Is an LLC that's wholly owned by an individual's IRA (through a custodian) exempt from Tennessee franchise and excise tax as a family-owned entity, if its only income is residential rent?

Plain-English summary

An individual owns a traditional IRA, structured as a custodial account (held by a trust company as custodian, for the individual's benefit). Federal tax rules require IRA money used to buy real estate to be held through a single-member LLC owned by the IRA -- so the individual directed the IRA's custodian to fund a new LLC, which then buys Tennessee residential rental properties. The LLC's only income is rent from those properties. The question: does this LLC qualify for Tennessee's franchise and excise tax exemption for "family-owned noncorporate entities"?

The Department said yes, but only in years the LLC meets a specific income test, working through three requirements:

1. Is it "family-owned"? Yes, and this took some careful analysis. The exemption statute normally treats trust-held ownership interests as disqualifying UNLESS the trust is a testamentary trust of a deceased family member. But here, the LLC's sole member is a trust company acting as custodian, not trustee, of the IRA -- and a custodial account is legally NOT a trust (it's more like an agency/bailment arrangement where legal title to the property stays with the beneficiary, here the individual). So the trust-ownership restriction never actually applies; the individual is treated as the LLC's real, 100% owner, and he qualifies as a "member of the family" under the statute's family-relationship definitions.
2. Is it a "noncorporate entity"? Yes -- it's an LLC, not a corporation.
3. Is "substantially all" of its activity passive investment income? This is the piece that has to be checked every single tax year. The Department interprets "substantially all" to mean at least 66.67% of gross receipts, and Tennessee's statute specifically defines "passive investment income" to include rents from residential property. As long as the LLC's income keeps coming entirely (or almost entirely) from residential rents, it clears this bar.

Because all three requirements were met on the facts given, the LLC qualifies for the exemption -- but the Department was explicit that this determination is made year by year, not once and for all; if in some future year less than 66.67% of gross receipts come from passive investment income, the exemption is lost for that year specifically.

The ruling also closed off a potential escape hatch: even in a year the LLC fails the 66.67% test and owes Tennessee F&E tax, ERISA does not preempt that tax. ERISA only preempts state laws affecting "employee benefit plans," and traditional/Roth IRAs are specifically NOT employee benefit plans under ERISA (they're not employer-established, and federal law expressly excludes IRAs from ERISA coverage) -- so there's no federal shield if the state exemption's income test isn't met.

What this means for you

Individuals using "checkbook IRA" LLCs to hold real estate

An IRA-owned single-member LLC holding Tennessee rental property can qualify as tax-exempt from franchise and excise tax, but only if you keep the LLC's income essentially all passive (rents, dividends, interest, royalties, gains on stock/securities) -- at least 66.67% of gross receipts each year. Mixing in active business income (property management fees, short-term flips, or similar) in a given year risks losing the exemption for that year, with no ERISA backstop to fall back on.

Accountants and tax professionals

Note the key legal distinction that made this exemption available: a custodial IRA account is not a trust, so the statute's testamentary-trust-only restriction on trust ownership never triggers. Don't assume that logic extends to a trust-held IRA (as opposed to custodial) or to other trust-owned LLC structures -- those would need to independently satisfy the testamentary-trust requirement. Also flag the annual filing mechanics: initial exemption applications are due within 60 days of the start of the first exempt tax year, with annual renewal applications due by the return's due date thereafter.

Common questions

Q: Does owning rental property through an IRA-owned LLC automatically exempt it from Tennessee franchise and excise tax?
A: Not automatically -- it depends on passing three tests every year: family ownership (satisfied here because a custodial IRA isn't a trust), noncorporate entity status, and at least 66.67% of gross receipts from passive investment income like residential rents.

Q: What happens if the LLC's income mix changes in a later year?
A: The exemption is determined year by year. If less than 66.67% of gross receipts in a given year come from passive investment income, the LLC owes Tennessee franchise and excise tax for that specific year.

Q: Does federal ERISA law protect this LLC from Tennessee tax if it fails the passive-income test?
A: No. ERISA preemption only applies to state laws affecting "employee benefit plans," and traditional/Roth IRAs are specifically excluded from ERISA's definition of employee benefit plans.

