Texas Attorney General Files Response to Franchise Tax Challenge; Supreme Court Orders Oral Argument for Late October, But Signals Dismissal of Two of Three Claims by Allcat?

  By Paul Masters and William Grimsinger

The Solicitor General of the Texas Attorney General has taken the lead and on August 18, 2011 filed a short response to Allcat’s petition to declare the new Texas franchise tax unconstitutional. In summary, Texas argues that (i) a tax on the income of an entity does not constitute a tax on a person’s share of that entity’s income, (ii) that the Texas Supreme Court’s ruling should be narrowed to a natural person with an interest in a limited partnership (as opposed to striking down the franchise tax in toto), and (iii) that the last two issues raised by Allcat are not properly before the Texas Supreme Court.

Tax on an Entity’s Income Is Not a Tax on a Natural Person

Texas argues that the franchise tax does not run afoul of the Bullock amendment, which prohibits a tax on the net income of a “natural person,” including a person’s share of partnership income, because the franchise tax is imposed at the entity level, not the individual level. In other words, it is a tax that reduces the partnership’s income itself, which is then divided up and allocated to the individual partners who may include natural persons.

The Solicitor General also points out that were Allcat to be correct, that then any tax that reduces a partnership’s income would constitute an unconstitutional tax, including the sales tax, which was already in place at the time the Bullock amendment became law. Why would this be true? Because any tax that reduces the income of a partnership will inevitably reduce a partner’s share of the income. In other words, remove the sales tax and the “net income” of a partner from his partnership interest would be more than with the imposition of the sales tax. Thus Allcat’s argument fails as being overly expansive and ignoring the plain language of the Texas Constitution.

Limit the Decision to Natural Persons Who Are Partners of Limited Partnerships

Finally, the Solicitor General argues that if Allcat is correct, such that the franchise tax is unconstitutional as applied to income of natural persons from partnerships, that such a ruling should be limited to only those cases. Thus the franchise tax would continue to be constitutionally imposed upon partnerships without natural persons, corporations, and other such entities.

Dismiss the Allcat’s Last Two Claims

The Solicitor General asks the Texas Supreme Court to dismiss Allcat’s claim for attorney fees, as no statutory authority exists for such and the claim via the Uniform Declaratory Judgment Act is not permitted via the statutory jurisdiction that Allcat used to petition the Texas Supreme Court.

Supreme Court Order

On August 22, 2011, the Supreme Court set the case for oral argument the week of October 24, and ordered the parties to address the following arguments in their briefs:

1. Whether the grant of original jurisdiction in section 24 of House Bill 3 (2006) is valid under Article V, Section 3 of the Texas Constitution.

2. The merits of Claim 1 (Bullock Amendment).

3. Whether Claim 2 (Equal and Uniform Taxation Clause) and Claim 3 (Attorney’s Fees) are beyond the scope of the jurisdictional grant in section 24 of House Bill 3.

This action seems to indicate that the Texas Supreme Court has taken a narrow view of two of Allcat’s claims: (i) that the Texas Comptroller treated Allcat differently than other contractors (a disparate treatment claim), and (ii) that Allcat is entitled to attorney fees based on the Uniform Declaratory Judgments Act (the “UDJA”).

As to the former, the Attorney General argues that the basis on which Allcat relied to acquire original jurisdiction by the Texas Supreme Court merely goes to the constitutionality of the franchise tax based on a violation of the Bullock Amendment. The jurisdictional provision of Section 24 to HB 3 does not provide for such a challenge. As to the latter, the Attorney General points to the general principle of law in Texas that, unless authorized by statute or contract, attorney fees are unavailable to a party. While Allcat argues that this is a UDJA claim, which provides for attorney fees, the Attorney General points to the limited jurisdiction upon which Allcat relied, via HB 3, and as no attorney fees were provided and HB 3 does not construe a constitutional challenge as a UDJA claim, then the request for attorney fees must be denied.

Using the UDJA to Get Attorney Fees

Historically, taxpayers in Texas have sought to characterize actions against the Texas Comptroller as a form of a UDJA claim, which argument has always been vigorously contested. See  Strayhorn v. Raytheon E-Systems, Inc., 101 S.W.3d 558, 572 (Tex.App.-Austin 2003, pet. denied) (“A UDJA claim brought merely to receive attorney’s fees will not lie.”). On rare occasion, the courts have agreed to treat such a claim as a valid UDJA claim for which attorney fees can be granted. The Texas Supreme Court may use the Allcat decision to further clarify the availability of UDJA actions, especially in the context in which the Texas Comptroller is a party, but the expectation is that the Texas Supreme Court will limit argument to the more narrow question of whether the newly-enacted Texas franchise tax violates the Bullock Amendment of the Texas Constitution.

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