This blog series will cover certain aspects of Tennessee’s Franchise and Excise tax and give particular focus to the more common exemptions available under the taxing statute.
The state of Tennessee imposes Franchise and Excise (“F&E”) tax on certain types of legal entities. Entities subject to tax include “C” corporations, “S” corporations, and the Limited Liability Company (“LLC”). General partnerships are not subject to F&E tax.
The franchise tax is based on the greater of the entity’s net worth or the book value of certain fixed assets, plus an imputed value of rented property. The excise tax is 6.5% of the net taxable income. Net taxable income starts with federal taxable income and certain adjustments are applied to arrive at net taxable income for Tennessee purposes.
The most common type of legal entity we encounter is the LLC. There are numerous exemptions for F&E purposes that allow an LLC to not be taxable. The most common exemptions are:
- Family-owned non-corporate entity (“FONCE”)
- Farming or the holding of a personal residence
- Obligated member entity (“OME”)
- Venture capital fund
In this blog, we will address the FONCE exemption.
To qualify the entity must be an LLC, limited partnership, or limited liability partnership. An LLC 100% owned by an individual also qualifies. The exemption is not available to corporate entities. “C” or “S” corporations therefore will not qualify for the FONCE exemption.
At least 95% of the ownership of the entity must be owned by members of the family or the estate or trust of a deceased individual who, while living, was a member of the family (e.g., a testamentary trust).
At least 66.67% of the entity’s gross income must either be from passive investment income or the combination of passive investment income and farming.
Passive investment income is gross receipts from royalties, dividends, annuities, interest, gains on the sale/exchange of stocks and securities (not gross sales proceeds), rents from residential property, and income/rents from farming. Residential property cannot have more than four residential units at any one location.
Rents from industrial and commercial real estate are not considered passive investment income for the purpose of the FONCE exemption.
Participation in a rental activity is not a determining factor for passive investment income for the FONCE exemption. It is the type of rental activity that determines if the passive income test is met.
Only gains from the sale or exchange of stocks or securities (i.e., capital gains) qualify as passive investment income. Gains from the sale of real or tangible personal property do not qualify since these aren’t technically “capital gains” even though under IRC Section 1231 they may qualify for the preferential federal capital gains tax rates.
An entity will meet the passive investment income test for the purpose of the FONCE exemption if it does not have any income for the taxable year.
Even though the entity is not required to file the F&E tax return it must complete a “Disclosure of Activity” form which is due with its Application for Exemption and each Annual Exemption Renewal. The due date is 15th day of the fourth month after year end or the extended due date of the accompanying federal tax return.
Please look for our next blog, which will continue to cover other common F&E tax exemptions.