Some owners wary as Revenue's Farr argues for equity and 'true VCs'
Published Thursday, January 8, 2009 3:04 pm
State Revenue Commissioner Reagan Farr believes most Tennessee business owners shouldn't worry about losing tax exemptions for which they qualify.
On the other hand, Farr made clear this week in a series of VNC interviews that it is true-as-ever that companies that fail to satisfy state requirements for exemptions may soon face a day of reckoning.
During the next session of the General Assembly, Farr will, once again, pursue legislation that could net the state as much as $45 million in annual tax payments the commissioner believes some businesses are dodging.
This week, Farr is preparing a report for the General Assembly, which he will submit Jan. 20 and which will detail the scope of exemptions now accorded limited-liability businesses. The 20th is also the second anniversary of Gov. Phil Bredesen's appointment of Farr as revenue commissioner.
Farr's report was mandated by legislators last spring, after Farr's tax-revision proposals ignited a brief, but intense skirmish between the Administration and industry lobbyists.
To halt that squabble, legislators tabled Farr's proposals and asked him for more data about companies that currently have tax exemptions.
To this point, most of the controversy has been driven by stakeholders in venture-capital firms and family-owned non-corporate entities (FONCEs), which enjoy exemptions from paying franchise or excise taxes.
Farr told VNC this morning that last year his proposals "quite frankly ran into a bit of a buzzsaw." He said he found the intensity of resistance to his proposed 2008 tax-code revisions "unbelievable," given what he described as the "huge bipartisan support" similar "technical corrections" had garnered in the Bredesen era, to that point.
Farr, who was an Ernst & Young consultant before joining state government, stressed he appreciates the vital economic role of VCs and other investors, but hopes "gross misunderstanding" and "misinformation" won't lead to another lobbying clash, this year.
Farr noted with a touch of irony that a couple years ago, when the General Assembly easily agreed to eliminate tax exemptions for real-estate investment trusts (REITs), not only did the measure easily pass, but – contrary to warnings from REIT lobbyists from out of state – REIT investments actually increased the following year, which underscored in Farr's mind the fact that good investments aren't tax plays.
In contrast, Farr said, efforts to tighten enforcement of FONCE rules have drawn sustained criticism. The difference, Farr suggested, flows from the fact that wealthy individuals participating in FONCEs are more politically active in Tennessee than corporate REIT executives, based elsewhere.
"When it was hitting not just business, but their individual friends they play golf with at the country club, it was just surprising the pushback we got on this," Farr said today. Farr's department has said more than 2,600 Tennessee families have claimed the FONCE exemption.
Farr did not hesitate to restate his belief that efforts nine years ago to exempt some limited-liability companies from corporate income taxes had gone too far, due to political horse-trading, without any underlying "good policy basis."
As a result, Farr said that, as the Bredesen Administration has done each year, he is working to clean up the tax code, partly in order to encourage "true venture-capital funds," while preventing abuse of tax law.
Thus, he aims to strengthen Tennessee tax law to ensure all parties understand that no individual investor can own more than 50 percent of a given venture-capital fund, in order that funds' management remains independent of the individual investors who invest in the funds.
He insisted that such a tweak in the language would "absolutely" create no new costs for otherwise qualified venture-capital funds.
Among other effects, such a tightening of existing language – which Farr said is "too loose," would serve to preempt wealthy individuals or family members who fail to qualify for the FONCE exemption and who then move to convert to a venture-capital fund, which also enjoys limited-liability protection, in hope they could continue to invest for their own personal interests, rather than in the interest of returns to the fund, as a whole.
Farr has often publicly explained that these issues have come to the fore largely as a result of abuse of limited-liability vehicles by some FONCEs that have been avoiding paying taxes by representing income from commercial real estate holdings as "passive" income that helps them in qualifying for the tax exemption, when, in fact, such incomes are not passive.
Among the consequences of that dodge, he has said, are underpayment of taxes due the state, possibly unearned protection from personal liability and a strikingly unfair competitive advantage in marketing some FONCE-owned properties in competition with properties owned by investors who are not related family members. The state has said that properties valued at $5 billion, generating $500 million in commerical rental income are now sheltered from taxes.
During interviews, Farr evinced some personal frustration when asked about VCs' oft-voiced complaints he is trying to eliminate, rather than merely tighten an exemption for VCs.
