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Tennessee Modifies the FONCE Exception to the Franchise and Excise Taxes and the Filing Requirements for Many Other Exemptions

Legal Services
06.22.09

The Tennessee General Assembly recently enacted the Tennessee Department of Revenue's (TDOR) annual "Technical Corrections Bill," and it is awaiting Governor Bredesen's signature. The Technical Corrections Bill includes provisions important to those who own, operate or advise a limited liability company, limited partnership or limited liability partnership (collectively, FLP) concerning Tennessee franchise and excise tax matters.  Among the items changed are the following:

  • Family-owned noncorporate entity (FONCE) exemption no longer includes rent from industrial and commercial property and certain farm property;
  • Partners of an FLP are permitted to elect, by October 1, 2009, obligated member entity status with retroactive effect;
  • Rental income paid monthly to an affiliated entity is limited; and
  • Established initial and annual exemption filing requirements.

FONCE Exemption Limited

Under existing law, FLPs in which at least 95 percent of the ownership interest is owned by members of a defined family group are exempt from the Tennessee franchise and excise taxes as long as substantially all of its income is derived from royalties, rents, dividends, interest, annuities and sales or exchanges of securities.  For all tax years ending after June 30, 2009, the FONCE exemption is no longer available to an FLP receiving substantially all of its income from the rental of "industrial and commercial property” or farm property used for recreational purposes.  FLPs which receive substantially all of their income from these sources will become subject to the Tennessee franchise and excise taxes for the current tax year, unless they qualify under another exemption. FLPs receiving rental income from residential rental property will continue to qualify for the FONCE exemption, provided the property has no more than 4 residential units, e.g. a quadplex.

This provision is effective July 1, 2009. Consequently, any rental income earned on or after that date for the current tax year by the FLP that thus becomes nonqualifying must be taken into consideration for purposes of determining if the income requirement is met for purposes of qualifying for the FONCE exemption during the current year.  Note that if the FLP elects obligated member entity status under the expanded window outlined below this income becomes sheltered under that exemption.

For those FLPs which desire to continue avoiding payment of the Tennessee franchise and excise taxes, several options exist. Among them is qualifying for the obligated member entity exemption by electing to waive limited liability protection as well as converting to a general partnership.  The two options have the same result of exposing the partners to entity liabilities, but they have significant governance differences, and the general partnership has an additional potential source of significant liability. Other options exist, including ones that minimize the liability exposure to partners.  FLPs should seek advice from legal counsel to explore all options and to determine both the tax and nontax consequences of each option.

Obligated Member Entity Election Expanded

Under existing law, FLPs for which all of the partners have complied with the statutory requirements to waive limited liability protection for the FLP are exempt from the Tennessee franchise and excise taxes.  The only exception is for those FLPs in which a partner (or any owner in the chain of ownership of the partner) of such FLP is itself an entity affording limited liability protection to its owners.  In that case, the FLP is subject to the taxes on the portion of its income and equity that is allocable to the partner retaining its own limited liability protection.  Generally, the election to waive limited liability protection must be filed by the later of the inception of the FLP or January 1st of the year for which the exemption is sought.

In light of the amendment to the FONCE exemption, the Technical Corrections Bill permits the owners of FLPs to file an election no later than October 1, 2009 to waive limited liability protection so that the FLP will qualify for the obligated member exemption for the current year.  Note that this expansion of the election time period applies regardless of whether the electing FLP is currently exempt under the FONCE exemption, and, affords a planning opportunity not only for those seeking an alternate exemption because of the change to the FONCE exemption but also for those entities that presently are not exempt from the Tennessee franchise and excise taxes.

Deduction for Rent Paid to Affiliated Entities Capped

Under current law, a lessee of real property can deduct all rent paid to an affiliated entity, regardless of whether it is subject to the Tennessee franchise and excise taxes (e.g. an FLP, owned by members of the same family, that owns the lessee which has elected to waive limited liability), thereby reducing the lessee's net income subject to the Tennessee excise tax.  The Technical Corrections Bill limits the rent the lessee can deduct for payments to an affiliate to a monthly amount equal to 2 percent of the property tax appraised value of the leased property. For example, for a parcel with a property tax value of $500,000, the lessee could deduct up to $10,000 per month ($500,000 x 2 percent) for rent.  Rent paid in excess of this cap would be added back to the net earnings of the lessee. Notably, rent is not defined in the statute, making it unclear how the payment of maintenance expenses and insurance will be treated for purposes of the 2 percent rule.  A plain reading of the statute suggests that those expenses can be deducted in addition to the rent threshold.

Exemption Filing Requirements

The TDOR presently requires that FLPs file an Application for Exemption following formation for the initial tax year and Form 183 by April 15th annually thereafter.  The TDOR has taken the position that absent the timely filing of such forms FLPs were subject to the Tennessee franchise and excise taxes regardless of whether they would otherwise qualify for an exemption.  The TDOR's position was not grounded in any statutory authority.

The Technical Corrections Bill makes certain exemptions contingent upon the filing of the initial Application for Exemption with the TDOR within 60 days of the FLP's formation (or in the case of an existing FLP seeking to qualify under an exemption, 60 days from the beginning of the tax year for which the exemption is sought) and Form 183 by April 15th annually.  If either form is not timely filed, then the FLP will not qualify for the exemption otherwise available, unless the TDOR grants permission for a late filing.  The TDOR has the option of imposing a $1,000 penalty for a late filed form.  Note that these filing requirements apply only to FLPs seeking to qualify for one of the following exemptions:  family-owned non-corporate entities, farming/personal residence, affordable housing, venture capital funds, diversified investing funds, obligated member entities, asset-backed securitization entities (REMIC/FASIT), or other entities exempt as securing third-party indebtedness.

WE ARE REQUIRED BY IRS CIRCULAR 230 TO INFORM YOU THAT THE PRECEDING DISCUSSION WAS NOT INTENDED OR WRITTEN TO BE USED, AND IT CANNOT BE USED, NOR RELIED UPON, BY ANY TAXPAYER FOR THE PURPOSE OF AVOIDING ANY PENALTIES THAT MAY BE IMPOSED UNDER FEDERAL TAX LAW.  THE ADVICE WAS WRITTEN TO SUPPORT THE PROMOTION OR MARKETING OF THE TRANSACTIONS OR MATTERS ADDRESSED IN THE DISCUSSION.  EACH TAXPAYER SHOULD SEEK ADVICE BASED ON ITS PARTICULAR CIRCUMSTANCES FROM AN INDEPENDENT TAX ADVISOR.

The opinions expressed in this bulletin are intended for general guidance only.  They are not intended as recommendations for specific situations.  As always, readers should consult a qualified attorney for specific legal guidance.

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