As the Special Session of the Texas Legislature gets into full swing, it’s imperative your leases are up to date and properly address tax issues that could affect the amount of money you get from the leases. The Special Session began April 17 and lasts for 30 days, and chances are good we will not know the specific outcome until after it ends. However, you need to be prepared since it is possible that a new margin tax will replace the current state franchise tax.

The margin tax has been proposed by the Texas Tax Reform Commission, appointed by Governor Perry and led by former Comptroller John Sharp. The margin tax is gaining traction as a viable option to members of the Legislature and has been endorsed by many top business organizations in the state. Currently, one in 16 businesses pay franchise taxes – the new proposal would double that to where about one in eight would pay the margin tax.

Though the results will not be known until late May at the earliest, make sure your operating expense clauses allow you to pass through various tax increases. While some leases afford owners flexibility in this area, others are quite restrictive. Landlords and owners need to review their leases as soon as possible to make any necessary changes to reflect the current environment.

Specifically, the Texas Tax Reform Commission is proposing to reduce school ad valorem maintenance and operations taxes by 50 cents to $1, and impose a margin tax that would apply to all forms of Texas businesses other than sole proprietorships.  In general, the margin tax would tax a business' total revenue apportioned to Texas, and allow the business to deduct either the cost of goods sold or compensation costs (wages, salaries and benefits). The resulting margin would then be taxed at 1 percent (.5 percent for retailers and wholesalers).

Currently, most commercial leases allow the landlord to pass ad valorem taxes or escalations through to the tenant as an operating cost of the property.  If the commercial lease does not allow the landlord to pass through the margin tax, then the building owner will take a financial hit because the margin tax is being substituted for the ad valorem tax.  Most commercial leases state that a franchise tax, income tax or a wide variety of other non-ad valorem taxes may not be passed through to the tenant, although some leases will say unless such tax is assessed in lieu of an ad valorem tax.

In order to maintain the same economic relationship between landlord and tenant under a commercial lease, it is important that your lease allow for a tax substituted for an ad valorem tax to qualify for the pass-through. We are currently seeking to develop legislative intent evidencing that the margin tax is as a substitute for a portion of school property taxes. Going forward, landlords should be aware of their lease language and provide for flexible tax substitution provisions.

Important items for you to consider are:

• Some ownership groups may not have language in their lease that allows a substitute business tax to be passed through to the tenant in lieu of a property tax.  Even if they do, it could be weak language that may not cover the needs of the owner.
• The above situation is probably more prevalent in regional owners or in a situation where a lease is very old (having been renewed a number of times) and does not have state of the art language.  National institutional owners may have already covered this situation in the lease due to a history with other states.
• The possibility of a school property tax reduction will decrease income from some owners who have tenant leases that are "triple net." When the school property tax goes down, the tenant pays less and the management fee may be less.  Additionally, both the owner and the management company may pay a business tax that it did not pay before. 

Owners that have a lease with a base year or expense stop also should carefully analyze the terms so they can properly address the various situations that might exist. Finally, management companies should carefully review their management contracts because a new business tax will be an added cost.

The Special Session promises to be a busy one, and taxes will be the main focus. Take steps now to ensure your house – well, building in this case --- is in order.