Q: Can another IRA-owned LLC rely on this ruling?
A: No. A Tennessee letter ruling binds the Department only as to the specific taxpayer and facts it was issued to, and it can be revoked or modified by the Commissioner. Whether your IRA is custodial vs. trust-based, and your LLC's actual income mix, should be confirmed independently.

Citations and references

Tennessee statutes (Tenn. Code Ann.):

• § 67-4-2008(a)(11)(A)-(B) (Supp. 2010) (family-owned noncorporate entity exemption; "family-owned," "passive investment income," "residential property" definitions)
• § 67-4-2007(a) (Supp. 2010) (6.5% excise tax); §§ 67-4-2105(a), 67-4-2106(a) (Supp. 2010) (franchise tax)
• § 67-4-2004(37) (Supp. 2010) ("person"/"taxpayer" definition)
• §§ 67-4-2007(d), 67-4-2106(c) (F&E classification follows federal classification; corporate-owned-LLC disregarded exception)
• §§ 67-4-2007(e)(1), 67-4-2106(c) (separate-entity taxation)
• § 67-4-2008(e), (f)(1)-(2) (exemption application/renewal filing deadlines)
• § 67-5-501(10) (2006) ("residential property" definition for property tax, incorporated by reference)
• § 65-7-113(d) (Uniform Transfers to Minors Act -- custodial property belongs to the beneficiary)

Federal statutes cited by the ruling:

• 29 U.S.C.A. § 408(a), (h) (individual retirement account definition, including custodial accounts)
• 29 U.S.C.A. § 1144(a) (ERISA preemption); § 1003(a)(1), § 1002(3), § 1002(2)(A) (employee benefit plan definitions); § 1051(6) (IRA exclusion from ERISA coverage)

Cases cited by the ruling:

• In re Estate of Davis, 589 N.E.2d 154 (Ill. App. Ct. 1992) (a custodial account is not a trust; it's an agency/bailment arrangement)
• Estate of Davis, 171 Cal. App. 3d 854 (Cal. Ct. App. 1985) (custodial-account IRAs treated as trusts only for federal tax-deferment purposes, not generally)
• Mackey v. Lanier Collection Agency & Serv., 486 U.S. 825 (1988) (ERISA preempts state laws specifically designed to affect employee benefit plans)

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/11-43fe.pdf

Original ruling text

TENNESSEE DEPARTMENT OF REVENUE
LETTER RULING # 11-43
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 that is wholly owned by a traditional individual retirement
account is exempt from the Tennessee franchise and excise taxes under TENN. CODE ANN. § 674-2008(a)(11) (Supp. 2010).
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 the taxpayer’s
detriment.
FACTS
[INDIVIDUAL] is the owner and beneficiary of a traditional individual retirement account (the
“IRA”) that was formed as a custodial account in accordance with 26 U.S.C.A. § 408(h).1 The
assets of the IRA are held by [NAME REDACTED] (the “Trust Company”) as custodian for the
benefit of [INDIVIDUAL].
[INDIVIDUAL] desires to invest IRA funds in residential rental properties located in Tennessee.
Applicable federal income tax laws and regulations require that all such real estate be held in a
single member limited liability company owned by the IRA. Accordingly, [NAME
REDACTED] (the “Taxpayer”), a [STATE OF ORGANIZATION] limited liability company,
was formed to effect the purchase of the residential rental properties. The Trust Company, as
custodian for the benefit of [INDIVIDUAL], is the sole member of the Taxpayer.
[INDIVIDUAL], as owner and beneficiary of the IRA, will direct the Trust Company to
contribute IRA funds to the Taxpayer. The Taxpayer will then purchase residential rental
properties located in Tennessee.2 The Taxpayer’s income will derive entirely from rents
collected with respect to such residential rental properties.
QUESTION
Is the Taxpayer exempt for purposes of the Tennessee franchise and excise taxes as a familyowned noncorporate entity under TENN. CODE ANN. § 67-4-2008(a)(11) (Supp. 2010)?
RULING
The determination of whether the Taxpayer is exempt for Tennessee franchise and excise tax
purposes pursuant to TENN. CODE ANN. § 67-4-2008(a)(11) (Supp. 2010) is made on a year-byyear basis. If the Taxpayer substantiates that at least 66.67% of its gross receipts in the taxable
year for which the exemption is claimed derive from passive investment income, the Taxpayer
will be exempt from the Tennessee franchise and excise taxes with respect to that taxable year.

