are concerned with an individual’s material participation in an activity, a concept that has no bearing on the Texas passive entity test.
The definitions of passive income also differ significantly between the two systems. For example, under federal rules, income from rental real estate is generally considered passive for the individual investor. However, for the Texas franchise tax calculation, rental income is explicitly defined as active, non-passive income. This means a partnership whose sole business is owning and operating a rental property would generate passive income for its partners under federal law, but the partnership itself would not qualify as a passive entity in Texas.
The consequences of these classifications are also distinct. Qualifying as a passive entity in Texas results in a $0 franchise tax liability for the business. The federal passive activity rules, on the other hand, determine whether an individual can use losses from an investment to offset other income on their personal Form 1040 tax return.