If you’ve ever asked what is a passive entity in Texas while planning your business taxes, you’re not alone—and the answer could save you thousands. In Texas, passive entities enjoy a powerful benefit: exemption from the state’s franchise tax. But qualifying isn’t automatic. It depends on how your income is earned, how your entity is structured, and how you report it. Whether you’re managing real estate holdings, investment income, or legacy assets, understanding this classification is critical.
And while Texas may not impose a sales tax or franchise tax on qualifying passive entities, other states might. That’s why businesses with multi-state exposure often rely on Hands Off Sales Tax (HOST), a one-stop solution for sales tax compliance that handles registrations, filings, nexus tracking, and more.
In this guide, we’ll break down who qualifies, what the rules mean for your taxes, and how to stay compliant while maximizing benefits.
Defining a Passive Entity in Texas
In Texas, a “passive entity” refers to a specific classification under the state’s franchise tax laws, offering certain tax exemptions to qualifying entities.
Legal Definition
According to Texas Tax Code §171.0003, an entity is considered a passive entity if it meets the following criteria:
- Entity Type: The entity must be a general partnership, limited partnership, or a trust (excluding business trusts).
- Income Composition: At least 90% of the entity’s federal gross income must derive from specific passive sources, including:
- Dividends
- Interest
- Capital gains from the sale of real property, securities, or commodities
- Royalties and bonuses from mineral interests
- Distributive shares of partnership income
- Income from limited liability companies
- Active Business Limitation: The entity must not receive more than 10% of its federal gross income from conducting an active trade or business.
It’s important to note that certain income types, such as rental income and income received by a non-operator from mineral properties under a joint operating agreement, are excluded from the definition of passive income for this purpose.
Entities that meet these criteria are exempt from the Texas franchise tax, providing a significant tax advantage.
Income Criteria for Passive Entities
In Texas, qualifying as a passive entity hinges on the nature of the income your business earns. The state delineates specific income types that count toward passive status, as well as those that disqualify an entity from this classification.
Qualifying Income
To be deemed a passive entity under Texas Tax Code §171.0003, at least 90% of the entity’s federal gross income must derive from the following sources:
- Dividends and Interest: Income from investments, including foreign currency exchange gains and certain financial instruments.
- Distributive Shares of Partnership Income: Profits allocated from partnerships, provided they are positive amounts.
- Capital Gains: Profits from the sale of real property, securities, or commodities traded on a commodities exchange.
- Royalties and Bonuses: Income from mineral properties, including delay rental income and earnings from nonoperating mineral interests.
These income types are considered passive and contribute to meeting the 90% threshold required for passive entity status.
Non-Qualifying Income
Certain income streams are explicitly excluded from the passive income classification:
- Rental Income: Earnings from leasing real estate or other property.
- Active Business Income: Revenue generated from conducting an active trade or business, which involves active operations and management functions.
Additionally, income received by a nonoperator from mineral properties under a joint operating agreement, where another member of the affiliated group is the operator, does not qualify as passive income.
The 90% Rule
The cornerstone of passive entity qualification is the “90% rule,” which mandates that at least 90% of the entity’s federal gross income must come from the specified passive sources mentioned above. Simultaneously, the entity must not receive more than 10% of its federal gross income from conducting an active trade or business.
It’s important to note that income categorized as passive under federal tax law may not align with Texas’s definition. Therefore, entities must carefully assess their income streams against Texas’s specific criteria to determine eligibility for passive entity status.
Tax Implications
In Texas, qualifying as a passive entity offers significant tax advantages, particularly concerning the state’s franchise tax.
Franchise Tax Exemption
Entities that meet the criteria for passive status, as defined in Texas Tax Code §171.0003, are exempt from paying the Texas franchise tax. This exemption applies to entities such as general partnerships, limited partnerships, and certain trusts, provided they derive at least 90% of their federal gross income from qualifying passive sources like dividends, interest, and capital gains. It’s important to note that this exemption is specific to the franchise tax and does not necessarily apply to other state taxes.
Combined Reporting
In Texas, businesses that are part of a unitary group are typically required to file a combined franchise tax report, consolidating the revenues and expenses of all affiliated entities. However, passive entities are excluded from such combined reporting groups. This means that even if a passive entity is affiliated with other businesses that are subject to combined reporting, it does not have to include its financial information in the group’s consolidated report. This exclusion simplifies the reporting process for passive entities and ensures that their passive income is not inadvertently subjected to franchise tax through combined reporting.
Reporting and Compliance Requirements
In Texas, passive entities benefit from specific reporting obligations that differ from other business structures, particularly following legislative changes effective in 2024.
