Can an LLC be a Texas passive entity, and what does an upper-tier partnership owe when its lower tiers already pay?

The passive entity definition turns on entity form

Section 171.0003(a) has three elements, all of which must hold for the period on which margin is based: "the entity is a general or limited partnership or a trust, other than a business trust"; "the entity's federal gross income consists of at least 90 percent of the following income," followed by the passive categories; and "the entity does not receive more than 10 percent of its federal gross income from conducting an active trade or business" (section 171.0003(a)(1) to (3)). The section was enacted with the margin tax by Acts 2006, 79th Leg., 3rd C.S., ch. 1, effective January 1, 2008, amended once before that date by Acts 2007, 80th Leg., ch. 1282, and not since; the entity-form element has read the same way for every report year of the margin tax.

The Comptroller's rule restates the list and adds timing: "the entity must be one of the following for the entire period on which the tax is based: (A) general partnership; (B) limited partnership; (C) limited liability partnership; or (D) trust, other than a business trust" (34 Tex. Admin. Code section 3.582(c)(1)). A limited liability company is absent from both lists, and the absence is deliberate: the same subsection names "income from a limited liability company" as a passive source for the holder of an LLC interest (section 171.0003(a)(2)(A); 34 TAC section 3.582(c)(2)(A)). The statute treats an LLC as something a passive entity can own, not something it can be.

Federal classification does not change the answer. The tax is imposed on "each taxable entity that does business in this state or that is chartered or organized in this state" (section 171.001(a)), and "taxable entity" is defined by state-law form: a list that names the partnership, the limited liability partnership, the corporation, the limited liability company, the business trust and other forms, ending in "holding company, or other legal entity" (section 171.0002(a)). Outside the term are a sole proprietorship, a general partnership "the direct ownership of which is entirely composed of natural persons" whose liability is not limited by statute or by registration as a limited liability partnership, a passive entity, and an entity exempt under Subchapter B (section 171.0002(b)). An LLC that elects partnership treatment computes total revenue from the partnership lines of Form 1065 (section 171.1011(c)(2)), but it remains an LLC for section 171.0003(a)(1). The Comptroller's FAQ states that a passive entity "is specifically defined for franchise tax purposes in Texas Tax Code Section 171.0003" and that the federal passive activity rules do not apply (Texas Comptroller, Franchise Tax Frequently Asked Questions, Passive Entities).

The timing element closes the one route an LLC might take. An LLC that converts to a limited partnership becomes an eligible form only from the conversion forward, and the rule requires the eligible form "for the entire period on which the tax is based" (34 TAC section 3.582(c)(1)). The FAQ states the consequence: the converted entity "may not qualify as passive for the accounting period during which the conversion occurs," even if it meets the 90 percent test for that period, and may qualify for subsequent reports (Passive Entities FAQ).

The 90 percent test for a holding partnership

For a partnership or trust that passes the form element, the income test decides. The passive sources are "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"; "distributive shares of partnership income to the extent that those distributive shares of income are greater than zero"; "capital gains from the sale of real property, gains from the sale of commodities traded on a commodities exchange, and gains from the sale of securities"; and "royalties, bonuses, or delay rental income from mineral properties and income from other nonoperating mineral interests" (section 171.0003(a)(2)(A) to (D)). That income "does not include" rent, or income a nonoperator receives from mineral properties under a joint operating agreement where another member of its affiliated group is the operator (section 171.0003(b)). The rule measures the gain categories net (34 TAC section 3.582(c)(2)(C)), and an entity with no federal gross income does not qualify (section 3.582(c)).

