End of the Road

New Tax Law Closes FONCE Exemption: Fresh Strategies Needed for Clients with Family-Owned Companies

The FONCE

Prior to July 1, 2009, "Family Owned" "Non-Corporate Entities," the activity of which was "Substantially All" "Passive Investment Income," did not pay any Tennessee franchise and excise taxes. This tax exemption was referred to as the Family Owned, Non-Corporate Entity Exemption or FONCE, and was codified at the former Section 67-4-2008(a)(11) of the Tenn. Code Ann. as it applies to the excise tax and referenced in section 67-4-2105(a) of the code as it applies to the franchise tax. To refresh your memory regarding the terminology, "Non-Corporate Entities" include limited liability companies (LLCs), limited partnerships (LPs), and limited liability partnerships (LLPs). Furthermore, an entity was "Family Owned" if 95 percent of the ownership interest was held by the members of one family group. The term "Substantially All" has been interpreted as being at least 66.67 percent. Lastly, "Passive Investment Income" consists of rents, royalties, dividends, and interest, and includes farming income.
 
The FONCE tax exemption applied to the state franchise tax and to the state excise tax. The franchise tax is a state business tax calculated at the rate of 25 cents per $100 of net worth of an entity (with a minimum tax of $100), and the excise tax is a state business tax determined at the rate of 6.5 percent of the entity's income.
 
Relationship of the FONCE to Estate Planning
In the estate planning arena, the FONCE exemption was a key component in convincing clients to use Tennessee noncorporate entities to shelter estate taxes, to manage and operate family-owned assets for the benefit of all family members, and to transfer the assets to the next generation. To accomplish such estate planning objectives, the practitioner primarily formed either a family limited partnership (FLP), which is a limited partnership owned primarily by the members of one family, or a family limited liability company (FLLC), which is a limited liability company owned primarily by the members of one family.
 
  
Prior to July 1, 2009, either an FLP or an FLLC formed under Tennessee law would have more than likely qualified for the FONCE exemption from state franchise and excise taxes. The FONCE exemption had been the law since June 17, 1999, when the General Assembly extended the corporate franchise and excise taxes to LLCs, LPs, and LLPs, yet exempted family owned, noncorporate entities from the corporate taxes.
 
Impact of the FONCE on State Revenues
In June 2008, the Tennessee Department of Revenue mailed all LLCs, LPs, and LLPs a Franchise and Excise Tax Family-Owned Noncorporate Entity Disclosure of Activity Form (2007 Disclosure Form) requiring the noncorporate entity to disclose the types of assets owned by the entity during the 2007 fiscal year. The noncorporate entity was required to disclose whether or not its assets were comprised of commercial or industrial real estate.
 
  
The 2007 Disclosure Form was not just the result of the curiosity of a few state bureaucrats. The purpose of the 2007 Disclosure Form, according to a Department of Revenue notice, was "so the Department may obtain the data necessary to report to the General Assembly information concerning the utilization, costs and benefits of the FONCE exemption." In other words, the Department of Revenue used the 2007 Disclosure Form to calculate how much tax revenue was being forfeited by the FONCE exemption.
 
  
In March 2009, the Department of Revenue published its Report on Family-Owned Non-Corporate Entities based on the information gathered by the 2007 Disclosure Forms. In the publication, Department of Revenue Commissioner Reagan Farr reported to the Tennessee General Assembly that the current FONCE exemption "allowed more than 3,200 entities to shield more than $5 billion in commercial real estate properties from franchise and excise tax" and that the "loophole results in estimated lost revenue of $25 million" annually. One of the primary arguments espoused in the report, other than the loss in revenues, in favor of closing the "loophole" was one of "fundamental fairness." In a nutshell, noncorporate entities comprised of unrelated owners paid the franchise and excise tax whereas noncorporate entities comprised of related owners did not. Despite this argument, the Department only recommended removal of the FONCE for commercial real estate, not all real estate.
  
The General Assembly heard the message loud and clear.
 
The New Law Closes the 'Loophole'
On or about June 18, 2009, the General Assembly passed Senate Bill 2318, which was signed into law by Gov. Phil Bredesen on June 25, 2009. The new law, which is commonly referred to as the Technical Corrections Act of 2009, modified the FONCE exemption, thereby closing the "loophole" and recapturing the "lost revenue."
  
Under the new law, effective July 1, 2009, the FONCE exemption is no longer available for a noncorporate entity if more than 33.33 percent of the entity's income is received from the rental of commercial, industrial, multi-family residential (five or more residential units per property) or club-owned recreational real estate. In other words, rents from commercial, industrial, multi-family residential (five or more residential units per property) or club-owned recreational real estate are no longer classified as "Passive Investment Income."
 
