Tennessee: Lawsuit Settlement Proceeds were Business Earnings; SMLLCs Must File Separate Returns

The Tennessee Court of Appeals recently held that an affiliated group was not allowed to compute its excise (income) tax liability on a consolidated basis and that proceeds from a malpractice lawsuit settlement constituted business earnings. The taxpayers at issue were a holding company and two operating subsidiaries.  The holding company was treated as a partnership for federal tax purposes and the subsidiaries were SMLCCs.  The taxpayers filed their 2010-2012 Tennessee Franchise and Excise tax returns on a consolidated basis.  In 2011, the holding company received a settlement from a legal malpractice claim related to a European patent dispute and reported such receipts as non-business earnings allocated outside of Tennessee.  Upon audit, the Department of Revenue took the position that the taxpayers were required to compute their 2010-2012 excise tax liabilities on a separate entity basis and that the lawsuit settlement proceeds constituted business earnings.

Under Tennessee law, businesses classified as disregarded entities for federal income tax purposes will generally not be disregarded for Tennessee Franchise & Excise tax purposes.  The legislature created one exception to the general rule, and that exception applies only to business entities that are: (1) SMLLCs, (2) classified as disregarded entities under the federal income tax system, and (3) the single-member parent is a corporation. In this case, the single-member parent was not a corporation, but was a partnership. As such, by statute, it was clear that the taxpayers’ legal structure did not allow them to compute its excise tax on a consolidated basis.  The taxpayers, however, challenged the constitutionality of the statute.  The court observed at the outset that the taxpayer bore the burden of proving that the statute was unconstitutional and to do so had to establish that (1) the state’s objective was not legitimate, or (2) the statutory classification did not rationally advance a legitimate state objective.  Applying the “rational basis” scrutiny test, the court held that reducing the risk of under-reporting and holding business entities accountable for reporting their business earnings was a legitimate objective. Further, the court rejected the taxpayer’s argument that because the exception applied to SMLCCs whose parents’ were S Corporations (i.e., pass-through entities) in addition to parents that were C Corporations, the statute’s purpose was undermined and violated the Equal Protection Clause because two similarly-situated entities were treated differently. In the court’s view, because S Corporations were required to file informational returns with the IRS, there was less a chance that they would underreport income. Further, with respect to the Equal Protection Clause argument, the court concluded that state did not have to treat all business entities equally and a statutory classification based on a business’s structure and the federal tax classification of the parent company was not inherently suspicious.

The court next addressed the issue of the malpractice settlement proceeds and applied the so-called functional test to determine whether the proceeds were business or non-business earnings.  The damages arose because the holding company’s New York attorneys failed to properly file a European patent and the taxpayer argued that it was paid consideration for giving up its right to move forward with a lawsuit. The court noted that if the attorneys had not committed malpractice by improperly filing the European patents, the revenue generated by those patents would have been taxable as business earnings. In the court’s view, the nature and basis of the settled action was akin to a business transaction in which the taxpayer was compensated for lost business earnings. The holding company argued that even if the settlement proceeds constituted business earnings, the proceeds should be apportioned because it did business in Europe and other states.  However, the holding company failed to establish that it had nexus outside of Tennessee and thus, did not have the right to apportion its income. For more information on Emerachem Power v. David Gerregano, please contact John Harper at (615) 744-2170.