Three features matter to a partnership whose assets are interests in other entities. First, a distributive share counts only "to the extent that those distributive shares of income are greater than zero" (section 171.0003(a)(2)(B)): a loss from one lower tier is not netted against income from another. Second, the rule defines "security" to include "an interest in a partnership where the investor has a non-controlling interest in the investee," with the same treatment for an LLC interest and a beneficial interest in a trust, and a non-controlling interest is one "that is less than or equal to 50%" held directly or indirectly (34 TAC section 3.582(b)(9), (b)(10)). A gain on the sale of a 40 percent limited partner interest is a gain from the sale of a security; a gain on the sale of an 80 percent interest is not, and falls outside the listed sources. Third, rent is excluded by statute, but the exclusion speaks of rent, not of a distributive share from a partnership that earns rent. Whether the lower tier's rental character carries up into the upper tier's distributive share is a question the statute does not answer and the FAQ does not address; the FAQ's rent answer says only that an entity "may qualify as passive even if the entity has some rental income" (Passive Entities FAQ, citing section 171.0003(b)). A limited partnership whose only income is distributive shares from property-owning lower tiers treats the point as open.

The 10 percent element is tested with the passive income removed: "income described by Subsection (a)(2) may not be treated as income from conducting an active trade or business" (section 171.0003(a-1)). An entity conducts an active trade or business if "the activities being carried on by the entity include one or more active operations that form a part of the process of earning income or profit" and "the entity performs active management and operational functions" (section 171.0004(b)); outside contractors' services count when they make up the entity's trade or business (section 171.0004(c)); and an entity whose assets are used in the active trade or business of related entities is active (section 171.0004(d)). Three things do not count: a royalty or nonoperating working interest in minerals, paying employees or contractors "for financial or legal services reasonably necessary for the operation of the entity," and holding a board seat by itself (section 171.0004(e); 34 TAC section 3.582(e), (f)). A holding partnership that pays an administrator and outside counsel, and whose partners sit on lower-tier boards, stays within those carve-outs.

What a passive entity files, and what its owners include

A passive entity "owes no tax" (34 TAC section 3.582(g)). A qualifying partnership or trust that "is registered or required to be registered with the comptroller's office or with the secretary of state's office" files an annual report affirming its status; one that "is not registered or otherwise required to be registered" with either office files nothing with the Comptroller (section 3.582(g)(1), (2)). The rule still names the No Tax Due Report as that filing. That report was discontinued for reports originally due on or after January 1, 2024 (Texas Comptroller, Franchise Tax Filing Requirements), and the FAQ and the 2026 forms page state the replacement: a registered passive entity "must file either a Long Form Report or an EZ Computation Report annually to affirm that the entity qualifies," blackening the circle in the taxpayer information section and completing only that part of the form (Passive Entities FAQ; Texas Comptroller, 2026 Texas Franchise Tax Report Forms). A passive entity "is not required to file a Public Information Report or an Ownership Information Report," though a limited partnership may owe a periodic report to the Secretary of State under the Business Organizations Code (34 TAC section 3.582(g)(3)).

A passive entity is also outside combined reporting: "Passive entities are not included in the combined group; however, the pro rata share of net income from a passive entity shall be included in total revenue to the extent it was not generated by the margin of another taxable entity" (34 TAC section 3.590(b)(2)(E)). The total revenue rule gives a taxable owner the same instruction, to include "its share of net distributive income from a passive entity, but only to the extent the net income of the passive entity was not generated by any other taxable entity" (34 TAC section 3.587(c)(4)), and that share "is sourced to the principal place of business of the passive entity" (34 TAC section 3.591(e)(20)). A taxable upper tier therefore includes income from a passive lower tier, net of anything a taxable entity below it already reported, and excludes income from a taxable lower tier altogether, as the next sections describe.

The taxable upper tier: nexus first

An LLC that holds lower-tier partnership interests is a taxable entity, and the first question is whether Texas can tax it. An entity "chartered or organized in this state" is subject without more (section 171.001(a)); a foreign entity is subject if it does business here, and "[n]exus is determined on an individual taxable entity level" (34 TAC section 3.586(c)).

