Wednesday, November 26, 2008

Tax exemption costs Tennessee $45 million

In the midst of falling state tax revenues and a growing economic crisis, Gov. Phil Bredesen is pushing for an end to what he calls a "fairly outrageous" tax loophole for the well-off, but it could be an uphill battle in a Republican-controlled legislature.

Jason Mumpower, R-Bristol, who is expected to take over the job as House Speaker for the new Republican majority legislature in January, said he considers the governor's idea a "tax increase warmed over."

"I'm confused,'' he said Monday. "I've read he's not in favor of tax increases. Now he's suddenly advocating for a $45 million tax increase."

The battle over the tax exemption had pitted business groups and some state legislators against Bredesen's administration in the closing days of the last legislative session, and now the issue could come up again during the next session, after the governor signaled a desire to recoup millions of dollars in potential revenue.

"I think it's sinful to on the one hand to be talking about laying off people and on the other hand giving a huge loophole to relatively wealthy individuals in the state of Tennessee who found some ways of working the system,'' Bredesen said last week. "I hope the legislature will consider that."

The Commissioner of the Department of Revenue, Reagan Farr, has preliminarily identified what he says is $5 billion in property and $500 million in commercial rental income from family-owned limited liability companies that is exempt from the state's franchise and excise tax.

"The amount of property that is being sheltered is even more than we anticipated," Farr said, adding that some family-owned retail stores are moving operating income into a special entity to avoid taxes.

At current tax rates, Farr's preliminary figures amount to $45 million in lost tax revenue. But he pointed out that some families would reorganize their businesses if the tax law changes, making it unlikely that the state would recoup the full $45 million.

The Department of Revenue has sent out notices to 8,000 limited liability companies demanding information on who claims the exemption and has gotten responses from 6,000. It has threatened to revoke the exempt status for those who don't respond.

Farr said the tax change would impact only those families with income from commercial properties, which includes duplexes and commercial real estate, but not rental income on single-family homes.

2,600 claim exemption

There are a lot of ways to structure a business to avoid paying the state franchise and excise tax. Generally, limited liability companies pay those taxes. In 2000, the state passed an exemption for family-owned entities, called family-owned non-corporate entities, or FONCEs.

To qualify, 67 percent of the income in the limited liability company has to come from passive investments — such as stocks or rental income.

Farr said so far, 2,600 family-owned corporations are claiming the exemption, which works out to an average annual income of $192,000 per entity that's tax-free. He said he was unable to divulge the names of families taking the exemption.

Farr said ending the exemption comes down to a fundamental issue of fairness: business owners who aren't family have to pay the tax while those who are don't.

Critics claim that the move amounts to the Bredesen administration trying to sneak a tax increase through late in the legislative session last spring and that more information is needed about who pays the tax and the impact of getting rid of the exemption.

"Several people said they wouldn't be in business without these (tax exemptions) to compete with larger business entities," said Jim Brown, the state director of the National Federation of Independent Business, which fought the measure last spring. "It's helped in many ways. To remove this at this point in time would hurt."

Bill Freeman, a partner in the real estate firm Freeman Webb Company, said his family qualifies for the tax exemption in the ownership of some commercial real estate, which is separate from the Freeman Webb business.

"You have family owned businesses struggling in a very difficult economy,'' he said, pointing out that out-of-state, publicly-traded REITS, or real estate investment trusts, also don't pay franchise and excise taxes. He wonders why the governor is singling out families.

"Who does he come after when times are tough?'' Freeman said. "Who is he trying to help and who is he trying to hurt?"

GOP controls legislature

Business groups lobbying against the measure scored a minor victory over the weekend when State Rep. Gary Odom, D-Nashville, was re-elected as leader of the Democratic Party in the House.

He had opposed the governor's tax measure in the last legislative session and has gotten financial support from real estate interests, including Freeman.

"I'm not going to sit there because it's an idea from our governor,'' Odom said. "I'm not going to follow it blindly."

Whether Bredesen will be successful in getting a tax increase through a Republican-controlled legislature is questionable.

Robin Smith, the chairman of the Tennessee Republican Party, said the state should "concentrate on reducing spending rather than raising taxes."

But then again, the state's worsening economic condition may provide the needed legs.

"This is a difficult year for the legislature, and they're all going to be looking for money," said Walt Baker, the chief executive officer of the Tennessee Hotel and Lodging Association, who had opposed the tax change as part of a coalition of business industry groups. "When you've got an $800 million to $1 billion shortfall, I wouldn't rule anything out.''

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