The Tennessee Court of Appeals held that a single member limited liability company (SMLLC) that is disregarded for federal income tax purposes is regarded for Tennessee excise tax purposes unless its single member is classified as a corporation for federal income tax purposes. The court also held that proceeds from the settlement of a legal malpractice claim constitute “business earnings” subject to excise tax where the proceeds represent lost business revenue. EmeraChem Power, LLC v. Gerregano, No. E2019-00292-COA-R3-CV (Tenn. Ct. App. June 1, 2020).
EmeraChem Holdings, LLC (Holdings), a limited liability company (LLC) treated as a partnership for federal income tax purposes, was the single member of EmeraChem Power, LLC (Power) and EmeraChem, LLC (EmeraChem), both of which were disregarded for federal income tax purposes. Holdings held and managed patents and purchased precious metals that EmeraChem used in manufacturing. Power provided engineering, design, and testing services.
Holdings elected to compute its Tennessee franchise tax on the basis of consolidated net worth; however, Holdings filed its initial Tennessee franchise and excise tax (F&E) returns as a consolidated return for franchise and excise tax purposes, including Power and EmeraChem’s net worth, assets, and income in its tax computations. Power and EmeraChem, for their part, filed minimum F&E returns. When the Tennessee Department of Revenue (DOR) objected, the companies filed separate amended F&E returns, but they eliminated certain intercompany transactions from their Tennessee excise tax computations. DOR rejected the returns on the grounds that a consolidated return is permissible for Tennessee excise tax purposes only if the single member of a disregarded SMLLC is a corporation. DOR also reclassified as taxable “business earnings” certain proceeds that Holdings had received in settlement of a legal malpractice claim involving the registration of a patent in Europe.
The Tennessee Court of Appeals upheld both of DOR’s adjustments. As to the first issue, the court said that Tenn. Code Ann. § 67-4-2007(d) and Tenn. Comp. R. & Regs. 1320-06-01-.40 were clear: SMLLCs that are disregarded for federal income tax purposes are regarded for Tennessee excise tax purposes except where the single member is classified as a corporation for federal income tax purposes. Because Holdings was classified as a partnership, not a corporation, for federal income tax purposes, Power and EmeraChem were required to compute their Tennessee excise tax on a separate-entity basis and file separate F&E returns.
The court rejected the taxpayers’ equal protection claims under the federal and state constitutions. Applying rational basis scrutiny, the court found that the statute rationally advanced the state’s legitimate objectives in reducing the risk of business earnings underreporting and increasing transparency by requiring more disregarded SMLLCs to file separate F&E returns. Although the court agreed with the taxpayers that disregarded SMLLCs whose single member is an S corporation would receive preferential treatment under Tennessee law (as S corporations, despite their pass-through nature, are classified as corporations for federal income tax purposes), the court disagreed that the differential treatment violated the federal and statutes constitutions. The court observed that S corporations, unlike disregarded SMLLCs, are required to file informational returns with the Internal Revenue Service, which in the court’s view reduces the risk of underreporting Tennessee excise taxes.
As to the second issue, the Tennessee Court of Appeals agreed with DOR that Holdings’ malpractice settlement proceeds were properly classified as “business earnings” under Tenn. Code Ann. § 67-4-2004(4). The statute incorporates two alternative tests—a “transactional test” and a “functional test”—for determining whether earnings constitute business earnings. Observing that the tax classification of malpractice settlement proceeds for Tennessee excise tax purposes was an unsettled issue, the court adopted the test applied by the Seventh Circuit in Freda v. Commissioner, 656 F.3d 570, 573-574 (7th Cir. 2011) for determining the tax classification of settlement proceeds for federal income tax purposes: “[A]mounts received in compromise of a claim must be considered as having the same nature as the right comprised.”
Applying the Seventh Circuit’s test, the court held that settlement proceeds which represent lost business revenue must be classified as “business earnings” for Tennessee excise tax purposes. The settlement proceeds in question represented Holdings’ right to receive revenue that would have been generated by European patents in the absence of the alleged malpractice, which revenue would have been treated as “business earnings,” and Holdings’ right to move forward in its malpractice lawsuit. The court concluded that the settlement proceeds satisfied the “functional test” because they arose from Holdings’ management, use, or acquisition of its U.S. patents in Tennessee and thus were “business earnings” to which Tennessee excise tax applied.