Tennessee Franchise & Excise Tax Update

Deduction for “Reasonable Rents”

Bryce M. Kirksey

If you currently have a rental agreement between affiliated persons or affiliated entities ("affiliates") or are considering entering into such an agreement, you need to plan properly for the new “reasonable rent” provisions in Tennessee. 

Recently, Governor Bredesen signed into law legislation that could affect the tax implications for organizations subject to the payment of the Tennessee franchise and excise (“F&E”) tax that have or enter into rental agreements with affiliated entities.  This new legislation, effective July 1, 2009 for all rental agreements regardless of the date of the agreement, limits the amount of rents that can be deducted in computing the F&E tax.

Prior to this law change, any amount of rents paid to an affiliated entity could be deducted for F&E purposes.  This presented a planning opportunity whereby one entity, exempt from the F&E tax, would receive rent payments from its related taxable entity so that a deduction for rents would be created.  The law now states that only “reasonable rent” can be deducted by a taxpayer, regardless of whether the “affiliate” to which the taxpayer pays rent is subject to the F&E tax.

“Reasonable rent” is defined as 2% per month (i.e., 24% annually) of the appraised property tax value of the property.   It includes any payments transferred between the taxpayer and an affiliate, including payments for taxes, insurance, and maintenance.  An “affiliate” is a member of a group of companies with more than 50% of common ownership.  It is important to note that this limitation applies regardless of whether someone is subject to, or exempt from, the F&E tax.

 If you have any questions regarding the application of the new “reasonable rent” provisions, please contact a member of our Real Estate or Tax and Estate Preservation Practice Areas.

Twelve-Month Rule for Obligated Member Entities

Recently, Governor Bredesen signed into law legislation that amended the application of the Tennessee franchise and excise (“F&E”) tax as it relates to a family-owned noncorporate entity (“FONCE”).  Effective July 1, 2009, the definition of passive income is modified to exclude rents received from commercial property.  A FONCE that originally qualified for F&E tax exemption under the old rule may lose its exemption, because rental income from commercial real estate no longer is considered passive income.

To avoid loss of exemption, you may be considering an election to become an obligated member entity (“OME”).  To become an OME, a limited liability entity (e.g., limited partnership, limited liability partnership, or limited liability company) must amend its charter or articles to relinquish the liability protection for all of its members.  In essence, members of a limited liability entity must elect to be treated as partners in a general partnership.  The cost-benefit analysis is that the cost of additional insurance premiums to insure against the risk of personal liability could be less than the amount of potential F&E tax.

While electing OME status could be beneficial for an entity to cut tax costs, an additional factor needs to be weighed.  Once an entity makes an OME election and becomes exempt from the F&E tax, any assets sold during the 12-month period beginning on the date that the OME election becomes effective will be subject to the F&E tax at a rate of 6.5%.  In other words, by electing OME status for your entity, you will need to wait at least one year before you sell any assets in order to benefit from the OME election.

If you have any questions regarding the application of the 12-month rule, or if you would like additional advice on weighing the factors for the organizational structure of your entity, please contact a member of our Real Estate or Tax and Estate Preservation Practice Areas.