Impact of the New Law on Existing Estate Plans
Since the enactment of the FONCE exemption in 1999, Tennessee estate planning practitioners have formed thousands of FLPs and FLLCs, the assets of which consisted of commercial, industrial, multi-family or club-owned recreational real estate. Many clients transferred such assets to FLPs and FLLCs from general partnerships, from joint ownership with other family members, from tenancies by the entirety among husbands and wives, and from individual, sole names. The transfer was a "no-brainer." The clients gained limited liability, the opportunity for estate tax reduction through valuation discounts, and a mechanism for management of family owned assets for future generations, yet owed no additional state franchise or excise taxes in exchange for such benefits.
 
  
With the modification of the FONCE exemption, if the substantial activity of such FLPs or FLLCs consists of rents from commercial, industrial, multi-family, or club-owned recreational real estate, then the FLP or FLLC will not qualify for the FONCE exemption and therefore will have to pay the state franchise and excise taxes.
 
New Filing and Reporting Requirements
Furthermore, the new law imposes on FLPs and FLLCs the following additional state filing requirements (the FONCE filing and reporting requirements):
  • Initial Application for Exemption from Franchise and Excise Taxes (RV-F1319201) to be filed within 60 days of the first day of the first tax year in which the exemption is claimed;
  • Franchise and Excise Tax Annual Exemption Renewal (FAE 183) to be filed on or before the 15th day of the fourth month following the close of the entity's taxable year (April 15 for most); and
  • Franchise and Excise Tax Exempt Entity Disclosure of Activity (RV-R1320501) to be filed on or before the 15th day of the fourth month following the close of the entity's taxable year (April 15 for most).
Trusts as FONCE Family Members
The new law clarified whether or not a trust is a family member for purposes of the FONCE exemption. Only trusts of deceased family members qualify. For example, if a family member owned an interest in a FLP or FLLC while living, and if the family member then died, and if the family member bequeathed the interest to a trust established upon the death of the family member under the deceased family member's Last Will and Testament or revocable grantor trust for the benefit of any surviving heirs, then the trust would qualify as a family member for the FONCE exemption. In other words, testamentary trusts qualify.
 
  
Based on the definition referenced in the new law, inter-vivos trusts or trusts created during the lifetime of the family member do not qualify. For example, if the family member created a revocable grantor trust, and then funded the revocable grantor trust with his or her interest in the FLP or FLLC during the family member's lifetime, then the revocable grantor trust would not qualify as a family member under the FONCE rules and therefore the FLP or FLLC would not be exempt from franchise or excise taxes on that basis. As further example, if the family member established an irrevocable minor's, gift or educational trust for a member of the younger generation, and then gifted the family member's interest in the FLP or FLLC to the inter-vivos, irrevocable trust, then the irrevocable trust would not qualify as a family member under the FONCE rules and therefore the FLP or FLLC would not be exempt from franchise or excise taxes on that basis.
 
  
This clarification will curtail the number of options available when developing and implementing a gifting strategy for estate tax reduction purposes. For example, the basic strategy of forming a FLP and then gifting FLP units to an irrevocable trust for the benefit of either a minor, disabled or spendthrift family member remains available to the practitioner and client " but with a price, the price being the payment of franchise and excise taxes if the gifted interests exceed 5 percent of the total ownership.
 
  
Furthermore, this clarification is a reminder that more than 5 percent of the total ownership of a FLP or FLLC qualifying for the FONCE exemption cannot be held by a revocable grantor or "living" trust. If the owner wants to satisfy both goals of probate avoidance at death and compliance with the FONCE rules, then the ownership interest in the FLP or FLLC would need to be held in the individual name of the owner with a Transfer On Death (TOD) designation on the certificate or the FLP or FLLC organizational documents would need to address the transfer of units upon the death of an owner.
 
Planning Options
In light of these changes in the law, owners and managers of FLPs and FLLCs will need to examine the status of their non-corporate entities.
The following modified decision tree will assist owners and managers of FLPs and FLLCs to determine the status of their entities and to develop a plan for addressing the changes in the law.
 
Owners and managers should ask the following questions:
1. Is more than 33.33 percent of the income of the FLP or FLLC derived from the rental of commercial, industrial, multi-family, or club-owned recreational real estate?
A. If no, then the FLP or FLLC continues to qualify for the FONCE exemption.
i. The FLP or FLLC is exempt from state franchise and excise taxes.
ii. The FLP or FLLC must comply with the FONCE filing and reporting requirements.
iii. The FLLC must continue to file an annual report with the Secretary of State and pay the annual report fee.

