Does a family-owned Tennessee LLC that licenses intellectual property, but also provides active services to its licensees, qualify for the franchise and excise tax exemption for family-owned entities earning passive investment income?

Subject

Whether a family-owned LLC licensing intellectual property qualifies for the family-owned non-corporate entity franchise and excise tax exemption.

Plain-English summary

The Tennessee Department of Revenue ruled that a family-owned LLC licensing intellectual property is not automatically exempt from Tennessee franchise and excise tax, even though it easily clears the "family-owned" ownership test.

The Taxpayer is a Tennessee LLC 100% owned by seven siblings (four brothers, three sisters), all lineal descendants of the same parent. It licenses intellectual property to other businesses in exchange for royalty fees, but its license agreement also requires it to provide active services to licensees related to that IP. Tennessee's family-owned non-corporate entity exemption under Tenn. Code Ann. § 67-4-2008(a)(11) requires three things: (1) family-owned — at least 95% of ownership held by lineal descendants of one individual, easily met here with 100% sibling ownership; (2) substantially all activity is passive investment income — which the Department interprets as at least 66.67% of gross receipts coming from royalties, rents, dividends, interest, annuities, or stock/security sale gains; and (3) non-corporate — the entity must not be classified as a corporation for federal tax purposes.

The sticking point was the second requirement. Because the license agreement bundles a flat royalty fee together with active services (with the agreement silent on how much of that fee compensates for the services), the Department couldn't conclude that 66.67%+ of receipts were truly passive royalty income rather than disguised compensation for services. Citing federal case law (including Sierra Club v. Commissioner) holding that ongoing service obligations under a licensing agreement can recharacterize purported "royalties" as service income, the Department ruled the Taxpayer must affirmatively demonstrate — on an annual basis — that at least 66.67% of its gross receipts are derived from the licensing itself, not from the active services bundled into the same fee.

What this means for you

Family-owned businesses that license intellectual property

Ticking the family-ownership box isn't enough. If your licensing agreement bundles active services (management, technical support, maintenance, quality control, etc.) into the same royalty fee, you need to be able to show — with real numbers, ideally by separately stating service fees — that at least 66.67% of your gross receipts are genuinely passive royalty income. Silence in the agreement about how the fee splits between royalties and services works against you.

Accountants and tax professionals

This ruling applies the Department's numeric gloss on "substantially all" (66.67%, derived from a related statutory revision to § 67-4-2008(a)(6)(A)) and leans on the same body of federal royalty-recharacterization case law that later Revenue Ruling 06-35 (issued the same day) applies to a much larger corporate intangible-holding-company structure. The two rulings are useful companions: this one covers the ownership-threshold exemption for small family entities; 06-35 covers the ordinary-and-necessary-business-expense deduction for the licensee side of a similar arrangement.

Common questions

Q: Does 100% family ownership automatically qualify an entity for this exemption?
A: No. Family ownership (at least 95%) is only one of three requirements — the entity also needs at least 66.67% of its gross receipts from passive investment income and must be non-corporate.

Q: Do royalty payments count as passive investment income even if the licensor also does work for the licensee?
A: Only the portion that's genuinely a royalty for the license itself. If active services are bundled into the same fee with no breakdown, the Department may treat some or all of the fee as service compensation, not passive income.

Q: What tax rate/status applies if the exemption doesn't apply?
A: The entity remains subject to ordinary Tennessee franchise and excise tax as a non-exempt non-corporate entity (assuming it's taxed as a partnership for federal purposes; if it elected corporate tax status the exemption would be unavailable outright).

Q: Does this ruling bind the Department for other similarly-structured LLCs?
A: No. A Tennessee letter ruling binds the Department only as to the specific taxpayer addressed and cannot be relied on by anyone else, though it shows how the Department analyzes similar bundled-royalty facts.