In conversation with VNC, Farr explained his irritation: He said that several years ago it was he, himself, who helped craft the VC exemption that some now accuse him of trying to undermine. (Farr did not mention, but it is widely known that he played a key role in creating incentives that helped lure Volkswagen to build its huge plant at Chattanooga, a pivotal role for which he attracted isolated criticism, as well as praise.)
Farr said that in the interest of encouraging venture funds to support Tennessee startups, "we drafted and put the [VC] exemption in place approximately three years ago, [so, for critics now] to sit there and say that we're trying to get rid of it, or that we're not sympathetic or we're antagonistic toward venture funds is just ludicrous." He added, "If people are running around saying the sky ifs falling, it isn't helpful to anybody, especially if [the critic's] got misinformation."
Farr does affirm that FONCE-affiliated investors and individuals who own more than 50 percent of a venture fund would almost certainly experience increased franchise and excise taxes, which Farr contends they inevitably owe. There is no prohibition against investors who may also be involved with a separate FONCE investing in a VC fund, provided they do not own more than 50 percent of the fund.
In addition, Farr insisted that FONCEs will not lose any tax advantages they deserve, provided they are complying with exemption criteria. The key criteria: FONCEs must be at least 95 percent owned by an individual or a family; also, at least 66.67 percent of the FONCE's income must be "passive income." At that point, Farr reiterated that he seeks to change the law to make very clear that commercial real-estate rents are not considered "passive income."
Nine months ago, having discovered late in the session what he viewed as a threat to VC earnings, Franklin-based VC Larry Coleman (at left) sprang to action, coordinating the VC community's hiring of a lobbyist to work for repeal of Farr's proposed "technical corrections."
Since that scrap, Coleman, who is managing partner of the VC firm Coleman Swenson & Booth, has regularly been among those voicing concerns that Farr's proposed changes would make Tennessee VC funds less competitive for investment.
Yesterday, when asked by VNC about reports he has resumed efforts to enlist VCs for another campaign to preserve current exemptions, Coleman declined to comment. Coleman also said he could not comment on the substance of Farr's previous or prospective legislative proposals. Several other VCs who supported Coleman's efforts a year ago, also declined to comment, when contacted this week by VNC.
"No comment" may be a wise strategy for special interests, for the moment. One observer close to several of the factions is this simmering dispute is Larry Hyatt, who once served as the state's assistant Revenue commissioner and whose Brentwood firm assists business owners and other CPAs in dealing with tax audits.
Hyatt told VNC yesterday he believes VCs are, in fact, well advised to keep their heads down until they're sure they're at risk, lest they invite unwelcome scrutiny.
Hyatt also warned, "Before the upcoming legislative session is over, it would not surprise me to see other exemptions on the table for discussion such as REITs, Venture Capital, Intangible deductions etc. The budget problems facing the State could result in any and all of these exemptions on the table. We are fooling ourselves if we think otherwise."
Another very interested observer, Mason Barrick, who is senior manager of Lattimore Black Morgan & Cain's state and local tax services division, told VNC today that "if, in fact, the legislature does agree with Commissioner Farr" and that leads to removing commercial rental income from protection of the tax exemption, he hopes property owners will be given a period of time to "determine whether they want to continue doing business" in their current form, or resort to other options, including general partnerships.
Meanwhile, Farr has a report to deliver. And, toward that end, Farr's staff have been surveying new or renewing FONCEs to ensure they meet state rules regarding passive income and other variables. Despite months of canvassing, hundreds of firms have not responded. Farr has authority to administratively dissolve those firms, but told VNC he will not take such action lightly.
Farr insisted his views are deeply grounded in equity and philosophy. "Corporations and businesses have an obligation to their shareholders to maximize value to the shareholders," but "they have absolutely no obligation to maximize the amount of taxes they pay to the State of Tennessee."
While corporations are looking after their interests, Farr continued, "it is our job as policymakers to ensure that our laws are set up in a way that similarly situated people are all taxed the same when they're competing against each other in the corporate marketplace."
To ensure such equity, he said, the Department of Revenue each year sponsors legislation "that closes what are, in our opinion, loopholes" that translate into inequities.
Farr said he is prepared to meet with VCs and FONCE interests and would be "curious" to hear their reasons for resisting his proposals.
Farr added that he is certain that continually repairing flaws that emerge in the tax code helps ensure Tennessee can maintain its current tax scheme – which is and should remain devoid of a personal income tax. That simple fact, he said, is generally regarded as one of the state's key economic-development advantages. ♦