2009 Technical Corrections Bill: FONCE and Related Provisions

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1 CHATTANOOGA TAX PRACTITIONERS 2009 Technical Corrections Bill: FONCE and Related Provisions J. Leigh Griffith, J.D., LLM, CPA Waller Lansden Dortch & Davis, LLP 511 Union Street, Suite 2700 Nashville, TN September 16, 2009

2 Leigh Griffith is a partner at Waller Lansden Dortch & Davis, LLP and manages the firm's Tax practice. He has extensive experience in state and federal taxes and estate planning. Mr. Griffith is one of the approximately 650 Fellows of the American College of Tax Counsel; he has been recognized for his vast tax law experience in The Best Lawyers in America (Woodward White, Inc.) since 1995; and is listed in Mid-South Super Lawyers. Mr. Griffith earned his B.A., magna cum laude, from the University of Virginia. He earned his J.D. from Vanderbilt University, earned his LL.M. from New York University and is a CPA. J. Leigh Griffith, J.D., LLM, CPA Waller Lansden Dortch & Davis, LLP 511 Union Street, Suite 2700 Nashville, TN lgriffith@

3 Topics for Today on 2009 TDOR Technical Corrections Bill FONCE Developments: Definition of passive investment income for FONCE qualification has changed. Rents from Commercial and Industrial properties (which include residential rents of greater than 4 plex) are now disqualified. October 1 is fast approaching if your clients will no longer meet the income test and want to avoid the Franchise and Excise Tax on former FONCES. Two percent per month rents and penalty for excess rents. Draconian penalty for failure to report certain affiliated transactions

4 Generally Franchise and Excise Tax is Price of Limited Liability Tennessee imposes its franchise and excise tax on business entities that offer limited liability to its owners. There are exceptions to this general statement. The excise tax exceptions are generally found in TCA Section The franchise tax exceptions generally mirror the excise tax exceptions. TCA Section (a)

5 FONCE Exception Prior to July 1, 2009 TCA Section (a)(11) There shall be exempt from the payment of the excise tax: Family owned non-corporate entity where substantially all of the activity of the entity is either production of passive investment income or combination of production of passive investment income and farming. Family owned non-corporate entity ( FONCE )

6 FONCE Exception Prior to July 1, 2009 (Cont d) 95% of ownership units are owned by members of the family, which means with respect to an individual only: Ancestor of individual; Spouse or former spouse of individual; Lineal descendant of: Such individual Such individual's spouse or former spouse Parent of such individual Spouse or former spouse of any lineal descendants of above; Estate or trust of deceased individual who while living was described above. (modified in 2009)

7 FONCE Exception Prior to July 1, 2009 (Cont d) A legally adopted child of an individual shall be treated as the child of such individual by blood

8 FONCE Exception Prior to July 1, 2009 (Cont d) Passive investment income gross receipts derived from: Royalties Rents (subject to 2009 modification) Dividends Interest Annuities Sales or exchange of stock or securities to the extent of gains

9 FONCE Exception Prior to July 1, 2009 (Cont d) The measuring individual does not have to be an owner of the FONCE. Do not have to have more than one owner. Only Trust within family-owned definition is trust of deceased individual which TDOR interprets as testamentary trust. There is at least one person at TDOR giving guidance that is different. Believes it does not have to be testamentary trust. Unfortunately a lower level person and is contrary to TDOR position. See FAQ 49. Additional 2009 requirement/clarification?

10 FONCE Exception Prior to July 1, 2009 (Cont d) Substantially all = 66.67% or more of gross receipts from passive investment income or passive investment income plus farming. TDOR position if NO INCOME IN ANY GIVEN YEAR, INCOME TEST IS NOT SATISFIED. Open a savings account and have a dollar of interest income. Year-by-year test. Some years entity could qualify and other years not. Measure is gross receipts except for sale of stock and securities where net gains should be used

11 FONCE Exception Prior to July 1, 2009 (Cont d) No gain from the sale of real or personal property is passive investment income for purposes of the FONCE exception. Only sale gain that is passive is from the sale of stock or securities. Rents are not defined in statute. TDOR does not believe charges for hotel and motel rooms are rent for this purpose exclusion of certain rents

