United States: "I Tax Dead People" - Texas Court of Appeals Holds That Prepaid Funeral Benefits Trusts’ Earnings Derived From Out-of-State Investments Are Included in Texas Gross Receipts

The 3rd District of the Texas Court of Appeals has held that earnings from investments in outof- state investment vehicles are Texas gross receipts for the earned surplus component of the Texas franchise tax if such investments are made through Texas grantor trusts. Anderson-Clayton Bros. Funeral Home, Inc. v. Stryhorn, NO. 03-03-00458-CV, 2004 WL 1792355 (Tex. App.—Austin 08/12/04, no pet. h.).

During the period from 1993-1996, Anderson- Clayton ("Plaintiff") owned and operated a group of funeral homes and memorial parks located in Texas. Customers could pre-pay funeral services for themselves or others by purchasing fixed price contracts for future funeral services to be provided after the death of the beneficiary. Contract proceeds were required under Texas law to be deposited either (1) in an interestbearing Texas bank or savings and loan institution insured by the federal government; or (2) with the trust department of a bank in Texas, or in a trust company authorized to do business in Texas, to be invested by the trust department.¹ Each account is required to be held in the name of the funeral service provider to whom the purchaser makes payment.

Plaintiff generally opted to deposit the contract proceeds in trusts (the "Trusts"). The assets in the Trusts were invested in stocks, bonds and money market-type accounts, generating interest, dividends, and capital gains (losses). Earnings generally were retained in the Trusts until the funeral services were provided to the customer or the contract was cancelled; but, unlike the original purchase payments, earnings could either be used to pay certain expenses of Plaintiff or withdrawn and retained by Plaintiff following the performance or cancellation of the contract.

The Trusts were classified as "grantor trusts" for federal income tax purposes. Pursuant to Section 671 of the Internal Revenue Code (the "IRC"), all items of income, deductions and credits are passed through to the grantor(s) of the trust. Thus, Plaintiff was required to recognize the income from the Trusts’ investments when the income was earned for federal income tax purposes, without regard to the timing of distributions.

All of the Trusts were created in Texas, and the trustees of such Trusts were financial institutions located in Texas.² However, at all relevant times, the Trusts’ earnings originated from investments in out-of-state investment vehicles. Based on this, Plaintiff determined that the Trusts’ earnings did not constitute Texas gross receipts for purposes of calculating its Texas franchise tax during the relevant period.

In 1997, the Comptroller audited Plaintiff and determined that the Trusts’ earnings during the relevant period should have been included in Plaintiff’s Texas gross receipts. The District Court granted the Comptroller’s motion for summary judgment, and Plaintiff appealed the District Court’s ruling to the 3rd District of the Texas Court of Appeals.

The sole issue presented was whether the Trusts’ earnings derived from investments in outof- state investment vehicles constituted Texas gross receipts for the earned surplus component of the Texas franchise tax. The parties’ contentions centered on the proper construction of Section 171.1121(b) of the Texas Tax Code (the "Code"), which states "[e]xcept as otherwise provided by this section, a corporation shall use the same accounting methods to apportion taxable earned surplus as used in computing reportable federal taxable income."

Plaintiff contended that the Trusts should be disregarded for purposes of determining the source of the Trusts’ earnings because the Trusts are disregarded for federal income tax purposes as grantor trusts, with all items of income, deductions and credits attributed directly to Plaintiff as the grantor. As a result, Plaintiff concluded that the Trusts’ earnings should be treated as direct payments from the out-of-state investment vehicles to Plaintiff and, accordingly, not included in Plaintiff’s Texas gross receipts.

Conversely, the Comptroller asserted that Section 171.1121(b) was not intended to address the source of receipts, but rather the timing of the recognition of gross receipts and related earned surplus income.

To ascertain the proper construction of Section 171.1121(b), the Court stated that its "paramount task is to ascertain the Texas Legislature’s intent in enacting that provision." To achieve this, a court must first look to the "plain and common meaning of the words the legislature used," with the presumption that "every word in a statute has been used for a purpose and that each word, phrase, clause, and sentence should be given effect." A court will "abide by the clear language of the statute and enforce it as written," unless the statute is ambiguous. Second, words or phrases with technical or particular meaning must be construed accordingly, and statutory provisions, among other things, on the same or similar subjects must be considered to have the same meaning unless otherwise meant to have different meanings. Third, terms in the statute must be viewed "in context with the Texas franchise tax law as a whole." Finally, the Code Construction Act authorizes a court to consider the objective of the statute when construing a statute.

Applying such principles, the Court upheld the Comptroller’s interpretation of Section 171.1121(b). In making this decision, the Court focused on the meaning of the terms "accounting method" and "apportion" as used in the statute.

First, in construing the term "accounting method," the Court looked to IRC Section 446(a), which lists "permissible methods" of accounting, including cash and accrual, installment and the percentage of completion method. The Court noted that these "accounting methods" relate to the timing of income recognition, not the source of the income. As a result, the Court held that the flow-through treatment afforded grantor trusts under federal income tax law is not an accounting method, but rather a substantive law governing whether tax is imposed on the grantor or the trust.

The Court next looked to the Texas Tax Code’s definition of "apportion" under Section 171.106, which generally provides that gross receipts are apportioned to Texas by multiplying total receipts by a fraction, the numerator of which is Texas gross receipts and the denominator of which is total receipts. The Court pointed out that this provision does not address the source of the income included in the calculation.

In a dissenting opinion, one of the Justices argued that the Court’s interpretation of Section 171.1121(b) would render it redundant in light of Section 171.1121(a), which already addresses the timing of income recognition for the earned surplus component of the Texas franchise tax.

