Tennessee Rentals and the FONCE Exemption

The FONCE Exemption is one of the most popular strategies individuals use when investing in rental real estate to avoid the Tennessee Franchise and Excise tax.

Just this past month we had a new client investing in the Volunteer State frustrated because they were being assessed additional taxes by the State of Tennessee. Obviously, this was a surprise to them as it is to many new rental property owners in Tennessee, and it’s because they missed the FONCE Exemption.

So, what do some people do to avoid the tax? They say… “I just won’t set up an LLC. That way I don’t even have to worry about this entire tax thing”. Bad move – That would be a mistake!

Don’t skip the LLC Structure

The limited liability company (LLC) is still the most affordable and effective asset protection when owning rental property in ANY State – hands down. However, it isn’t just one piece of paper either and simply paying for the ‘Articles’ to set up an LLC either.

There are several steps involved when setting up an LLC, and maintaining it, in order to actually get the asset protection you think you’re receiving. See “LLCs must do Annual Maintenance just like Corporations.”

Also, remember that if you’re going to own “rental property” in Tennesse in order to obtain asset protection at all you must either:

• Set up your LLC in Tennessee, or
• File with Foreign Registration “doing business” in Tennessee, with your LLC from another State.

This is absolutely required to make your LLC legit in Tennessee! Don’t find an article or someone that says differently. If they do, and I presume they’re not a lawyer, then next require them to stand behind their advice in writing – I know they won’t.

Bottom line, there’s a basic legal principle that underlies this position taken by our law firm, as well as many other reputable law firms across the country…it goes like this:

If I own a rental in Tennessee, then my tenants are in Tennessee, I pay property tax in Tennessee, and if the tenants or their guests get hurt on the rental property in Tennessee, which state law is going to be applied by the Court in the lawsuit? Delaware? Nevada? WRONG… Tennessee!

So first, get the LLC set up properly in Tennessee.

How much is the Tennesse Franchise and Excise Tax?

Next, if you don’t file the proper exemption, a Tennessee LLC is subject to a franchise and excise tax for the privilege of doing business in their State.

Tennessee imposes an excise tax at the rate of 6.5% on the net earnings of certain taxpayers doing business within Tennessee, pursuant to TENN. CODE ANN. § 67-4-2007(a) (Supp. 2010). Tennessee ALSO imposes a franchise tax at the rate of $0.25 per $100, or major fraction thereof, on the net worth of a taxpayer doing business in Tennessee, pursuant to TENN. CODE ANN. §§ 67- 4-2105(a) (Supp. 2010) and 67-4-2106(a) (Supp. 2010).

Now...in English…there are two taxes:

• Excise tax – 6.5% on net earnings (It’s unlikely you would ever pay this with a rental property due to depreciation write-offs, etc..)
• Franchise Tax – Pay attention, this WILL apply to you as a rental property owner! The tax is based on the entity’s net-worth, OR the book value of all real estate, and taxed at the rate of 25 cents per $100 of value (Example: You own a property with a Fair Market Value of $200,000. It doesn’t matter how much the mortgage is or your equity, just the FMV. Your Franchise Tax would be $500. $200,000/$100 x .25).

These taxes are reported and paid with Form FAE 170, due on April 15th each year, for the preceding year. See the FAE 170 Instructions for information on how to prepare and file this form – IF you have to.

The only way out of these two taxes is an exemption granted by the Tennessee Department of Revenue!

There are 10 possible Exemptions that exist to avoid paying these taxes. The Exemption that is most common for rental property owners in Tennessee, whether you’re a personal resident or not, is the “FONCE” (Family-owned non-corporate entity) exemption.

How to obtain the FONCE Exemption

• What to File. Taxpayers hoping to receive the FONCE Exemption must file Form FAE 183, titled “The TENNESSEE DEPARTMENT OF REVENUE Franchise and Excise Tax Application for Exemption/Annual Exemption Renewal.”
• When to File. Form FAE 183 is due by April 15th for the previous year. Otherwise stated, it’s due the 15th day of the 4th month following the close of your books and records. Due to the Covid Pandemic, the State of Tennessee granted an automatic extension to file this form from April 15, 2021, to May 17, 2021. 
• Is there a penalty for not filing Form FAE 183? Yes. Any entity that fails to timely file an application for exemption or renewal may be charged a $200 penalty, ON TOP of the taxes owed.
• What are the Requirements? There are two requirements to qualify for the FONCE exemption (both must be met):
• First, the activity of the entity must be passive in nature. Passive investment income is defined as gross receipts derived from royalties, rents, dividends, interest, annuities, and the amount of any gain on the sale or exchange or stock or securities. An entity can also qualify with a combination of passive income and farming income, AND
• Second, at least 95% of the ownership units of the entity must be owned by members of the family. As it relates to this test family is any lineal descendant, spouse, former spouse, estate or trust of a deceased individual who, while living, meet the relationship test.

Do LLC owners need to apply each year for the FONCE Exemption?

Yes. Once an LLC receives the Exemption, it needs to be renewed each year by April 15th. Essentially, the determination of whether the Taxpayer is exempt for Tennessee franchise and excise tax purposes pursuant to TENN. CODE ANN. § 67-4-2008(a)(11) is made on a year-by-year basis.

Thus, the Taxpayer must satisfy all of the same requirements set forth above with respect to each year for which it claims the exemption. If the ownership of the LLC changes to non-qualified parties (under the FONCE Exemption), or the purpose of the LLC is changed from passive activities, the LLC will not qualify for the prior year and be subject to the Franchise and Excise Tax.