B. If yes, then the FLP or FLLC no longer qualifies for the FONCE exemption. Go to 2.

2. If the FLP or FLLC no longer qualifies for the FONCE exemption, then which of the following options is best for the FLP or FLLC and its owners and managers?
A. Pay. The FLP or FLLC can retain its existing structure and pay the taxes. The pros of this option are: the asset protection benefits of the FLP or FLLC are retained; and no expense is incurred for dissolving and terminating the FLP or FLLC or for transferring the real estate to the owners or to another entity. The cons of this option are: the franchise and excise taxes must be paid; the FLP or FLLC must comply with the FONCE filing and reporting requirements; and the FLP or FLLC remains subject to any future taxes or fees levied by the State of Tennessee on such entities.

B. Elect & Waive. The new law permits owners of an FLP or FLLC to elect "Obligated Member Status" thereby waiving any and all limited liability protection afforded the owners by the FLP or FLLC. An "obligated member entity" is defined in section 67-4-2004(28) of the Code as an LLC, LP or LLP whose members are fully liable for the debts of the entity. The FLP or FLLC could elect "Obligated Member Status" and retain its existing structure. The election process is outlined in section 67-4-2008(d) of the Code. Basically, the election is made by amending the FLP's certificate or the FLLC's articles with the Tennessee Secretary of State and declaring in the amendment that the owners are personally liable for the debts, obligations, and liabilities of the entity. To preserve the FONCE exemption for the 2009 tax year, the obligated member status election must have been made on or before Oct. 1, 2009. Obviously, that date has now passed. To qualify for the FONCE exemption for years 2010 and later, the obligated member status election would have to be made on or before the first day of the next tax year for which the FONCE exemption is sought. The pros of this option are: no expense is incurred for dissolving and terminating the FLP or FLLC or for transferring the real estate to the owners or to another entity; and no franchise or excise taxes are paid. The cons of this option are: an expense is incurred for amending the certificate or articles; the FLLC must continue to file an annual report with the Secretary of State and pay the annual report fee; the FLP or FLLC must comply with the FONCE filing and reporting requirements; and the FLP or FLLC remains subject to any future taxes or fees levied by the State of Tennessee on such entities; and the owners lose the personal asset protection benefits of the FLP or FLLC.

C. Dissolve. The owners can dissolve and terminate the FLP or FLLC, distribute the real estate to the owners individually, and then purchase additional liability insurance to cover the loss in asset protection. The pros of this option are: no franchise or excise taxes are paid since individuals are not subject to such taxes; and no FLP or FLLC exists to be subject to any future taxes or fees levied by the State of Tennessee on such entities. The cons of this option are: an expense is incurred for dissolving and terminating the FLP or FLLC and for transferring the real estate to the owners; an expense is incurred for purchasing additional liability insurance; the owners lose the personal asset protection benefits of the FLP or FLLC; and, if the owners sell the real estate within 12 months of the distribution of the real estate to the owners, then the owners owe excise tax on any realized capital gain.

D. Convert. The FLP or FLLC can be converted to a general partnership, and additional liability insurance can be purchased to cover the loss in asset protection. The pros of this option are: no franchise or excise taxes are paid since a general partnership is not subject to such taxes; and no FLP or FLLC exists to be subject to any future taxes or fees levied by the state of Tennessee on such entities. The cons of this option are: an expense is incurred for converting the FLP or FLLC to a general partnership and for transferring the real estate to the new entity; an expense is incurred for purchasing additional liability insurance; and the owners lose the personal asset protection benefits of the FLP or FLLC.

E. Remove. The owners can remove some or all of the commercial, industrial, multi-family, and club-owned recreational real estate from the FLP or FLLC so that the FLP or FLLC would meet the "substantially all" test. For example, if the income of an FLP or FLLC is derived 40 percent from commercial real estate and 60 percent from agricultural real estate, then the FLP or FLLC would not qualify for the FONCE exemption since less than 66.67 percent of its income is derived from agricultural real estate. The owners could distribute to themselves all or part of the commercial real estate only (retaining the agricultural) so that more than 66.67 percent of its income is derived from farming, and then the FLP or FLLC would qualify for the FONCE exemption. The pros of this option are: no franchise or excise taxes are paid since the FLP or FLLC no longer meets the "substantially all" test; the owners retain the asset protection benefits of the FLP or FLLC for the retained real estate; and no expense is incurred for dissolving and terminating the FLP or FLLC. The cons of this option are: an expense is incurred for transferring the removed real estate to the owners or to a new entity; an expense is incurred for purchasing additional liability insurance to protect the removed real estate; the owners lose the personal asset protection benefits of the FLP or FLLC for the removed real estate; and, if the owners sell the removed real estate within 12 months of the distribution of the real estate to the owners, then the owners owe excise tax on any realized capital gain.