The rule addresses partnership interests directly. Physical presence includes "acting as a general partner in a general partnership that is doing business in Texas" and "acting as a general partner in a limited partnership that is doing business in Texas," with a parenthetical for the other side: "a foreign taxable entity that is a limited partner in a limited partnership does not have physical presence in Texas, if that is the limited partner's only connection with Texas" (section 3.586(d)(12)(A), (B)). A holding company has physical presence by "maintaining a place of business in Texas or managing, directing, and/or performing services in Texas for subsidiaries or investee entities" (section 3.586(d)(8)). Economic nexus applies for each federal accounting period ending in 2019 or later when a foreign taxable entity "had gross receipts from business done in Texas of $500,000 or more, as sourced under section 3.591(e) and (f)" (section 3.586(f)(1)). The cross-reference matters, because "[a]ny item of revenue that is excluded from total revenue under Texas law or United States law is excluded from gross receipts from an entity's entire business and Texas gross receipts" (34 TAC section 3.591(d)(5)), and net distributive income from a lower-tier partnership is excluded from total revenue. A foreign upper tier whose Texas connection is a limited partner interest, managed from outside Texas, with no Texas-sourced receipts of its own, has no physical presence under the rule and does not reach the receipts threshold on distributive income. The library's article on Texas franchise tax economic nexus covers the threshold and the physical presence list; the managing member of a Texas LLC is a separate question with its own article.

Separate reporting: the exclusion and the zero factor

Where the upper tier is subject to the tax, because it is organized in Texas, is a general partner, manages lower tiers from Texas, or has other Texas receipts, and is not part of a combined group, its report rests on two exclusions.

The first is in total revenue. A taxable entity treated as a partnership builds total revenue from Form 1065 line 1c, lines 4, 6 and 7, Schedule K lines 3a and 5 through 11, Form 8825 line 17, Schedule F, and "any total revenue reported by a lower tier entity as includable in the taxable entity's total revenue under Section 171.1015(b)," then subtracts, among other items, "to the extent included in Subsection (c)(2)(A), net distributive income from a taxable entity treated as a partnership or as an S corporation for federal income tax purposes" (section 171.1011(c)(2)(A), (B)(iii)). Net distributive income is "[t]he net amount of income, gain, deduction, or loss relating to a pass-through entity or disregarded entity reportable to the owners for the tax year of the entity" (34 TAC section 3.587(b)(9)), and the rule repeats the subtraction with the passive entity exception described above (section 3.587(d)(3)(B)(iii), (c)(4)). The exclusion is not conditioned on the lower tier having paid Texas tax, having nexus, or having filed anything; it applies to net distributive income from any taxable entity treated as a partnership.

The second is in apportionment: "In apportioning margin, receipts excluded from total revenue by a taxable entity under Section 171.1011 may not be included in either the receipts of the taxable entity from its business done in this state as determined under Section 171.103 or the receipts of the taxable entity from its entire business done as determined under Section 171.105" (section 171.1055(a)). The distributive share leaves both numerator and denominator. That is the mechanism behind the result that an upper tier owes nothing when the lower tiers pay: the payment is not the reason; the upper tier's base and factor are computed without the lower-tier income, and an entity with no Texas receipts of its own has a Texas factor of zero.

An example shows the computation. A holding LLC taxed as a partnership and organized outside Texas holds 40 percent limited partner interests in three Texas limited partnerships that own and operate apartment communities, each with an unrelated general partner. Each lower tier has about $15 million of rental revenue and $7.5 million of net income, files its own franchise tax report and pays its own tax; the holding LLC's distributive shares total $9 million, and it earns $1 million of interest on reserves and a note. If the holding LLC has Texas nexus, its total revenue is $1 million, the $9 million having been subtracted under section 171.1011(c)(2)(B)(iii); its receipts everywhere are $1 million, its Texas receipts are whatever part of the interest section 3.591(e) sources here, and the $9 million is in neither figure (section 171.1055(a)). At $1 million of total revenue the holding LLC is below the no tax due threshold, $2,650,000 for report years 2026 and 2027 and $2,470,000 for 2024 and 2025 (Texas Comptroller, Franchise Tax overview; section 171.002(d)(2)), and for reports due on or after January 1, 2024 an entity at or below the threshold files no annual franchise tax report but must still file a Public Information Report or an Ownership Information Report (Franchise Tax Filing Requirements). If instead the holding LLC's own revenue were $5 million of interest and fees sourced outside Texas, it would file the Long Form or the EZ Computation Report showing zero Texas gross receipts, and a PIR or OIR; the forms page lists "[e]ntities above the no tax due threshold with zero Texas gross receipts" among those that must file (2026 Texas Franchise Tax Report Forms). A taxable entity formed as a corporation, LLC, limited partnership, professional association or financial institution files the PIR; a taxable entity of any other form, including a general partnership and a trust, files the OIR (Texas Comptroller, Public Information Report and Ownership Information Report Filing Requirements). The holding LLC files the PIR, owes no tax on the lower-tier income in any year, and the lower tiers' separate reports are the correct filings, because a 40 percent interest is not a controlling interest and the lower tiers are not under common control with it.