If for some reason the entity fails to qualify for exempt status for a year then it is required to pay the franchise and excise tax based on the income of the company. However, if the next year it meets the above qualifications again it can become an exempt entity for that year.

Can my IRA or Solo 401k owned LLC obtain the FONCE Exemption?

Yes. In a Tennessee Department of Revenue (hereinafter “TDR”) Letter Ruling #11-43, the Commissioner stated specifically that if an IRAs are owned by the same family members (that would have qualified) under the FONCE exemption in the first place, the LLC will receive the FONCE exemption.

Example. A Tennessee LLC holding rental property exclusively, owned by the husband, wife, child, and parent (25% each), the family should be able to apply and receive the FONCE exemption and renew it each year thereafter. Conversly, if the same LLC investing in rental real estate was owned by husband’s IRA, wife’s Roth, child’s ESA, and grandparent’s HSA, irrespective of the percentages of ownership, the LLC would still qualify for the FONCE exemption.

Although a Solo 401k, HSA, Roth, ESA, or SEP for that matter, are not mentioned specifically in Letter Ruling #11-43, it’s a reasonable interpretation of Tennessee law that these types of tax-advantaged accounts would also qualify for the FONCE Exemption.

The TDR defines an IRA as a “custodial account established for the benefit of” an individual. Further, the Commissioner states that “in the case of a custodial account, the custodian does not have legal title to the property held in the account. Rather, title to the custodial property resides in the principal, i.e., the person for whose benefit the account was established. See, e.g., the Uniform Transfers to Minors Act, TENN. CODE ANN. § 65-7-113(d) (referring to custodial property as the “property of the minor”).

Further, the TDR recognizes that an IRA is essentially established for the benefit of an individual. A trust company then holds the interests (or assets, in this case, an LLC) in the IRA merely as a custodian for and on behalf of the individual. Accordingly, “the individual is the legal owner of the interests in the LLC.” (see TDR Letter #11-43 pg 4-5). Again, it’s also well recognized that a tax-advantaged account such as a Roth, HSA, SEP, SIMPLE, ESA, or Solo 401k, is also exclusively set up for the benefit of an individual and in effect acts just like an IRA. Hence, any custodian or trust company for a tax-advantaged account is merely holding the assets for the beneficiary, or investing the assets based on the direction of the beneficiary (as is the case with a self-directed IRA). See www.directedira.com.

Can a Revocable Living Trust own the LLC and qualify for the FONCE Exemption?

According to a published Q&A FONCE/OME Webinar from the Tennessee Department of Revenue, the question posed was: Can a family member of an LLC have interest in a revocable trust, which is considered a “disregarded entity” by the IRS and equivalent to the person? The answer was yes. A family member can have interest in a revocable trust, however, both entities are separate for state law purposes even though treated as disregarded for federal purposes.

Are long term capital gains from the sale of real estate considered passive income?

No. The capital gains from the sale of real property is taxable.

Does Commercial Rental Property qualify under the FONCE Exemption?

Regrettably, commercial property does not qualify for the FONCE Exemption. Under the “Technical Corrections Bill,” passed under Governor Bredesen and effective July 1, 2009, the FONCE exemption is no longer available to an LLC receiving substantially all of its income from the rental of “industrial and commercial property” or farm property used for recreational purposes. LLCs that receive substantially all of their income from these sources will become subject to franchise and excise taxes unless they qualify under another exemption.

So many then ask…what is considered “commercial” property. IDR has defined residential property as “any property that a municipality has designated for single-family homes, apartments, cooperatives, townhouses, and any other place where people live.” (see Q&A FONCE/OME Webinar).

What about 4-plexes? Tennessee now defines any property with more than 4 units as commercial property. Conversely, properties with 4 residential units or less will still be considered residential (duplexes and quadplexes still qualify as residential property). Therefore, rental income from these units will still qualify as passive investment income for purposes of the FONCE exemption gross receipts test.

What about short-term vacation rentals? These types of rentals still appear to qualify for the FONCE Exemption. Again, according to a published Q&A FONCE/OME Webinar from the Tennessee Department of Revenue, the question posed was: Is rent from short-term vacation rentals (which are zoned and taxed as residential property) passive investment income? ANSWER: Income earned from residential properties may qualify as passive investment income. Passive Income is defined as income earned from the rental property or an enterprise that the investor is not actively involved.

The issue with short-term rentals doesn’t appear to be a question of commercial property. They agree that a “short-term vacation rental’ more than likely going to be a residential property in a VRBO type situation and thus NOT commercial property.

However, the 2nd part of the test to obtain the FONCE exemption is that it must be passive income. The TDR defines passive income “as income earned from a rental property or an enterprise that the investor is not actively involved.” So apparently if the taxpayer is actively operating, cleaning, and running the vacation rental, they may not qualify for the FONCE Exemption. This will probably be determined on a case by case basis by the TDR.

In summary, if you live in Tennessee OR want to purchase a rental property in Tennessee please contact either our tax or legal team to help you set up and maintain your entity the correct way to minimize your tax.

Mark J. Kohler is a CPA, Attorney, Radio Show host, and author of the new book “The Tax and Legal Playbook- Game Changing Solutions For Your Small Business Questions”  and “What Your CPA Isn’t Telling You- Life Changing Tax Strategies”. He is also a partner at the law firm Kyler Kohler Ostermiller & Sorensen, LLP, and the accounting firm K&E CPAs, LLP. For more information visit him at www.markjkohler.com