1

29 U.S.C.A. § 408(a) (West 2011) defines the term “individual retirement account” as “a trust created or organized
in the United States for the exclusive benefit of an individual or his beneficiaries,” provided that the trust’s
governing document complies with certain statutory requirements. 29 U.S.C.A. § 408(h) provides that, for federal
income tax purposes, a custodial account will be “treated as a trust if the assets of such account are held by a bank
… or another person who demonstrates … that the manner in which he will administer the account will be consistent
with the requirements of this section, and if the custodial account would, except for the fact that it is not a trust,
constitute an individual retirement account described in” 29 U.S.C.A. § 408(a).
2

The Taxpayer has confirmed that all such properties are classified as residential real estate for purposes of the
Tennessee property tax.

2

ANALYSIS
The Taxpayer is exempt for purposes of the Tennessee franchise and excise taxes as a familyowned noncorporate entity under TENN. CODE ANN. § 67-4-2008(a)(11) (Supp. 2010) with
respect to taxable years in which at least 66.67% of its gross receipts in the taxable year for
which the exemption is claimed derive from passive investment income.
Tennessee imposes an excise tax at the rate of 6.5% on the net earnings of certain taxpayers
doing business within Tennessee, pursuant to TENN. CODE ANN. § 67-4-2007(a) (Supp. 2010).
Tennessee also imposes a franchise tax at the rate of $0.25 per $100, or major fraction thereof,
on the net worth of a taxpayer doing business in Tennessee, pursuant to TENN. CODE ANN. §§ 674-2105(a) (Supp. 2010) and 67-4-2106(a) (Supp. 2010).3 Taxpayers subject to the franchise and
excise taxes include, but are not limited to, corporations, limited partnerships, and limited
liability companies. TENN. CODE ANN. § 67-4-2004(37) (Supp. 2010) (defining the terms
“person” and “taxpayer”).
TENN. CODE ANN. §§ 67-4-2007(d) and 67-4-2106(c) provide that, for purposes of Tennessee
franchise and excise taxation, a business entity shall be 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) and 67-4-2106(c) further provide that “entities
that are disregarded for federal income tax purposes, except for limited liability companies
whose single member is a corporation, shall not be disregarded” for Tennessee franchise and
excise tax purposes. Accordingly, a single member limited liability company that is wholly
owned by a corporation and that is disregarded for federal income tax purposes will be
disregarded for Tennessee franchise and excise tax purposes as well. All other entities are taxed
for franchise and excise tax purposes on a separate entity basis. TENN. CODE ANN. §§ 67-42007(e)(1) and 67-4-2106(c).
The Taxpayer is a limited liability company doing business within Tennessee. Because the
Taxpayer is not wholly owned by a corporation, it is taxed for franchise and excise tax purposes
on a separate entity basis. Accordingly, the Taxpayer will be subject to Tennessee franchise and
excise taxation unless an exemption or exclusion from taxation applies.
TENN. CODE ANN. § 67-4-2008(a)(11)(A) exempts from the franchise and excise taxes any
“family-owned noncorporate entity,” where “substantially all the activity of the entity” is the
production of “passive investment income.”4 To come within the scope of the family-owned
noncorporate entity exemption under TENN. CODE ANN. § 67-4-2008(a)(11), the following
requirements must therefore be met: 1) the Taxpayer must be family-owned; 2) the Taxpayer

3

However, under TENN. CODE ANN. § 67-4-2108(a)(1) (Supp. 2010), the franchise tax base “shall in no case be less
than the actual value of the real or tangible property owned or used in Tennessee, excluding exempt inventory and
exempt required capital investments.” For purposes of this section, “property” is to be “valued at cost less
accumulated depreciation in accordance with generally accepted accounting principles.” TENN. CODE ANN. § 67-42108(a)(3).

4

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.