12 FONCE Exception Prior to July 1, 2009 (Cont d) "Farming" is defined in the statute as the growing of crops, nursery products, timber or fibers, such as cotton, for human or animal use or consumption; the keeping of horses, cattle, sheep, goats, chickens or other animals for human or animal use or consumption; or the keeping of animals that produce products, such as milk, eggs, wool or hides for human or animal use or consumption; or the leasing of the land to be used for the purposes herein described

13 FONCE Exception Prior to July 1, 2009 (Cont d) A general partnership with only passive investment income is owned by two limited partnerships. Each limited partnership is owned 100% by members of a family, but each limited partnership has different families. Each qualify for FONCE exception as general partnership is not taxable and its income retains character when passed to limited partnerships and each limited partnership satisfies family FONCE requirement

14 FONCE Exception Prior to July 1, 2009 (Cont d) TN-based Limited Partnership 1 has nothing but passive investment income. It is 95% owned by Limited Partnership 2, a TN LP which in turn is 100% owned by husband and wife. LP1 is not a FONCE as its 95% owner is a limited partnership. LP2 is not a FONCE as the character of income of an entity subject to TN tax does not pass through. Q&A 54 and trap for the unwary

15 FONCE Exception Prior to July 1, 2009 (Cont d) TDOR exemption may not be automatic. The FONCE must initially file an application for exemption with TDOR. Annual filing claiming exemption by 15 th day of 4 th month following the beginning of the tax year Act gives authority for position

16 Filings Required of FONCEs Application for Exemption Franchise and Excise Tax (when first form or qualify for exemption). Thereafter an annual exemption renewal: Due 15 th day of 4 th month of tax year; Includes Disclosure of Activity; Names of members or partners and relationship, Passive Investment income information, Includes appraised value of property (ties into new 2% per month rent provision), and Farming

17 Failure to File Application for Exemption Form and instructions presently do not have a due date Technical Corrections requires filing within 60 days of first tax year for which person claims exemption. TDOR says that failure to file the form may cause loss of exemption status and entity becomes liable for F&E tax if TDOR is unable to verify that the entity meets the qualifications for exemption

18 Failure to File Application for Exemption (Cont d) 2009 Technical Corrections made the exemption dependent on the filing of the application and the annual exemption renewal. Commissioner authorized to accept late filing (not required to accept). Late filing penalty of $1,000. Commissioner authorized to waive penalty, IN WHOLE OR IN PART, for good and reasonable cause

19 Failure to File Application for Exemption (Cont d) Person claiming exemption but fails to meet criteria for exemption is subject to all tax, penalty, and interest otherwise applicable under law. Initial and annual renewal and penalties not apply to person qualifying for exemption as: Industrial development corporation, Certain Masonic lodges, Certain RICs, Certain credit unions, TN historic property preservation or rehabilitation entities, Insurance companies defined in Section

20 2009 Technical Correction Act FONCE Changes Public Chapter No. 530 ( Act ) Section 28 reads: TCA Section (a)(1)(B), is amended by deleting the word rents from subdivision (iii) and by substituting instead the words rents from residential property or farm property

21 2009 Technical Correction Act FONCE Changes (Cont d) New subdivisions are added: (iv) Farm property and residential property shall have the same meaning as in Section except residential property shall include any property leased or rented for residential purposes that includes not more than four (4) residential units and farm property shall not include acreage used for recreational purposes by clubs including golf course playing hole improvements; [Section 28 of Act]

22 2009 Technical Correction Act FONCE Changes (Cont d) (v) ownership units that are held in trust shall not be treated as owned by members of the family, unless such ownership units are property of a trust described in subdivision (a)(11)(b)(i)(e); [Section 28 of Act] TDOR characterized as a clarification

23 2009 Technical Correction Act FONCE Changes (Cont d) Effective Date of Act Provisions concerning FONCEs, Section 133 of the Act provides that Sections are effective July 1, 2009, This is not tax years beginning on or after, this is an effective date. Ramification is the definition of passive investment income changed mid-year

24 2009 Technical Correction Act FONCE Changes (Cont d) Transition rule for FONCEs that qualified under pre-act law but not post-act law, if they want to elect OME status: Tax years beginning on or after July 1, 2008 but before October 1, 2009, the OME election shall be filed on or before October 1, 2009 with the SOS. All other tax years, appropriate documentation filed on or before the first day of the taxable year for which a return is filed

25 FONCE Ramifications of Act Must file within 60 days of creating a FONCE or becoming a FONCE or: Risk not qualifying for exemption, and Risk penalty of up to $1,000. Question, since FONCE qualification is an annual determination, if cease being a FONCE one year and think you will be one the next year, do you file Exemption Application (even though filed in past years?)

