How Real Estate Investors in Tennessee Avoid Franchise and Excise Taxes: The FONCE Exemption

by | Nov 3, 2022 | Business Law

Your first thought when reading that headline might have been, “Why do I want to avoid Franchise and Excise Taxes?” For more information on these sometimes very expensive taxes, read our article HERE.

Anyone who owns an LLC in Tennessee is liable for Franchise and Excise taxes unless they qualify for one of seventeen exemptions (the article referenced above lists all of them.) This article is going to focus on exemption #11: the Family Owned Non-Corporate Entity (FONCE) exemption.

The FONCE Exemption. It’s a Glorious Thing.

Let’s say you want to invest in short-term vacation rentals in Tennessee. And who wouldn’t? We have the glorious Smoky Mountains, Signal Mountain, Nashville, Graceland, and about a million other gorgeous places to see and experience. Tennessee is one of the most visited tourist destinations in the country, so the short-term rental market is very healthy here.

The problem is that the State of Tennessee gets a lot of revenue from the taxation on LLCs, and LLCs just so happen to be the entity of choice for owners of rental real estate. LLCs provide a limit on liability and offer very flexible ownership, operational, and management features. But thankfully, the State of Tennessee wants to encourage families to invest in real estate together, so the legislature carved out an exception to the dreaded franchise and excise taxes for certain entities.

Here’s the rule:

In order to qualify for the FONCE franchise and excise tax exemption [#11], the entity must meet two criteria:

(1) at least 95% of the entity’s ownership must be directly held by family members, and

(2) substantially all (66.67% or 2/3) of the activity of the entity is either the production of passive investment income or the combination of the production of passive investment income and farming.

Passive investment income is gross receipts derived from . . . rents from residential property … Residential property can not have more than four residential units at any one location.—excise-tax/exemptions/exemption-fonce.html

Let’s Break That Down

The devil is in the details, so let’s go over them. I’ve underlined the relevant parts above. First of all, for all intents and purposes, this has to be a closely-held family business. We’re talking husband and wife, siblings, parents and kids, grandparents and grandkids. . .It can’t be any farther along the family tree than that.

The words “directly held” mean that you cannot have a Trust hold shares of the LLC unless those shares were inherited and put into a testamentary trust (meaning someone owned the LLC shares in his name, died, and his Will created a “testamentary trust” where the shares were put for the person who was his beneficiary.)

“Passive investment income” means rents received from the people who pay to stay at the property. What those words do not mean is income you’d get from an activity like flipping houses (buying, renovating, and re-selling a property.)

Substantially all (66.67%) of the revenue has to come from the rents, so if you have other income being generated by that property (for example, you have a gift shop attached that’s selling items you got from another location), it better not be more than 1/3 of the LLC’s income or the whole thing is going to be taxed.

Finally, this exemption only applies to residential units, not commercial property. In most states, a property becomes commercial when it has more than 4 dwellings in one attached building. A duplex is ok, a triplex is ok, a four-plex is ok, a five-plex. . .not so much. And things that aren’t dwellings like offices do not qualify.

The good news is that you can have an unlimited number of residential properties in one LLC and still qualify for the exemption. Whether that’s a good idea or not is another story!

If you have rental properties and want to know if an LLC is the right entity for you to use for your business, or if you want to know if you qualify for the FONCE exemption, fill out our INTAKE FORM , and we’ll get back to you within 24 hours.