3

must be a noncorporate entity; and 3) substantially all of the Taxpayer’s activity with respect to
the taxable year at issue must be the production of passive investment income.
The determination of whether the Taxpayer is exempt for Tennessee franchise and excise tax
purposes pursuant to TENN. CODE ANN. § 67-4-2008(a)(11) is made on a year-by-year basis.
Thus, the Taxpayer must satisfy all of the requirements set forth above with respect to each year
for which it claims the exemption.5
First, the Taxpayer is family-owned. TENN. CODE ANN. § 67-4-2008(a)(11)(B)(i) provides that
“‘family-owned’ means that at least ninety-five percent (95%) of the ownership units of the
entity are owned by members of the family, which means, with respect to an individual, only:”
(a) an ancestor of such individual; (b) the spouse or former spouse of such individual; (c) a lineal
descendent of such individual, of such individual’s spouse or former spouse, or of a parent of
such individual; (d) the spouse or former spouse of any such lineal descendent; or (e) the estate
or trust of a deceased individual who, while living, was as described” above. TENN. CODE ANN.
§ 67-4-2008(a)(11)(B)(v) further provides that “[o]wnership units that are held in trust shall not
be treated as owned by members of the family, unless the ownership units are the property of”
the type of trust described above, i.e., a testamentary trust. In other words, if all or a portion of
the ownership interests in a taxpayer entity are held through a trust, such trust must be the
testamentary trust of a deceased member of the family for the exemption to apply.
On an initial note, TENN. CODE ANN. § 67-4-2008(a)(11)(B)(v), which limits trust ownership to
testamentary trusts, is not applicable in the Taxpayer’s case. Here, all of the ownership interests
in the Taxpayer are held through the IRA, a custodial account established for the benefit of
[INDIVIDUAL]. A custodial account is not a trust. Rather, a custodial account “is a type of
agency account in which the custodian has the obligation to preserve and safekeep the property
entrusted to him for his principal.” In re Estate of Davis, 589 N.E.2d 154, 162 (Ill. App. Ct.
1992) (quoting BLACK’S LAW DICTIONARY 384 (6th ed. 1990)).6 A custodial account is,
essentially, a “bailment to be returned intact upon demand.” Id. at 161.
The Trust Company, as custodian for the benefit of [INDIVIDUAL], is the sole member of the
Taxpayer. However, in the case of a custodial account, the custodian does not have legal title to
the property held in the account. Rather, title to the custodial property resides in the principal,
i.e., the person for whose benefit the account was established. See, e.g., the Uniform Transfers to
5

TENN. CODE ANN. § 67-4-2008(e) requires each person claiming exempt status under TENN. CODE ANN. § 67-42008(a)(11) to file such information forms as are required by the Commissioner of Revenue. Additionally, TENN.
CODE ANN. § 67-4-2008(f)(1) requires all persons claiming exemption to file an initial exemption application within
sixty days of the beginning of the first tax year for which the person claims the exemption. TENN. CODE ANN. § 674-2008(f)(2) requires that an application for renewal of exemption be filed by the due date of the return with respect
to subsequent years.
6

Individual retirement accounts may be created as trusts or as custodial accounts. Importantly, individual retirement
accounts created as custodial accounts are not trusts; such accounts are afforded federal tax exempt status by virtue
of being treated as though they were trusts for purposes of the exemption under 29 U.S.C.A. § 408. A custodial
account IRA is not an express trust “because there is no intent to establish a trust.” In re Estate of Davis, 589 N.E.2d
154, 162 (Ill. App. Ct. 1992) (paraphrasing Estate of Davis, 171 Cal. App. 3d 854, 857 (Cal. Ct. App. 1985))
(holding that the “court’s finding that the IRAs be treated as trusts is limited to Internal Revenue Code section 408’s
purpose of tax deferment.”).

