On June 17, 2009, the Tennessee State Legislature passed a bill which removed the exemption from Tennessee Franchise and Excise Tax which commercial real estate had enjoyed since 2000 when TCA 67-4-2008(8)(a)(11)(B)(i) was passed. It is anticipated that governor Bredesen will sign the legislation into law. The effective date of the new legislation is July 1, 2009. However, it is expected that this effective date will be deferred. The provision in the Tennessee tax code which allowed the exemption was under attack by the Tennessee Department of Revenue for several years because of the loss of tax revenue. There were a number of qualifications that had to be met, but here is how the tax was calculated:
Example: A non-family owned LLC owning commercial property with a net book value of $5 million and generating an annual net income (from rent) of $100,000 would have to pay Tennessee tax as follows:
$5 million Franchise Tax Base taxed at .25 per $100 = $12,500
$100,000 Taxable Income taxed at 6.5% = $6,500
Total Tennessee Franchise and Excise Tax = $19,000
However, if the same LLC was owned 95% or more by family members, the entity would be exempt from Tennessee Franchise and Excise tax altogether (assuming the entity meets all the qualifications for exemptions) saving this entity $19,000 in tax in one year. Therefore, the savings for qualified entities is quite significant with the Department of Revenue estimating that the annual loss in tax revenue exceeds $25 million according to the Department of Revenue's March 2009 Report on Family-Owned Non-Corporate Entities prepared by Reagan Farr.
During the summer and fall of 2008, all FONCE's registered as exempt from franchise and excise tax were requested to complete a Disclosure of Activity form. According to the Report on Family-Owned Non-Corporate Entities, 8,797 forms were mailed to both in-state and out-of-state FONCEs. The Disclosure of Activity form had questions about the organizations structure, a description of each rental real estate property, its appraised value, name of the lessees, and the gross rents received. The form also contained questions about the sources of other forms of passive investment income and non-passive income.
As of March 2009, the Department of Revenue had received 7,205 responses and the results are quite interesting:
5,557 of those entities qualified for the FONCE exemption; 466 entities qualified for a separate exemption; 1,018 respondents did not qualify for any exemption and the Department was seeking additional information on the remaining 118 respondents.
Of the 5,557 entities that qualified for the FONCE exemption, 3,200 entities qualified for the exemption because they received substantially all their income from the rental of commercial real estate. Details on these entities:
- The appraised value of the commercial property is over $5 billion.
- The average entity controls over $1.6 million in commercial property
- More than 1,200 of the entities are leasing property to either an owner of the FONCE or to an affiliated company.
- 20% of these entities are held by wealthy out-of-state investors with the property having a combined appraised value of over $1 billion making Tennessee a tax-haven for out-of-state investors
- The investors come from 43 different states (with California and Virginia leading the way in both number and value).
Effective for years beginning on or after January 1, 2008 every exempt entity has been required to renew their exemption annually:
- Each entity must now complete a Franchise and Excise Tax Annual Exemption Renewal form by April 15th. The entity must indicate the exemption type for which they qualify and certify that they meet all requirements for their exemption.
- FONCE applicants must also complete a Franchise and Excise Tax Exempt Entity Disclosure of Activity form indicating the organizational structure, the sources of their gross receipts, farming income and assets and information on any personal residences held inside the entity.
If the renewal forms for 2008 were not filed timely, the entity will automatically lose its exempt status. The due date of the Franchise and Excise Tax Annual Exemption Renewal form was automatically extended with a Federal Income Tax extension
The original intent of the FONCE legislation was to exempt from Franchise and Excise tax passive income that had traditionally been subject to the Hall income tax, but that had become subject to Franchise and Excise tax in 1999. However, the legislation included other forms of passive income (primarily rent) that were traditionally subject Franchise and Excise tax instead of the Hall income tax. The Department of Revenue has concluded that the corporate rent exemption is fundamentally unfair and how now been successful in getting the Legislature to remove commercial real estate activities from the scope of the FONCE exemption.
A copy of the Department of Revenue's Report on Family-Owned Non-Corporate Entities can be obtained from their website www.tennessee.gov/revenue
If you are a member of a FONCE, please consult your tax advisor prior to the effective date to begin planning for this legislative change. This will likely require additional tax planning and an understanding of the legal implications of various options.