Annual Filings
Previously, passive entities were required to submit a No Tax Due Report (Form 05-163) annually to affirm their exemption from the franchise tax. However, for reports due on or after January 1, 2024, this requirement has been eliminated. Instead, qualifying passive entities must now file either the EZ Computation Report (Form 05-169) or the Long Form Report (Form 05-158). When completing these forms, entities should select the appropriate designation indicating their passive status in the taxpayer information section. No additional financial details are necessary beyond this selection and the entity’s signature.
Post-2024 Changes
The discontinuation of the No Tax Due Report streamlines the compliance process for passive entities. Importantly, these entities are no longer required to file a Public Information Report (Form 05-102) or an Ownership Information Report (Form 05-167), further reducing administrative tasks.
Other Obligations
While the filing requirements have been simplified, passive entities must ensure they continue to meet the criteria outlined in Texas Tax Code §171.0003 to maintain their exempt status. This includes deriving at least 90% of federal gross income from qualifying passive sources and not exceeding 10% from active business activities. Regular review of income sources and adherence to the specified thresholds are essential for ongoing compliance.
Strategic Considerations
Strategic planning is essential for businesses aiming to qualify as passive entities in Texas. By carefully structuring your entity and managing income streams, you can maintain compliance and benefit from franchise tax exemptions.
Entity Structuring
To qualify as a passive entity under Texas Tax Code §171.0003, your business must be organized as a general partnership, limited partnership, or a trust (excluding business trusts). Limited liability companies (LLCs) and corporations are ineligible, even if they meet income criteria. If you’re operating as an LLC or corporation, consider restructuring into a qualifying entity type. Note that the entity must maintain its qualifying status for the entire accounting period; conversions during the period may disqualify the entity for that year.
Investment Planning
Maintaining passive entity status requires that at least 90% of federal gross income comes from qualifying passive sources, such as dividends, interest, capital gains, and certain royalties. To achieve this:
- Prioritize investments that yield qualifying passive income.
- Limit activities that generate active income, including rental income and business operations.
- Regularly review income sources to ensure compliance with the 90% threshold.
Strategic investment planning helps in sustaining the required income composition for passive entity classification.
Risk Management
Several pitfalls can jeopardize passive entity status:
- Entity Conversion Timing: Converting to a qualifying entity type mid-year may disqualify the entity for that tax period.
- Income Misclassification: Incorrectly categorizing active income as passive can lead to non-compliance.
- Inadequate Documentation: Failing to maintain proper records of income sources can hinder the ability to prove compliance.
To mitigate these risks, consult with tax professionals familiar with Texas franchise tax laws and regularly audit your income streams and entity structure.
By proactively managing your business structure and income sources, you can effectively maintain passive entity status and benefit from associated tax exemptions.
Why Texas Passive Status Isn’t the End of Your Tax Compliance—and How HOST Can Help
Qualifying as a passive entity in Texas can exempt your business from franchise tax—but it doesn’t automatically shield you from sales tax obligations in other states. If your entity earns income from out-of-state sales, digital goods, licensing, or services, you may still trigger nexus and be required to collect and remit sales tax elsewhere.
That’s where HOST steps in.
HOST is a full-service sales tax compliance platform designed for modern, multi-state businesses. Their services include:
- Nexus analysis to determine where you’re liable for sales tax
- Sales tax registration in all applicable jurisdictions
- Automated filings and remittances to keep you on schedule
- Resale certificate generation to streamline compliance
- Audit defense and tax notice resolution
- Custom tax matrix creation for complex product/service catalogs
- Sales tax software integration across platforms like Shopify and Stripe
For Texas passive entities with out-of-state exposure, HOST provides the infrastructure to stay compliant and audit-ready—without the manual burden. If you want your tax compliance handled while you focus on investment returns or operational growth, HOST is your one-stop solution.
Passive Doesn’t Mean Hands-Off
Texas passive entity status can offer major tax advantages, but it doesn’t eliminate the need for thoughtful compliance. From structuring your entity correctly to maintaining the 90% passive income threshold, staying exempt from the franchise tax takes strategy. And while Texas may give you a break, other states won’t. If your business crosses state lines or deals in taxable goods or services, sales tax compliance becomes non-negotiable. That’s where HOST comes in. With automated tools and expert guidance, HOST handles the complexities of multi-state sales tax so you can protect your passive status—and grow with confidence.
Ready to simplify your compliance? Contact HOST today for a personalized quote and see how effortless sales tax can be.