26 FONCE Ramifications of Act (Cont d) Rental income of commercial property (other than 4 plex or smaller residential rental) was good through end of June of 2009, but will not be good for remainder of year or future. Recomputed passive investment income for year. Confusing new language concerning trust of a deceased individual

27 If FONCE Status will be Lost, What are the Alternatives? Do nothing and pay the Franchise and Excise Taxes as cost of doing business and liability protection. Compute the tax cost and evaluate liability exposure. Will insurance cover most of exposure and what is cost? Elect unlimited liability via Obligated Member Entity ( OME ) filing and status. Convert FONCE into a general partnership. Liquidate and hold assets as tenants in common. Readjust the asset mix within the entity so that its income will satisfy the new requirements Addition of assets producing good income; Distribution of one or more pieces of commercial or industrial rental property to reduce the bad income Revise leases and lower bad rent

28 FONCE Exemption Preservation If have proper ownership; and As result of change in law or other reasons, will not have appropriate income by end of 2009 and cannot feasibly alter the asset mix to achieve such income: If do the math now and because the rents on commercial property were qualified until July 1 and if the entity qualifies as a FONCE now, can convert to a General Partnership; and/or

29 FONCE Exemption Preservation (Cont d) Even if not have qualifying income now, before Oct 1, 2009 have option to elect unlimited liability equivalent to that of a general partnership: Become an obligated member entity ( OME ); Requires specific filing filed at the SOS office with each member signing up for the liability; Note: slightly different election proceedings depending as to whether a limited partnership or an LLC

30 OME Election Selected Points Election by LP (b) Election by LLP (c) Election by LLC (d) The election is an amendment to the Articles of Organization or other organic document and must contain specific information and be signed by all obligated members. If all members are not obligated, will not qualify for exemption. Each Signature must be notarized for LP and LLP; Notarization not required but recommended for LLC

31 FONCE Exemption Preservation (Cont d) The filing with the SOS must be filed on or before Oct. 1, That means the SOS must process and date the filing on or before Oct. 1, Mailing it in on Oct. 1, 2009 will not work. There is no extension

32 What is an OME LLC, LP or LLP, all of whose members or partners are fully liable for the debts, obligations and liabilities of the entity as provided in (b)-(d), and that have filed appropriate documentation to that effect with the SOS (30)

33 OME is Broader than FONCE Rehabilitation An LLC, LP or LLP that was never a FONCE can avail itself of the OME exemption. An LLC, LP or LLP that was never a FONCE can do the appropriate filings before October 1 and escape TN Franchise and Excise tax for 2009 and subsequent years

34 GP or OME? If have option to be a general partnership or elect unlimited liability which should you do? Need to understand the differences; the liability is essentially the same (maybe): GP has right of contribution. May want OME to have that right. Recommend put in OPA or Articles. Not clear exists otherwise. GP has apparent authority (may not want that)

35 GP or OME? (Cont d) The OME remains a limited partnership or an LLC, LP or LLP. Structure of governance and rights of parties do not change (other than liability). May be a difference in a GP and an OME in valuation for estate tax purposes. If go OME, do not have to address governance and related matters as those do not change. If change entity forms, need to make sure that titles and insurance are modified if needed. If LP or LLP goes OME, specific provisions in partnership agreement are required and partnership agreement must be written

36 GP or OME? (Cont d) Since real estate is involved, there may be mortgages. The owners should determine if the loan is non-recourse and if not, weigh the impact of being liable on the loan if decide to be a GP or OME. Can the loan be modified to limit the individual exposure? Other strategies for reducing exposure?

