Tennessee upholds flow-through exception, settlement proceeds apportionable

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June 2020

Overview

The Tennessee Court of Appeals on June 1 ruled that an LLC parent, taxed as a partnership for federal income tax purposes, could not determine its Tennessee excise tax liability on a consolidated basis with its disregarded LLC subsidiaries. Tennessee generally does not follow federal disregarded tax classification rules and requires disregarded LLCs that have nexus with Tennessee to file separate corporate excise tax returns. An exception applies when a disregarded LLC’s parent is a person that is taxed as a corporation for federal income tax purposes. 

The Court ruled that since the parent LLC was not a corporation, the disregarded LLCs beneath it did not qualify as disregarded entities for Tennessee excise tax purposes and were required to file at the separate-entity level. Further, the court held that allowing disregarded entity status only for LLCs owned by a corporation did not violate equal protection as required by both the United States and Tennessee Constitutions.

Also at issue was the treatment of income received from the settlement of a legal malpractice lawsuit involving the registration of intangibles owned by the LLC parent. The Court disagreed with the taxpayer’s argument that the income qualified as allocable, nonbusiness income and held that the income was apportionable business income. Further, the taxpayer failed to demonstrate that it even had a right to apportion its income as it was unable to demonstrate that it was taxable in another state.

Finally, the Court ruled that a 10% negligence penalty was appropriately applied to the additional tax that resulted from the deconsolidation of the three LLCs; however, the 10% negligence penalty assessed for the nonbusiness position was abated.

The takeaway

The court’s findings in this case seem straightforward.  The Court viewed the statutory language limiting disregarded entity status only to LLCs whose single member is a corporation as unambiguous. While straightforward, the case highlights the fact that Tennessee consistently poses a risk to taxpayers due to its unique approach of taxing nearly all business entities that afford limited liability protection to their owners. 

Interestingly, had either of the single-member LLCs in this case not had nexus with Tennessee, that LLC would have been ‘consolidated’ with the parent entity —   another quirk in Tennessee tax law.

The equal protection argument was interesting; however, the Court’s reasoning demonstrates why equal protection arguments seldom have succeeded in tax cases.  Courts generally have viewed the standard required to sustain a tax classification against an equal protection challenge as being quite low, rendering successful challenges to tax provisions difficult in most instances.

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Peter Michalowski

State and Local Tax Leader, PwC US

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