4

Minors Act, TENN. CODE ANN. § 65-7-113(d) (referring to custodial property as the “property of
the minor”). Here, the IRA was established for the benefit of [INDIVIDUAL]; the Trust
Company holds the interests in the Taxpayer merely as custodian on behalf of [INDIVIDUAL].
Accordingly, [INDIVIDUAL] is the legal owner of the interests in the Taxpayer.
[INDIVIDUAL] is a “member of the family” because he is the lineal descendent of the
hypothetical individual referenced in TENN. CODE ANN. § 67-4-2008(a)(11)(B)(i). Because
[INDIVIDUAL] owns 100% of the interests in the Taxpayer, the Taxpayer is family-owned.
Second, the Taxpayer is considered a noncorporate entity for purposes of the exemption because
it is a limited liability company.
Third, the Taxpayer has indicated that its sole activity is the production of rental income from
residential property.7 Provided that the Taxpayer derives income solely from the rental of
residential property, substantially all the Taxpayer’s activity is the production of passive
investment income. As noted above, TENN. CODE ANN. § 67-4-2008(a)(11)(A) exempts any
family-owned non-corporate entity where “substantially all the activity” of the entity is the
production of “passive investment income.” The Tennessee 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.8 TENN. CODE ANN. § 67-4-2008(a)(11)(B)(iii)
defines the term “passive investment income” as “gross receipts derived from royalties, rents
from residential property or farm property, dividends, interest, annuities, and sales or exchanges
of stock or securities to the extent of any gain therefrom.” (Emphasis added.)
Accordingly, the Taxpayer is exempt for purposes of the Tennessee franchise and excise taxes as
a family-owned noncorporate entity under TENN. CODE ANN. § 67-4-2008(a)(11) with respect to
taxable years in which at least 66.67% of its gross receipts in the taxable year for which the
exemption is claimed derive from passive investment income.
An additional consideration is whether the Employee Retirement Income Security Act of 1974
(“ERISA”) preempts the application of the franchise and excise taxes to the Taxpayer with
respect to any year in which less than 66.67% of its gross receipts derive from passive
investment income. 29 U.S.C.A. § 1144(a) (West 2011) states that ERISA provisions relating to
the protection of employee benefit rights “shall supersede any and all State laws insofar as they
may now or hereafter relate to any employee benefit plan described in section 1003(a) of this
title and not exempt under section 1003(b) of this title.” Subject to certain limited exceptions that
do not apply here, 29 U.S.C.A. § 1003(a)(1) extends the protections afforded by ERISA to

7

TENN. CODE ANN. § 67-4-2008(a)(11)(B)(iv) states that the term “residential property” has “the same meaning as
in § 67-5-501, except that ‘residential property’ includes any property leased or rented for residential purposes that
includes not more than four (4) residential units.” For Tennessee property tax purposes, TENN. CODE ANN. § 67-5501(10) (2006) defines the term to mean “all real property that is used, or held for use, for dwelling purposes and
that contains not more than one (1) rental unit.”
8

The term “substantially all” is not statutorily defined. The Tennessee Department of Revenue has interpreted the
term to mean “at least 66.67% percent” based on a prior technical clarification to TENN. CODE ANN. § 67-42008(a)(6)(A), which replaced the term “substantially all” with “at least 66.67%.”

5

“employee benefit plans.”9 State laws specifically designed to affect employee benefit plans are
accordingly preempted by ERISA. Mackey v. Lanier Collection Agency & Serv., 486 U.S. 825,
829 (1988).
In the Taxpayer’s case, however, there is no preemption by ERISA. Whether or not an individual
retirement account is considered an “employee benefit plan” as the term is defined for purposes
of ERISA under 29 U.S.C.A. § 1002(3) depends on the type of account; generally speaking, only
individual retirement accounts that are used to provide retirement income in the employment
context qualify.10 Traditional and Roth individual retirement accounts are not considered
“employee benefit plans” as the term is defined under 29 U.S.C.A. § 1002(3) because they are
not established or maintained by an employer to provide retirement income to employees.
Additionally, 29 U.S.C.A. § 1051(6) specifically excludes individual retirement accounts from
ERISA coverage. Thus, in the event the Taxpayer fails to qualify for the family-owned
noncorporate entity exemption under TENN. CODE ANN. § 67-4-2008(a)(11) in a particular
taxable year, the Taxpayer will be liable for the franchise and excise taxes with respect to that
year.

Kristin Husat
Senior Tax Counsel

APPROVED:

Richard H. Roberts
Commissioner of Revenue

DATE:

09/07/2011

9

There are three types of employee benefit plans: employee welfare benefit plans, employee pension benefit plans,
and plans that are both of the foregoing. 29 U.S.C. § 1002(3). An “employee pension benefit plan” is defined as
“any plan, fund, or program which was heretofore or is hereafter established or maintained by an employer ... to the
extent that by its express terms or as a result of surrounding circumstances such plan, fund, or program (i) provides
retirement income to employees, or (ii) results in a deferral of income by employees for periods extending to the
termination of covered employment or beyond.” 29 U.S.C. § 1002(2)(A).
10

For example, SEP and SIMPLE IRAs generally fit within this definition because such plans are funded by
employers to provide retirement income to employees (typically in the context of self-employment).

6