In response, the majority asserted that Section 171.1121(a) and (b) are not redundant because Section 171.1121(a) provides for the use of consistent accounting methods for purposes of determining gross receipts used in the apportionment factor, whereas Section 171.1121(b) provides for the use of consistent accounting methods for the purpose of determining taxable earned surplus. The Court noted that if the dissent were correct, then a corporation could theoretically choose one accounting method to determine gross receipts for purposes of the apportionment factor and a different accounting method for purposes of determining taxable earned surplus. As a result, a corporation could recognize income for taxable earned surplus that is not taken into account in the apportionment factor, or vice versa. This would lead to under-apportionment of taxable earned surplus if gross receipts are not also included in the apportionment factor or overapportionment of taxable earned surplus if gross receipts are included in the apportionment factor but not in taxable earned surplus.

The Court also found it helpful that the parallel provision to Section 171.1121(b) governing the taxable capital component of the Texas franchise tax, Section 171.112(h), provides that "a corporation shall use the same accounting methods to apportion its taxable capital as it used to compute its taxable capital." The legislative history for such provision states it was enacted to ensure the same "‘parallel accounting treatment’ required for earned surplus."

After holding that Section 171.1121(b) was a timing rule rather than a sourcing rule, the Court examined other law to determine the proper source of the Trusts’ earnings. The Texas Supreme Court, in Humble Oil & Refining Co. v. Calvert, 414 S.W.2d 172 (Tex. 1967), approved the Comptroller’s use of the "location of the payor rule" for purposes of sourcing intangible receipts, such as dividends and interest. The Anderson-Clayton Bros. Court held that the location of the payor rule was consistent with the broad concept underlying tax apportionment and that only income from business done in Texas should be subject to the Texas franchise tax. The Court also noted that it would accept the Comptroller’s interpretation of the statute as long as it was consistent with the language and purpose of the statute, regardless of whether other reasonable interpretations exist. Thus, the Court deferred to the Comptroller’s determination under the location of the payor rule that taxing receipts derived from trusts located in Texas was an appropriate interpretation of its power to tax business done in Texas.

The Court further noted that the Comptroller’s determination that the Trusts were the payors in the present case was reasonable in light of the longstanding Texas law treating trusts as separate and distinct entities, regardless of the fact that they are not subject to federal income tax or Texas franchise tax. Therefore, the Court, applying the location of the payor rule, concluded that the Trusts were the payors of the Trusts’ earnings and that such earnings were properly sourced to Texas because the Trusts were domiciled in Texas. Finally, the Court noted that sourcing the Trusts’ earnings to Texas was consistent with the policies underlying tax apportionment, stating that "[b]y establishing a Texas trust to hold and invest revenues from its sale of prepaid funeral benefit plans, [Plaintiff] availed itself of the benefits and protections of Texas law."

Interestingly, the Court did not address the apparent inconsistency between sourcing the receipts of a grantor trust to the domicile of the trust and sourcing the receipts of a partnership as though the corporate partner directly earned such receipts, as required under 34 Tex. Admin. Code §3.557(e)(24)(A) ("Rule 3.557"). Conceptually, the federal income tax treatment of a grantor trust and a partnership are almost identical. All items of income, deductions and credits generally flow-through to the grantor or partner based on their percentage of ownership in the trust or partnership.³ Moreover, from a Texas law perspective, partnerships and trusts are treated similarly in that both entities are separate and distinct entities from their owners.

In the present case, the Court focused on the separate and distinct entity status of the Trusts, stating that it was reasonable to conclude that the Trusts were the payor of the Trusts’ earnings because trusts are separate and distinct entities for Texas law purposes, and Plaintiff availed itself of the benefits and protections of Texas law by organizing the Trusts in Texas. These same arguments hold true for partnerships as well. The only difference of note between a grantor trust and a partnership is the federal income tax classification of these entities. Partnerships are treated as separate entities for federal income tax purposes, while grantor trusts are treated as disregarded entities for federal tax purposes.⁴ As a result, under federal income tax law, grantors are deemed to directly own the property held in the grantor trust,⁵ while the partnership, and not its partners, is treated as the owner of the property held in the partnership. Thus, the Court’s holding is perplexing in that the only discernable difference between the federal income tax and state law treatment of grantor trusts and partnerships is that grantor trusts are disregarded entities for federal income tax purposes, with the grantor deemed to own the assets held in trust directly, a factor that would seemingly be more favorable to Plaintiff’s position in the present case.

The Court’s holding may adversely affect nonqualified deferred compensation plans that are implemented by corporations subject to the Texas franchise tax. In general, non-qualified deferred compensation plans set aside assets, subject to the general creditors of the corporation, for the benefit of an employee. Certain non-qualified deferred compensation plans utilize trusts to hold the segregated assets. For federal income tax purposes, these trust are treated as grantor trusts, with all income, deductions and credits therefrom directly taxable to the corporate grantor. It is uncertain whether corporations utilizing such structures are sourcing receipts of the trusts based on the domicile of the trusts or the location of the investment vehicles in which the trust’s invest.

Rule 3.557(e)(42), effective February 12, 2003, provides that "[d]istributions to a corporation that is the beneficiary of a trust are apportioned to the legal domicile of the trust." However, this rule apparently has no bearing on grantor trusts because distributions are not made to the grantor, but rather to the ultimate beneficiary, and such distributions are not taxable for federal income tax purposes. Thus, the Court’s decision may significantly affect those corporations utilizing Texas grantor trusts in non-qualified deferred compensation plans that are not currently sourcing trust earnings based on the domicile of the trust.

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