Tennessee generally imposes franchise and excise taxes on all entities that provide limited liability protection and, therefore, does not follow federal tax law regarding the default classification of a single-member limited liability company (SMLLC) being a disregarded entity. An SMLLC that is owned 100% by a corporation is disregarded for Tennessee franchise and excise tax purposes. Tenn. Code Ann. § 67-4-2007. One question that sometimes comes up for multi-tiered entities is whether an SMLLC whose sole member is a limited liability company (LLC) that has checked the box to be treated as a corporation for federal tax purposes is disregarded for Tennessee franchise and excise tax purposes pursuant to the foregoing statutory rule.

It has been broadly thought in the Tennessee taxpaying community that when an LLC checks the box to be treated as a corporation, any SMLLC under that parent LLC is disregarded for Tennessee franchise and excise tax purposes under Tenn. Code Ann. § 67-4-2007(d). This was largely attributable to Tennessee's limited liability company law, which specifically provides that:

For purposes of all state and local Tennessee taxes a domestic or foreign LLC shall be treated as a partnership or an association taxable as a corporation, as such classification is determined for federal income tax purposes. Tenn. Code Ann. § 48-249-1003.

In addition, Tennessee excise tax law provides that “[f]or purposes of the excise tax levied by this part, a business entity shall be classified as a corporation, partnership or other type of business entity consistent with the way the entity is classified for federal income tax purposes.” Tenn. Code Ann. § 67-4-2007(d).

Based on recent informal guidance from Tennessee Department of Revenue, however, it appears that the Department is now taking the position that an LLC checking the box to be treated as a corporation for federal tax purposes is not a “corporation” for purposes of determining whether an SMLLC is owned 100% by a corporation and is, therefore, disregarded.

The Department is apparently relying on the second sentence of Tenn. Code Ann. § 67-4-2007(d) which starts off “notwithstanding any provision of law to the contrary, entities that are disregarded for federal income tax purposes, except for limited liability companies whose single member is a corporation, shall not be disregarded for Tennessee excise tax purposes.” By construing the term “corporation” narrowly, in reliance on the “notwithstanding” language, the Department is changing prior guidance that had been given to taxpayers on what was widely believed to be the Department's policy on this issue that an entity checking the box could qualify as a “corporation” such that any SMLLC under the entity would be disregarded for Tennessee tax purposes.

Based on this new position, an SMLLC that is owned by an LLC that is taxed as a corporation for federal tax purposes is a separate taxpayer for franchise and excise tax purposes. Only if an SMLLC is owned by a state-law corporation will the SMLLC be disregarded for franchise and excise tax purposes.

This change in policy will not, however, alter Departmental guidance that a multimember LLC that is disregarded for federal income tax purposes will also be disregarded for Tennessee franchise and excise tax purposes if its owners are two disregarded SMLLCs that are, in turn, owned by a disregarded SMLLC that is itself owned by a single corporation. See Tenn. Ltr. Rul. 11-46 (9/12/11). This top-down analysis can still result in a SMLLC being disregarded in these limited circumstances.

Practice Pointer: Multi-tiered organizations that have not been filing Tennessee F&E returns for SMLLCs owned by LLCs checking the box to be treated as a “corporation” for federal tax purposes should evaluate current filing positions to determine what impact the Department’s new position will have on returns filed in Tennessee. The economic impact of this change will vary depending on the facts of a given situation, but a real problem could exist when one LLC is operating at a loss and the other is operating at a gain. In that case, the Department’s position could result in an increase in the amount of taxable net earnings because the losses will be unavailable to offset net earnings.

This article was published in Business Entities, Volume 14, No. 4 (WG&L July/August 2012).