Citations and references

Statutes:

• Tenn. Code Ann. § 67-4-2008(a)(11) (family-owned non-corporate entity excise tax exemption)
• Tenn. Code Ann. § 67-4-2105(a) (franchise tax exemption tied to the excise exemption)
• Tenn. Code Ann. § 67-4-2008(a)(11)(B)(i) (95% family-ownership requirement; "members of the family" defined as lineal descendants)
• Tenn. Code Ann. § 67-4-2008(a)(11)(B)(ii) (definition of "passive investment income": royalties, rents, dividends, interest, annuities, stock/security sale gains)

Cases:

• Sierra Club, Inc. v. C.I.R., T.C. Memo 1999-86 (Tax Ct. 1999); Sierra Club, Inc. v. Commissioner, 86 F.3d 1526 (9th Cir. 1996) (service obligations can recharacterize royalties as non-royalty income)
• Shatterproof Glass Corp. v. Libbey-Owens-Ford Co., 482 F.2d 317 (6th Cir. 1973) (defining "royalty" as consideration for a license)
• American Airlines, Inc. v. Johnson, 56 S.W.3d 502 (Tenn. Ct. App. 2000) (exemptions strictly construed against the taxpayer)

Source

• Landing page: https://www.tn.gov/revenue/tax-resources/legal-resources/tax-rulings.html
• Original PDF: https://www.tn.gov/content/dam/tn/revenue/documents/rulings/fae/06-34fe.pdf

Original ruling text

TENNESSEE DEPARTMENT OF REVENUE
LETTER RULING # 06-34
WARNING
Letter rulings are binding on the Department only with respect to the individual taxpayer
being addressed in the ruling. This presentation of the ruling in a redacted form is
informational only. Rulings are made in response to particular facts presented and are not
intended necessarily as statements of Department policy.

SUBJECT
Whether a limited liability company qualifies as an exempt family-owned non-corporate entity
under Tenn. Code Ann. § 67-4-2008(a)(11).
SCOPE
This letter ruling is an interpretation and application of the tax law as it relates to a specific set of
existing facts furnished to the Department by the taxpayer. The rulings herein are binding upon
the Department, and are applicable only to the individual taxpayer being addressed.
This letter ruling may be revoked or modified by the Commissioner at any time. Such
revocation or modification shall be effective retroactively unless the following conditions are
met, in which case the revocation shall be prospective only:
(A) The taxpayer must not have misstated or omitted material facts involved in
the transaction;
(B) Facts that develop later must not be materially different from the facts upon
which the ruling was based;
(C) The applicable law must not have been changed or amended;
(D) The ruling must have been issued originally with respect to a prospective or
proposed transaction; and
(E) The taxpayer directly involved must have acted in good faith in relying upon
the ruling and a retroactive revocation of the ruling must inure to his detriment.
FACTS
[TAXPAYER] is a Tennessee limited liability company. The Taxpayer is engaged in the
business of providing intellectual property services and licenses to other businesses. The
Taxpayer is 100% owned by [SEVEN RELATED INDIVIDUALS].
Pursuant to the sample Intellectual Property Services and License Agreement provided by the
Taxpayer (the “Agreement”), the licensee pays the Taxpayer a royalty fee in exchange for a

license to use the Taxpayer’s intellectual property. The intellectual property includes [TYPES
OF INTELLECTUAL PROPERTY]. Additionally, the Taxpayer is required pursuant to the
Agreement to provide a number of services to the licensees, either directly or through its agents.
Such services include [ACTIVE SERVICES RELATED TO THE INTELLECTUAL
PROPERTY].
QUESTION
Is the Taxpayer exempt as a family-owned non-corporate entity from the payment of Tennessee
excise tax under Tenn. Code Ann. § 67-4-2008(a)(11) and from the payment of Tennessee
franchise tax under Tenn. Code Ann. § 67-4-2105(a)?
RULING
No. The Taxpayer is not exempt from the payment of the Tennessee franchise and excise taxes
under Tenn. Code Ann. §§ 67-4-2008(a)(11) and 67-4-2105(a) unless it demonstrates that at least
66.67% of its gross receipts with respect to the current taxable year are derived from royalties or
other passive investment income.
ANALYSIS
Tenn. Code Ann. § 67-4-2008(a)(11)(A) exempts from the Tennessee excise tax any familyowned non-corporate entity where substantially all the activity of the entity is the production of
passive investment income. Tenn. Code Ann. § 67-4-2105(a) provides an exemption from the
Tennessee franchise tax for any entity exempt from the excise tax under the provisions of Tenn.
Code Ann. § 67-4-2008.
1.

The “family-owned” requirement.

