Tennessee taxation of passthrough entities

Editor: Mary Van Leuven, J.D., LL.M.

Tennessee’s entity classification rules only partially conform to the federal entity classification rules. An insufficient understanding of the rules, like a little knowledge, can be dangerous to taxpayers when determining which entity has a filing responsibility in Tennessee. Many entities that are disregarded for federal, and most other states’, income tax purposes are regarded for Tennessee franchise and excise (FAE) tax purposes. Coupled with mandatory separate legal entity filing for most taxpayers, but required combined filing for captive real estate investment trust (REIT) affiliated groups and unitary groups of financial institutions, determining the proper Tennessee filer can be challenging.

Not only is ascertaining the proper filing entity in Tennessee more difficult because of the state’s partially nonconforming rules on entity classification, but issues also arise in determining which entity reports the gain from selling interests in entities that are disregarded for federal purposes but regarded for Tennessee purposes. That can mean the difference between no Tennessee FAE tax on a transaction and substantial tax.

Starting with the basics, Tennessee imposes both an excise tax based on the apportioned net earnings (income) of taxable persons (taxpayers) and a franchise tax based on the higher of the entity’s Tennessee property or apportioned net worth. Tennessee’s FAE taxes apply to most limited liability entities — not just entities taxed as corporations for federal income tax purposes.

Tennessee taxable and disregarded entities

Under Tennessee law, “all persons, except those having not-for-profit status, doing business in [Tennessee] and having a substantial nexus in [Tennessee]” are subject to the franchise and excise taxes (Tenn. Code §§67-4-2007(a) and 67-4-2105(a)). Tennessee defines the term “persons” as “every corporation, subchapter S corporation, limited liability company, … limited partnership, … business trust, regulated investment company, REIT, … bank, or … savings and loan association” (Tenn. Code §67-4-2004(38)). Essentially, every nonexempt limited liability entity with one exception (described below) is subject to tax. Nonlimited liability entities, including general partnerships, are not subject to tax. Also, Tennessee has a number of specific exemptions contained in Tenn. Code Section 67-4-2009, including for venture capital funds and obligated member entities, that potentially could exempt otherwise taxable entities from Tennessee FAE taxes.

There is an exception, as noted above, to the general rule that limited liability entities are subject to the taxes: Limited liability companies (LLCs) are disregarded entities if (1) their single member is a corporation (or an entity treated as a corporation for federal income tax purposes) and (2) they are disregarded for federal income tax purposes (Tenn. Code §67-4-2007(d)). No other federally disregarded entities — no federally disregarded partnerships, no qualified REIT subsidiaries, no qualified Subchapter S subsidiaries, no disregarded single-member LLCs (SMLLCs) owned by individuals, partnerships, or other noncorporate entities — are disregarded for Tennessee FAE purposes (Tenn. Comp. R. & Regs. §1320-06-01-.40(2)).

A corollary to the exception discussed above is that in tiered LLC structures, LLCs indirectly wholly owned by corporations may also be disregarded. Tennessee regulations adopt a “top down” approach to determine whether an LLC indirectly owned by a corporation is disregarded (Tenn. Comp. R. & Regs. §1320-06-01-.40(3)). For example, LLC3 is 50% owned by LLC1 and 50% owned by LLC2. Both LLC1 and LLC2 are wholly owned by the same corporation. All three LLCs are disregarded for federal income tax purposes. In this situation, as LLC1 and LLC2 are both disregarded into the corporation for federal income (and Tennessee FAE) tax purposes, LLC3 is wholly owned by the corporation and therefore disregarded for Tennessee FAE tax purposes.

Tennessee combined/consolidated filings

Tennessee requires captive REIT affiliated groups (CRAGs) and unitary groups of financial institutions to file on a combined basis on Tennessee Form FAE 174, Franchise and Excise Financial Institution and Captive Real Estate Investment Trust Tax Return. The CRAG rules can trip up taxpayers, as the captive REIT combined filing includes all entities owned greater than 50% by the captive REIT, including entities that would otherwise separately file, including partnerships and SMLLCs owned by those partnerships (Tenn. Code §67-4-2004(8)). A captive REIT is a federal REIT in which an entity or individual, directly or indirectly, has an 80% or greater ownership interest, with a few exceptions (Tenn. Code §67-4-2004(7)).

Tennessee, in addition, allows certain affiliates to elect to determine franchise tax net worth on a consolidated basis (Tenn. Code §67-4-2103(d)). However, separate returns are generally required, and Tennessee property, the other measure of the franchise tax, is generally determined on a separate-entity basis. CRAGs do determine net worth on a combined basis on Schedule F1, Captive Real Estate Investment Trust Net Worth, of Form FAE 174.

Nonflowthrough of nexus, taxable income, and apportionment for Tennessee passthrough entities

As a result of Tennessee’s separately taxing many federal disregarded or passthrough entities, these separately taxed entities, with a few defined exceptions, do not flow through income or loss or apportionment factors to their partners or members. Instead, those entities themselves are subject to Tennessee tax. This affects the nexus, taxable income, and apportionment of the upper-tier entities.

