United States: Important Notice For Family-Owned Investment Entities

Effective on June 28, 2000, the Tennessee legislature passed technical corrections legislation (the "Corrections Act") amending certain provisions of the Tax Revision and Reform Act of 1999 (the "Act"), which generally subjected all limited liability entities (e.g., limited partnerships, limited liability companies, professional limited liability companies, limited liability partnerships, etc.) to the Tennessee Franchise and Excise Tax (the "F&E Tax"). Among the amendments is a new exemption for family-owned investment entities.

The Act required most entities (other than general partnerships) operating or owning property in Tennessee to pay: (i) the Tennessee excise tax, which is levied at a six percent (6%) rate on the entity’s net earnings from business conducted in Tennessee, subject to certain adjustments, and (ii) the Tennessee franchise tax, which is calculated at a rate of $0.25 per $100 of the value of the greater of: (a) the entity’s net worth for financial accounting purposes (as apportioned to Tennessee) or (b) the book value of the entity’s property located in Tennessee. Following passage of the Corrections Act, however, "any family-owned non-corporate entity where substantially all the activity of the entity is the production of passive investment income" is exempt from the F&E Tax.

The Corrections Act defines a "family-owned" entity as an entity in which at least 95% of the ownership units are held by members of a single family, which includes an individual’s ancestors, spouse or former spouse, lineal descendants, the spouse or former spouse of any lineal descendant or the estate or trust of a deceased individual who while living qualified under one of the foregoing provisions. The Corrections Act then defines passive investment income as "gross receipts derived from royalties, rents, dividends, interest, annuities, and sales or exchanges of stock or securities to the extent of any gains therefrom."

Although the new exemption is intended to exempt most family investment entities from the F&E Tax, taxpayers should be aware that the new exemption contains some anomalies. For example, while the definition of passive investment income includes rental income, it does not specifically list gains from the sale or exchange of assets that give rise to rental income (e.g., real estate) as a type of passive investment income. It is our understanding that this anomaly is simply a drafting error and that the authors intended to encompass passive, family-owned real estate investment entities. Nevertheless, under a technical reading of the language contained in the statute, one could conclude that this exemption does not apply to entities that derive a substantial portion of their income from sales of investment real estate. The definition of "passive investment income" also lacks any reference to or description of the term "passive." Consequently, it is not clear what level of activity within a family-owned entity would be permissible under the exemption. Finally, while the effective date of the new exemption is June 28, 2000, it is not clear whether the exemption would apply to the entire 2000 taxable year of a calendar year family-owned entity.

Regardless of the ambiguities in the exemption, it represents a significant change in the F&E Tax benefitting family investment entities. Accordingly, participants in family investment entities should review their situation to see if they qualify for the exemption or if planning opportunities are available.