F. Divide. The owners can divide the FLP or FLLC into multiple entities based on the types of income received and types of real estate owned by the FLP or FLLC. For example, if the income of an FLP or FLLC is derived 30 percent from commercial real estate, 5 percent from industrial real estate, 20 percent from farming, and 45 percent from non-multi-family residential real estate, then the FLP or FLLC would not qualify for the FONCE exemption. The owners could form a new FLP or FLLC and then transfer the commercial real estate to the new FLP or FLLC. The old FLP or FLLC would then qualify for the FONCE exemption since substantially all of its income would be derived from the non-multi-family residential real estate and farming (92.85 percent).

G. Sell. The FLP or FLLC can sell all of its Tennessee commercial, industrial, multi-family and club-owned recreational real estate. The FLP or FLLC could then either purchase non-multi-family or agricultural real estate located in Tennessee to be owned by the FLP or FLLC, or form a new entity in another state with more tax-friendly laws and then purchase commercial, industrial, multi-family and club-owned recreational real estate located in the tax-friendly state. The pros of this option are: no franchise (except for the minimum) or excise taxes are owed since the FLP or FLLC owns no assets and has no income. The cons of this option are: U.S. tax liability for any realized capital gain; disruption of the FLP's or FLLC's existing business plan; the FLP or FLLC remains subject to any future taxes or fees levied by the State of Tennessee on such entities, unless it is dissolved and terminated; and Tennessee excise tax liability for any realized capital gain.

H. Elect, Waive and Then Sell. The FLP or FLLC could elect "Obligated Member Status" and then sell all of its Tennessee commercial, industrial, multi-family and club-owned recreational real estate. If the FLP or FLLC qualified for the FONCE exemption prior to July 1, 2009, and then had elected "Obligated Member Status" on or before October 1, 2009, then the rule that requires the payment of excise tax on any realized capital gain would not apply since the FLP or FLLC was never subject to taxation.

I. Trust Transfer. The owners can dissolve and terminate the FLP or FLLC, and then distribute the real estate to a non-business trust. A business trust is subject to franchise and excise taxes, whereas a non-business trust is not. The Code defines the term "business trust" in sections 67-2-104(e)(16)(A)(iv) and 48-101-202(a). If a trust issues transferrable certificates, then it is a business trust. In other words, if investors can own interests in a trust, then it is a business trust. Therefore, a trust with beneficiaries whose beneficial interests are not transferable is not a business trust and would not be subject to the franchise and excise tax. If the non-business trust is revocable, then, in accordance with section 505 of the Uniform Trust Code, the assets are subject to the claims of the creditors of the settlors. See Tenn. Code Ann. Section 35-5-505(a)(1). If the non-business trust is irrevocable, then the Uniform Trust Code provides that the assets are subject to the claims of the creditors of the settlors only to the extent that the assets can be distributed to or for the benefit of the settlors. See Tenn. Code Ann. Section 35-5-505(a)(2). If the non-business trust is an irrevocable trust formed under the Investment Services Act, then the assets would not be subject to the claims of the creditors of the settlors if the trust and the transfers complied with the requirements for the establishment of a Tennessee Asset Protection Trust or TAPT. Non-business trust variations are numerous and can be tailored to the specific needs of the family owners and assets.
The planning option selected will vary based on the purpose, revenues, assets, and owners of a specific FLP or FLLC.
 
Conclusion
The modification of the FONCE is a continuation of a trend by the state of Tennessee to close perceived tax loopholes and augment revenue collections. Existing FLP's and FLLC's have planning options available to avoid the resulting levy of the franchise and excise tax, although none of the options are as beneficial as the prior, unmodified FONCE exemption.

 


OLEN M. “MAC” BAILEY JR. OLEN M. “MAC” BAILEY JR. is the founding member of The Bailey Law Firm PC, in Memphis. He concentrates his legal practice in the ares of wills and trusts, estate taxation and planning, asset protection planning, charitable gift planning, business succession planning, elder law and estate administration and probate. He received his law degree from Vanderbilt University School of Law in 1989. He is an alumnus of the Institue for Comparative Political and Economic Systems at Georgetown University, and of the London School of Economics, London, England. Bailey is an accredited estate planner and is licensed to practice law in Mississippi and Tennessee.