Co-author Kamal Omar*

Texas, famously, does not tax individuals’ income, but it does impose franchise taxes on “taxable entities”, such as limited liability companies. Federal tax law treats them as partnerships unless they elect to be treated otherwise. In Hibernia Energy LLC v. Hegar, a Texas court addressed how Hibernia, a non-taxable entity under federal law, is taxable under Texas law. 

The franchise tax

Hibernia sold leasehold interests. Its franchise-tax reports to the Comptroller in 2013 and 2015 reported gains that were almost entirely attributable to the sale of the interests. The gains were included in the determination of its total revenue and corresponding liability for franchise taxes. Hibernia paid the taxes.

Hibernia later sought a refund for the two tax years and attached two key documents to its request:  Amended franchise tax reports removing the gains from the sale of the interests previously reported, and a “Statement of Grounds” explaining that it had “overstated” its total revenue by erroneously including the gains from the sale when such an inclusion is not required under law.

The Comptroller disagreed, disallowed the proposed adjustments, and denied the requested refund.  

The federal tax

Partnerships are not subject to federal income taxes but still must file informational returns on Form 1065, which allocates to partners their proportional share of gains, losses, and other information necessary to calculate and report individual income-tax liability. An entity’s Texas franchise tax liability is based on amounts “reportable as income” on federal tax return line 11, Schedule K, where the partnership must report “any other item of income” not reported elsewhere on the return. Hibernia left the line empty.

The Texas court’s conclusion

On appeal from the Comptroller’s decision to deny Hibernia’s refund, the court of appeals addressed whether Hibernia was required by federal tax law to include its net gains from the sale of the leaseholds on line 11, Schedule K.

Hibernia advanced two arguments for why the gains were not “reportable as income” on line 11. First, Form 1065’s instructions expressly exclude gains on the disposition of an interest in oil or gas properties because the applicable instruction states merely “disposition of an interest” rather than “gains (loss) from the disposition of an interest.” The instructions direct the partnership to “enter any other item of income or loss not included on lines 1 through 10” and further require the partnership to “identify the type of income” in the space next to line 11 and describe the type of income using one of several codes. The instructions twice mandate the partnership to list on Schedule K “any other” item or type of income not otherwise disclosed. The Court concluded that Hibernia’s proposed construction of the instructions runs counter to the Internal Revenue Code’s requirement that a partnership must report all items of gross income. The court further concluded that the instructions must be construed in a way that avoids hyper-technical readings.

Second, Hibernia claimed that it could not determine its “gain” because the adjustments depended on elections unknown to the partnership. In rejecting the argument, the court considered evidence that Hibernia did in-fact calculate its gains on its original franchise-tax reports. Furthermore, because depletion adjustments were unavailable to Hibernia, its gains on the leasehold sales were simply the amount realized on the sale less its cost to purchase them.

Hibernia was required to report its gain from the sale of the leasehold interests on line 11 and include those gains in its total revenue for Texas franchise-tax purposes. Hibernia was not entitled to a refund.

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*Kamal is a rising 3L at SMU Law School and a Gray Reed summer associate.