Nexus: Regarding nexus, ownership of an interest in a limited liability passthrough entity taxable in Tennessee by itself will not create nexus. As stated in the Tennessee Department of Revenue’s Franchise and Excise Tax Manual (ch. 3, pg. 51):

Each taxable entity stands on its own attributes as to whether it is doing business and has substantial nexus in the state. An ownership interest in a passthrough entity (e.g., an LP, LLC, or S corp.) that operates in Tennessee does not create a franchise and excise tax filing requirement for the owner.

However, because corporate-owned SMLLCs are disregarded, an ownership interest in an SMLLC with Tennessee nexus will subject the corporate member to FAE taxes. The same is true of an interest in a general partnership doing business in Tennessee. And, of course, if the partner or member otherwise is doing business in or has substantial nexus with Tennessee, that could independently create nexus.

Taxable income: In computing Tennessee net earnings, a passthrough owner’s federal taxable income must be adjusted for any item of income or loss attributable to a passthrough entity “which is subject to and files a return for the tax imposed by this part” (Tenn. Code §§67-4-2006(b)(1)(J) and (2)(L)). This is because the passthrough entity’s taxable income does not flow through to the passthrough owner. No adjustment is made for income or loss attributable to general partnerships, because general partnerships are not subject to Tennessee FAE tax at the entity level.

In contrast, for federal income tax purposes, passthrough entities are not generally the taxpayer. The income or loss of passthrough entities generally flows through to the individual or corporate partners. As a result, Tennessee’s conformity to federal taxable income differs based on whether the entity is taxed federally as a C corporation, S corporation, partnership, business trust, SMLLC owned by an individual or a general partnership, etc. (Tenn. Code §§67-4-2006(a)(1)-(9)).

For a federally disregarded but Tennessee regarded entity, Tennessee considers the classification of the federally disregarded entity to be the same classification as the entity it is regarded into (see, e.g., Tenn. Letter Ruling No. 11-46 (Sept. 12, 2011)). Therefore, if a federally disregarded LLC is disregarded into a partnership, the entity would compute federal taxable income for Tennessee excise tax purposes as if it were a partnership.

Apportionment factors: As with income or loss, apportionment factors do not flow through to upper-tier partners or members from limited liability passthrough entities that are subject to Tennessee FAE taxes and file the appropriate returns. In computing Tennessee apportionment, the statutes require only property, payroll, and sales related to general partnerships and to limited liability passthrough entities that are “not doing business in Tennessee and thus [are] not subject to Tennessee excise tax” to be added to the upper-tier partner’s or member’s factors (Tenn. Code §§67-4-2012(b), (e), and (g)).

Sales of interests in Tennessee regarded but federally disregarded entities

One of the many questions that arise due to the partial nonconformity to the federal entity classification rules concerns the Tennessee excise tax consequences of the sale of a federally disregarded, but Tennessee regarded, entity. Consider, for instance, an SMLLC owned by a limited partnership. For federal income tax purposes, the sale of a disregarded entity is treated as the sale of the entity’s assets. However, does the same result ensue for Tennessee excise tax purposes?

In other words, on the sale of the LLC interest:

• Does the LLC report the gain as an asset sale (as it is reported for federal purposes); or
• Does the partnership report the gain respecting the legal form of the transaction as the sale of an interest in an LLC (as the LLC is a taxable entity for Tennessee FAE purposes)?

The answer may significantly change the taxability of the transaction, as the upper-tier partnership may not separately have nexus with Tennessee. Therefore, if the partnership is regarded as selling the LLC interest, this transaction may not be taxed by Tennessee. If the LLC is regarded as the seller, the transaction would be taxed by Tennessee.

Tenn. Rev. Rul. No. 11-53 (Sept. 22, 2011) appears to obliquely address the issue. The facts in this ruling are complicated, but the key fact is that, as part of an overall transaction, an entity taxed as a partnership for Tennessee excise tax purposes sold an interest in a French entity (not an LLC). The French entity was federally disregarded but regarded for Tennessee FAE tax purposes. The ruling states that the entity taxed as a partnership “will not include in its Tennessee net earnings any gain from the Transaction that is attributable to” the French entity.

For federal purposes, as the French entity was disregarded, the sale would have been treated as a sale of the assets of the French entity. The revenue ruling might be interpreted as suggesting that the partnership’s federal taxable income was determined based on the federal classification of the French entity as a disregarded entity and not on Tennessee’s classification of it as a regarded entity. However, this is less than clear, and there is no explicit guidance from the Department of Revenue on this issue.

Therefore, taxpayers are advised to review their Tennessee filings closely to ensure the correct entity or combined group is filing and that sales of partnership or membership interests and other transactions with the federally disregarded or passthrough entities are properly analyzed for Tennessee FAE purposes.

EditorNotes

Mary Van Leuven, J.D., LL.M., is a director, Washington National Tax, at KPMG LLP in Washington, D.C.

For additional information about these items, contact Ms. Van Leuven at 202-533-4750 or mvanleuven@kpmg.com.

Contributors are members of or associated with KPMG LLP.

The information in these articles is not intended to be “written advice concerning one or more federal tax matters” subject to the requirements of Section 10.37(a)(2) of Treasury Department Circular 230 because the content is issued for general informational purposes only. The information is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser. The articles represent the views of the author or authors only, and do not necessarily represent the views or professional advice of KPMG LLP.