When the tiers are a combined group, the separate reports are wrong

The analysis changes with ownership. "Taxable entities that are part of an affiliated group engaged in a unitary business shall file a combined group report in lieu of individual reports based on the combined group's business" (section 171.1014(a)). An affiliated group is "a group of one or more entities in which a controlling interest is owned by a common owner or owners, either corporate or noncorporate, or by one or more of the member entities" (section 171.0001(1)). A controlling interest in a partnership is "more than 50 percent, owned directly or indirectly, of the capital, profits, or beneficial interest," and in an LLC "more than 50 percent, owned directly or indirectly, of the total membership interest" or of the beneficial ownership interest in it (section 171.0001(8)(B), (C)). A unitary business is "a single economic enterprise that is made up of separate parts of a single entity or of a commonly controlled group of entities that are sufficiently interdependent, integrated, and interrelated through their activities so as to provide a synergy and mutual benefit that produces a sharing or exchange of value among them and a significant flow of value to the separate parts," and the Comptroller considers whether the members are in the same general line of business, are steps in a vertically structured enterprise, or "are functionally integrated through the exercise of strong centralized management" over purchasing, financing, product line, personnel and marketing (section 171.0001(17)).

Pass-through entities are members: "Eligible pass-through entities including partnerships, limited liability companies taxed as partnerships under federal law, limited liability companies that are disregarded under federal law and S corporations are included in a combined group" (34 TAC section 3.590(b)(2)(D)), and "[a] combined group must include eligible entities even if those entities do not have nexus" (section 3.590(b)(2)(C); Texas Comptroller, Franchise Tax Frequently Asked Questions, Combined Reporting). The combined group "is a single taxable entity" (section 171.1014(b)); it determines total revenue by computing each member's total revenue "as if the member were an individual taxable entity," adding the amounts, and subtracting "items of total revenue received from a member of the combined group" (section 171.1014(c)); the no tax due threshold "applies to the combined group as a whole" (Combined Reporting FAQ); and "[e]ach member of the combined group shall be jointly and severally liable for the tax of the combined group" (section 171.1014(i)). The reporting entity, the parent if it is in the group, files on the group's behalf (34 TAC section 3.590(b)(5), (e)(1)(B)), with the Affiliate Schedule (Form 05-166) and the Common Owner Information Report (Form 05-177), and each member organized in Texas or with Texas nexus files its own PIR or OIR (PIR and OIR Filing Requirements). A member without nexus of its own contributes its total revenue and its receipts to the denominator, but its Texas receipts "are excluded from the numerator" (section 3.590(d)(5)(B)), and a member with no Texas receipts contributes nothing to the numerator (Combined Reporting FAQ).

