Tennessee Explains How Eligibility for Sales Tax Exemption May Depend on Entity Classification

February 28, 2024

By: Jeff Glickman, SALT Partner

At a glance

The main takeaway: A recent Tennessee ruling addresses how the state’s unique application of the federal entity classification rules can impact a business’ eligibility for sales tax exemptions.
Assess the impact: While almost all states that conform to the federal entity classification rules limit that conformity to state income tax purposes only, there are several that apply the rules more broadly, and it’s important to understand the significant impact it can have on nexus determinations, exemptions qualification, and how non-income taxes are reported.
Take the next step: Aprio’s State and Local Tax (SALT) team can assist your business with addressing the impact of state entity classification rules to ensure that you are in compliance and minimize your multi-state tax liabilities.

Schedule a free consultation today to learn more!

The full story:

For federal income tax purposes, certain entities (most notably, limited liability companies (LLC)), may either choose to keep their default classification or elect an alternative classification.¹ For example, a single member LLC (SMLLC) is treated as a disregarded entity by default, but may elect to be treated as a corporation.²

It is generally the case that states conform to this treatment for net income purposes, but not necessarily for other state tax purposes. For example, Georgia’s LLC statute provides that:

Each limited liability company and foreign limited liability company shall be classified as a partnership for Georgia income tax purposes unless classified otherwise for federal income tax purposes, in which case the limited liability company or foreign limited liability company shall be classified for Georgia income tax purposes in the same manner as it is classified for federal income tax purposes.³

For state sales and use tax purposes, LLCs are typically treated as separate business entities regardless of how they are treated for federal income tax purposes. However, that is not always the case, and the failure to identify those outlier situations can create unexpected and unwanted tax consequences. This is illustrated in a recent Tennessee letter ruling addressing a taxpayer’s eligibility for the state’s industrial machinery exemption under its sales and use tax rules.⁴

A closer look at the ruling

The Taxpayer was recently formed by its Parent as a wholly-owned LLC under Tennessee law. The Taxpayer will elect to be treated as a corporation for federal income tax purposes. The Parent – formed and headquartered in Tennessee – is in the business of fabricating and selling certain goods to contractors, consumers, and other users, as well as providing design, installation, project management, and detailing services. As part of the expansion of its operations, the Parent will be transferring to the Taxpayer all machinery, equipment, and personnel specifically involved in the fabrication business.

The Taxpayer will only fabricate goods for resale and use off the premises, and it will not provide any installation or other services. At least 51% of the Taxpayer gross sales will come from the sale of the fabricated goods, which will be sold to the Parent and third parties, and title and possession to those goods will be passed to the Taxpayer’s customers at the job site to which the goods are shipped.

Unpacking the ruling

The ruling request addresses whether the Taxpayer will qualify for the state’s industrial machinery exemption for manufacturers.

Tennessee law provides: “For purposes of all state and local Tennessee taxes, a domestic or foreign LLC shall be treated as a partnership or an association taxable as a corporation, as such classification is determined for federal income tax purposes.”^[5] Thus, unlike Georgia and most other states, Tennessee’s LLC classification statute applies to all Tennessee taxes, and not just income tax. Notably, the statute does not address disregarded entities. However, a prior Tennessee ruling explains that this statutory language pre-dated the federal check-the-box rules that addressed SMLLC entity classification, and it is the state’s view that its legislature’s original intent was to classify LLCs in the same manner as they are classified for federal income tax purposes. Thus, a SMLLC that is disregarded for federal income tax purposes will also be disregarded for Tennessee sales and use tax purposes.

The sales and use tax industrial machinery exemption is granted to entities whose principal business is the fabrication or processing of tangible personal property for resale and consumption off the premises.⁶ An activity is a taxpayer’s principal business if more than 50% of its revenues at a given location are derived from fabricating or processing tangible personal property for resale; this is known as the “51% test.”⁷

By electing to be treated as a corporation, the Taxpayer will satisfy the 51% revenue test for the exemption because its business consists only of fabricating or processing tangible personal property for resale. Had the Taxpayer been treated as a disregarded entity, then it may not have satisfied the 51% revenue test because it would have been treated as a division of its Parent. As a result, for purposes of applying the “51% test”:

Sales of its goods to the Parent would not have constituted a sale and
The Parent’s non-qualifying revenue from installation and other services would have been taken into account.

The bottom line

As noted above, almost all states conform to the federal entity classification rules for state income tax purposes only. However, for states where that is not the case, the impact of entity classification for all tax purposes needs to be analyzed, as it can affect nexus determinations, exemption qualification, and how non-income taxes are reported.

Aprio’s SALT team has experience with state entity classification rules. We can assist your business with addressing the impact of these rules on its current organizational structure in order to ensure that the business is in compliance with its multi-state tax obligations. In addition, we can identify opportunities within the current structure or recommend alternative business structures to minimize multi-state tax liabilities. We constantly monitor these and other important state tax topics, and we will include any significant developments in future issues of the Aprio SALT Newsletter.

¹ See Treas. Reg. §§ 301.7701-1, -2, and -3.

² Treas. Reg. §§ 301.7701-3(b), -3(c).

³ O.C.G.A. § 14-11-1104 (emphasis added).

⁴ Tenn. Dept. of Rev. Ltr. Rul. 23-08 (August 24, 2023)

⁵ Tenn. Code Ann. § 48-249-1003 (emphasis added).

⁶ Tenn. Code Ann. § 67-6-102(46)(A)(i).

⁷ Tenn. Farmer’s Coop. v. State ex rel. Jackson, 736 S.W.2d 87, 91-92 (Tenn. 1987); see also Beare Co. v. Tenn. Dep’t of Revenue, 858 S.W.2d 906, 908 (Tenn. 1993).