The Taxpayer is “family-owned” for purposes of the exemption under Tenn. Code Ann. § 67-42008(a)(11).
As noted above, Tenn. Code Ann. § 67-4-2008(a)(11)(A) exempts from the Tennessee excise tax
any “family-owned” non-corporate entity where substantially all the activity of the entity is the
production of passive investment income. Tenn. Code Ann. § 67-4-2008(a)(11)(B)(i) defines
“family-owned” to mean that at least ninety-five percent (95%) of the ownership units of the
entity are owned by “members of the family.” Tenn. Code Ann. § 67-4-2008(a)(11)(B)(i)(c)
defines “members of the family” as the lineal descendents of a particular individual.
As noted in the facts, the Taxpayer is currently owned by seven individuals, namely four
brothers and three sisters. Each of these owners is the lineal descendant of a particular individual,
i.e., one individual is the parent of all of the owners. The seven owners of the Taxpayer are
therefore “family members” for purposes of the exemption. The seven family members hold 100
percent of the ownership interest in the Taxpayer. Because at least 95 percent of the ownership
interest in the Taxpayer is owned by members of the family, the Taxpayer qualifies as “familyowned” under Tenn. Code Ann. § 67-4-2008(a)(11)(B)(i).

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2.

The “substantially all the activity” requirement.

Under the facts presented, it is unclear whether substantially all the Taxpayer’s activity is the
production of passive investment income for purposes of the exemption under Tenn. Code Ann.
§ 67-4-2008(a)(11). The Taxpayer may not claim the exemption unless it shows that it meets this
requirement.
As noted above, Tenn. Code Ann. § 67-4-2008(a)(11)(A) exempts from the Tennessee excise tax
any family-owned non-corporate entity where “substantially all the activity” of the entity is the
production of “passive investment income.” The Department of Revenue interprets “substantially
all the activity” to mean that at least 66.67% of the gross receipts of the entity must be derived
from passive investment income. 1 Tenn. Code Ann. § 67-4-2008(a)(11)(B)(ii) defines “passive
investment income” as “gross receipts derived from royalties, rents, dividends, interest,
annuities, and sales or exchanges of stock or securities to the extent of any gains therefrom.”
Gross receipts include all receipts, from whatever sources, before deductions.
The Taxpayer’s gross receipts in the current taxable year include royalty income from the
licensing of its intellectual property. Royalty income comes within the definition of “passive
investment income” under Tenn. Code Ann. § 67-4-2008(a)(11)(B)(ii). Because royalty
payments are the only form of consideration provided for in the Agreement, it would initially
appear that 100% of the Taxpayer’s gross receipts qualify as passive investment income.
However, the Agreement also requires the Taxpayer to provide a number of active services to the
licensee. Such services include [LANGUAGE REDACTED].
The Agreement is silent with respect to the consideration that the Taxpayer receives in exchange
for such services. Because a party to a transaction such as the one embodied in the Agreement is
unlikely to provide such extensive and costly services for no consideration, a portion of the
royalty fee presumably compensates the Taxpayer for the services. Notably, the United States
Tax Court has stated that the contemporaneous existence of obligations under an agreement may
indicate that some or all of the receipts received pursuant to the agreement cannot properly be
characterized as “royalties.” Sierra Club, Inc. v. C.I.R., T.C. Memo 1999-86 (Tax Ct. 1999).
Compensation for the provision of active services such as those listed in [LANGUAGE
REDACTED] of the Agreement does not come within the definition of “passive investment
income” under Tenn. Code Ann. § 67-4-2008(a)(11)(B)(ii); i.e., such income is not derived from
“royalties, rents, dividends, interest, annuities, and sales or exchanges of stock or securities.” The
term “royalty” is not defined in the Tennessee Code, nor have the Tennessee courts defined the
term. The Sixth Circuit Court of Appeals, however, has described a “royalty” as the “cost,
consideration, compensation, or price paid or incurred for a license.” [Emphasis added.]
Shatterproof Glass Corp. v. Libbey-Owens-Ford Co., 482 F.2d 317, 323 (6th Cir. 1973).
Importantly, various courts have found that consideration received for services cannot be
characterized as a royalty; these courts permitted the recharacterization of purported royalty
1

The term “substantially all” is not statutorily defined. The Department of Revenue has interpreted the term to mean
“at least 66.67%” based on a technical revision to Tenn. Code § 67-4-2008(a)(6)(A), which replaced the term
“substantially all” with “at least 66.67%.”