In the variant of the example where the holding LLC owns 80 percent of a lower-tier limited partnership that owns Texas apartments, and the two share management, financing and personnel, the lower tier's separate report and payment discharge nothing. The two are an affiliated group, and affiliated entities are presumed unitary (34 TAC section 3.590(b)(6)(B)), so a combined report was required, with the lower tier's $15 million of rent in the group's total revenue and its Texas rent in the group's Texas receipts, and the holding LLC's distributive share kept out of its own total revenue under section 171.1011(c)(2)(B)(iii). "A taxable entity that is not included in a combined report must file a separate report if it is doing business in Texas" (34 TAC section 3.590(c)), and the converse holds: a taxable entity that belongs in a combined report is not a separate filer. The lower tier's payment becomes an amount to reconcile against the group's liability, and the reporting entity has a report to file for each open year. The combined group question therefore comes before any reliance on the lower tiers' separate reports; inside a group each member still computes its total revenue as if it were an individual taxable entity, so the exclusion still applies (section 171.1014(c)). The 50 percent line is counted through tiers, "owned directly or indirectly," and the Comptroller attributes a spouse's ownership to an individual but no other family member's (Combined Reporting FAQ).

The tiered partnership election is the lower tier's choice

Texas also offers an elective route that moves revenue up instead of eliminating it. A "tiered partnership arrangement" is "an ownership structure in which any of the interests in one taxable entity treated as a partnership or an S corporation for federal income tax purposes (a 'lower tier entity') are owned by one or more other taxable entities (an 'upper tier entity')" (section 171.1015(a)). An upper tier "may include, for purposes of calculating its own taxable margin, the total revenue of a lower tier entity if the lower tier entity submits a report to the comptroller showing the amount of total revenue that each upper tier entity that owns it should include," according to ownership interest (section 171.1015(b)); the revenue enters the upper tier's total revenue through section 171.1011(c)(2)(A)(vi) and leaves the lower tier's. Both tiers file the Tiered Partnership Report (Form 05-175) with their franchise tax reports (Texas Comptroller, Franchise Tax Frequently Asked Questions, Tiered Partnerships).

Four limits confine it. "This provision is not mandatory" (34 TAC section 3.587(c)(8)). It is unavailable "if the upper tier entity is not subject to the tax under this chapter," in which case "the lower tier entity is liable for the tax on its taxable margin" (section 171.1015(c)), so a lower tier cannot report revenue to a passive upper tier or to one without nexus. It "is not an alternative to combined reporting" and "is not allowed if the lower tier entity is included in a combined group" (section 3.587(c)(8)(E); Tiered Partnerships FAQ). And the no tax due threshold and the EZ Computation "do not apply to an upper or lower tier entity if, before the attribution of any total revenue by a lower tier entity to upper tier entities under this section, the lower tier entity does not meet the criteria" (34 TAC section 3.587(c)(8)(C); see section 171.1015(d)), while a lower tier that owes no tax before attribution may not file under the provision at all (section 3.587(c)(8)(G)). The election cannot manufacture a no-tax-due result at either tier. Where the lower tiers file and pay on their own, no election has been made, and the upper tier's treatment is the exclusion, not an inclusion under section 171.1015.

Practice notes

The sound sequence for a holding partnership with Texas lower tiers runs in a fixed order. First, form: an LLC is a taxable entity, and a partnership or trust is tested against the 90 percent and 10 percent elements for the entire period, with distributive shares counted only when positive, gains on interests over 50 percent kept out of the securities category, and the rent look-through treated as open. Second, ownership: any interest above 50 percent, counted through tiers, raises the combined group question, and a unitary group files one combined report in which the lower tiers are members and separate lower-tier reports are errors to correct rather than payments to rely on. Third, nexus for a non-passive upper tier holding only minority interests: a foreign limited partner managed from outside Texas with no Texas receipts of its own has none, while one organized in Texas, acting as a general partner, or managing from Texas files on its own base, with net distributive income out of total revenue and out of both sides of the fraction. Fourth, the filing: the Long Form or EZ with the passive circle for a registered passive entity, nothing for an unregistered one, a PIR or OIR alone for a taxable upper tier at or below the threshold, and a report showing zero Texas receipts plus a PIR or OIR for one above it. A prior-year report that claimed passive status for an LLC is a report to amend; the amended report shows no tax only where the exclusion or the no tax due threshold carries it, because interest, dividends and gains stay in total revenue (section 171.1011(c)(2)(A)). G&G State Tax Group provides Texas franchise tax entity classification, combined group determinations and tiered partnership filing reviews alongside its state and local tax practice.