37 GP or OME? (Cont d) If OME status is elected, owners will have to file the annual exemption report, file the annual report at the SOS, and pay the annual filing fee. If OME status is elected, identity of owners is disclosed in public record

38 If OME Status is Elected The form of exemption from Franchise and Excise Tax will change: Going from FONCE to OME; or General Partnership Remember the new rule that tax exemption is dependent on filing an Application for Exemption within 60 days. Recommendation file the Application for Exemption if go OME

39 OME and Tiered Arrangements If an OME has as a member/partner, an obligated member (LLC, LP or LLP) and all of the members/partners of the OME elect unlimited liability: OME will be subject to F&E Tax on portion of income and equity attributable to the obligated member if such member itself is not subject to an election. If the obligated member of the OME in turn elects OME status, the process of exemption continues with its owners then tested

40 Advisor Checklist or Disclosure If the owners of a FONCE determine to accept personal liability (OME or General Partnership), the advisor(s) may want to have standard disclosure and something the client(s) signs to protect advisor. OME required language and signing may go a long way. Minors present interesting situation. Do both the minor and the parent sign for minor? Hopefully UGMA applies

41 2% Per Month Rents The 2009 Technical Corrections Act added new Section (b)(1)(N): Amount in excess of reasonable rent for industrial and commercial property owned by an affiliate (whether or not subject to TN tax), is added back to determine taxable income. Reasonable rent means rent that does not exceed 2% per month of the property tax appraised value of the property

42 2% Per Month Rents (Cont d) If rent is more than the 2% per month, excess is not added back, and such failure is determined by the Commissioner to be due to negligence: Penalty equals 50% of the adjustment required; Penalty may be waived for good and reasonable cause

43 2% Per Month Rents (Cont d) Payments in lieu of rent such as property taxes, insurance and maintenance are treated as rent for purposes of the 2% limitation per the TDOR. Use property tax appraised value to compute the 2%. If made big improvements between appraisals, can apply to TDOR for a variance. Without variance, private appraisals do not count. 2% limitation applies to all affiliated lease payments paid or accrued on or after July 1, 2009 regardless of date of lease

44 2% Per Month Rents (Cont d) 2% per month does not require the presence of a FONCE. Only applies if rented to affiliate: Affiliate defined in % direct or indirect ownership. Unclear the reasoning by the TDOR for the 2% per month of assessed value: Probably great for real property; Maybe not so great for personal property. Rent may well fluctuate downward, particularly with respect to personal property leases

45 2% Per Month Rents (Cont d) Although rents greater than 2% per month are not deductible for purposes of determining Lessee s excise tax, the excess counts, according to the TDOR in FAQ for computing the franchise tax. Q.8. Are amounts in excess of reasonable rent includable as rent for purposes of determining the taxpayer s franchise tax basis and the taxpayer s franchise and excise tax apportionment ratios? Yes

46 Dramatic Penalty Increase Negligence Penalty / Intangible Expense Deductions and Dividend Received Deductions Public Chapter 530, Sections 31-32, sets a penalty of 50% of adjustment under TCA Section (d) or (e) with a minimum of $10,000 for failing to disclose transactions: involving an intangible expense deduction in a transaction with an affiliate; or a captive REIT dividend received deduction. The Commissioner is authorized to waive all or part of the penalty in certain circumstances. Effective date: Applies to any tax period beginning on or after January 1,

47 Dramatic Penalty Increase (Cont d) Any taxpayer that deducts intangible expenses arising from a transaction with one (1) or more affiliates must disclose such intangible expenses on the face of the franchise and excise tax return and complete the appropriate schedule as required by the commissioner. TCA Section The FONCE/OME may be receiving payments for intangible assets from an affiliate and if the affiliate does not disclose, the penalty can arise

48 Conclusion The law change has occurred. This is not just a 2010 potential issue, but a 2009 potential issue. The decision of what, if anything, to do needs to be made after analysis and discussion and for many implemented by October 1. Carefully document the action and meet the statutory requirements for any exception. Don t forget to Apply for Exemption if change basis for the exemption. Time is of the essence

49 Conclusion (Cont d) If insufficient time to decide and implement for 2009, cannot wait until 2010 if the entity desires to avoid the 2010 franchise and excise tax. Must be out of taxable solution before January 1 (for calendar year entities) or will be stuck with 2010 taxes