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income as non-royalty compensation for services. See, e.g., Sierra Club, Inc. v. Commissioner,
86 F.3d 1526, 1532 (9th Cir. 1996); Arkansas State Police Ass’n, Inc. v. C.I.R., T.C. Memo
2001-38 (Tax Ct. 2001); Mississippi State Univ. Alumni, Inc. v. Commissioner, T.C. Memo
1997-397 (Tax Ct. 1997); Mourad Bros, Inc. v. Dep’t of Treasury, 431 N.W.2d 98
(Mich.Ct.App. 1988).
It is unclear under the facts presented the extent to which the Taxpayer’s income may be
attributed to compensation for the provision of services. To qualify for the exemption under
Tenn. Code Ann. § 67-4-2008(a)(11), the Taxpayer must demonstrate that at least 66.67% of its
gross receipts with respect to the current taxable year are derived from the licensing of
intellectual property, and not from the provision of services. The Tennessee Supreme Court has
stated that “[a]lthough the rule is well-established that taxing legislation should be liberally
construed in favor of the taxpayer and strictly construed against the taxing authority, it is an
equally important principle of Tennessee tax law that ‘exemptions from taxation are construed
against the taxpayer who must shoulder the heavy and exacting burden of proving the
exemption.’” American Airlines, Inc. v. Johnson, 56 S.W.3d 502, 506 (Tenn.Ct.App. 2000)
(quoting Rogers Group, Inc. v. Huddleston, 900 S.W.2d 34, 36 (Tenn.Ct.App. 1995)). The
Tennessee Supreme Court has also stated that the burden is on the taxpayer to establish the
exemption, and any well-founded doubt is sufficient to defeat a claimed exemption from
taxation. American Airlines, Inc. v. Johnson, 56 S.W.3d at 506 (citing Tibbals Flooring Co. v.
Huddleston, 891 S.W.2d 196, 198 (Tenn. 1994); United Canners, Inc. v. King, 696 S.W.2d 525,
527 (Tenn. 1985)).
Accordingly, to claim the exemption under Tenn. Code Ann. § 67-4-2008(a)(11), the Taxpayer
must demonstrate that at least 66.67% of its gross receipts with respect to the current taxable
year are derived from royalties or other passive investment income, and not from compensation
for the provision of services.
3.

The “non-corporate” requirement.

As noted above, Tenn. Code Ann. § 67-4-2008(a)(11)(A) exempts from the Tennessee excise tax
any family-owned “non-corporate” entity where substantially all the activity of the entity is the
production of passive investment income. Thus, in addition to the “family-owned” and
“substantially all the activity” requirements discussed above, Taxpayer must be a non-corporate
entity in order to qualify for the exemption under Tenn. Code Ann. § 67-4-2008(a)(11).
The Taxpayer is a limited liability company. Based on the facts presented, it is unclear whether
the Taxpayer is classified as a corporation or as a partnership for Tennessee franchise and excise
tax purposes. 2 For purposes of this ruling, it is assumed that the Taxpayer has elected the default
federal partnership classification under Treas. Reg. § 301.7701-2(a). However, if the Taxpayer
has instead elected to be taxed as a corporation for federal income tax purposes, the exemption
would not be available because the Taxpayer would be classified as a corporation for Tennessee
franchise and excise tax purposes.
2

For Tennessee franchise and excise tax purposes, an entity is classified as a corporation, partnership or other type
of business entity consistent with the way the entity is classified for federal income tax purposes. Tenn. Code Ann.
§§ 67-4-2007(d); 67-4-2106(c).

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4.

Conclusion.

The Taxpayer is not exempt from the payment of Tennessee franchise and excise taxes under
Tenn. Code Ann. §§ 67-4-2008(a)(11) and 67-4-2105(a) unless it demonstrates that at least
66.67% of its gross receipts with respect to the current taxable year are derived from royalties or
other passive investment income. Please note that the Taxpayer must qualify for the exemption
under Tenn. Code Ann. § 67-4-2008(a)(11) on an annual basis. 3

Kristin Husat
Tax Counsel

APPROVED:

Loren L. Chumley
Commissioner of Revenue

DATE:

9/22/06

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Regardless of whether the Taxpayer is exempt for Tennessee franchise and excise tax purposes, please note that the
Taxpayer may nevertheless be subject to the Tennessee business tax pursuant to Tenn. Code Ann. § 67-4-708(3)(C),
which specifically makes certain services taxable. For further information about the business tax, please refer to the
Department of Revenue’s website at http://www.tennessee.gov/revenue/tntaxes/localtaxes/business.htm.

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