Texas Supreme Court Rejects Challenge to Texas Franchise Tax

In a 7-2 vote, the Texas Supreme Court (“Court”) rejected a constitutional challenge to the revised Texas franchise tax (also known as the “Margins Tax”). In the closely watched case In Re: Allcat Claims Service, L.P. et al. (“Allcat”), No. 11-0589 (Tex. – November 28, 2011), the Court overruled the taxpayers’ contention that the Margins Tax, in effect since 2006, constitutes a tax on the income of natural persons. Such a tax would violate the “Bullock Amendment” to the Texas Constitution, which provides that the state may not impose a net income tax on natural persons without the approval of a majority of registered voters.

After affirming that it had original jurisdiction over the taxpayers’ challenge, the Court determined that the Margins Tax is valid on its face. The Court held that the imposition of the Margins Tax on partnerships is not equivalent to the imposition of a net income tax on natural persons. The Court relied heavily on the “entity theory” of partnership law, reasoning that the State of Texas treats partnerships as legal entities separate from their individual partners. Because the Margins Tax is imposed on the partnership entity before partnership profits have been distributed to the individual partners, it does not violate the Bullock Amendment. The Court did not accept the taxpayers’ theory that allocation of partnership profits to natural persons, prior to distribution, resulted in net income to those persons for purposes of the Bullock Amendment.

Finally, the Court declined to accept jurisdiction over additional constitutional claims relating to the Comptroller’s administration of the Margins Tax. The Court concluded that, although the Legislature had empowered it to determine the facial constitutionality of the tax, other provisions of the Tax Code vested exclusive jurisdiction in the district courts of Travis County to determine whether the Comptroller was administering the tax in an equal and uniform fashion.

The taxpayers are entitled to request a rehearing from the Court. In addition, their concurrent lawsuit remains pending in the Travis County District Court challenging the Comptroller’s administration, enforcement, and collection of the Margins Tax. A similar pending case, In Re: Nestle USA, Inc., No. 11-0855 (Tex.), will likely be resolved in the same manner as Allcat, meaning Nestle USA, Inc.’s claims regarding the facial constitutionality of the Margins Tax will be overruled, and its remaining claims regarding the administration of the tax will have to be tried in the lower courts.