- Update: Venture Capital Funds -- New Tennessee Tax Exemption
- September 2, 2004 | Authors: Karla R. Hyatt; Donald B. Stuart
- Law Firm: Waller Lansden Dortch & Davis, LLP - Nashville Office
According to recent statistics released by the National Venture Capital Association, there is increased optimism as venture capital investment and venture capital fundraising figures released for 2004 currently are far outpacing those for 2003. With this renewed optimism also comes a new Tennessee tax exemption for venture capital funds to supplement the already existing exemption. The structure recommended for a venture capital fund in Tennessee often depends on whether the fund qualifies for an exemption from Tennessee's franchise and excise taxes.
Generally, a venture capital fund can be operated through either a limited partnership (LP) or a limited liability company (LLC). If an LP is utilized then another entity should be created to act as the general partner. Many times the general partner will be an LLC, which offers the tax flow-through treatment of a partnership but with limited liability similar to a corporation. An LLC, on the other hand, does not require a general partner and, therefore, only one entity would need to be formed for the fund. The down-side of using the LLC form is that it is slightly more difficult to vest all of the management authority in one entity or person than in an LP.
Until recently, there existed only one type of exemption from Tennessee's franchise and excise taxes for venture capital funds (venture capital funds exemption). A second broader exemption, however, went into effect on May 3, 2004, which exempts those venture capital funds qualifying as diversified investing funds from the franchise and excise taxes (diversified investing funds exemption). Although a fund may meet one of the exemptions for franchise and excise taxes described below, such exemption, however, will not extend to the Tennessee "Hall" income tax on dividends and interest received by the fund.
Venture Capital Funds Exemption. Under this exemption, a venture capital fund will be exempt from franchise and excise taxes if it is an LP, LLC or limited liability partnership (LLP) that is formed and operated for the exclusive purpose of buying, holding and/or selling securities, including debt securities, primarily (i.e., over 50 percent) in non-publicly traded companies on its own behalf and not as a broker. A "non-publicly traded company" is any company that is not traded on (a) a national securities exchange; (b) a foreign securities exchange; (c) a regional or local exchange; (d) an interdealer quotation system that regularly disseminates firm buy or sell quotations by identified brokers or dealers; or (e) a secondary market. The capital of the fund must be primarily derived from investments by entities or individuals that are not related to or affiliated with the fund.
Diversified Investing Funds Exemption. Under this new exemption, a venture capital fund will be exempt from franchise and excise taxes if it is an LP, LLC or LLP that is formed and operated for the primary purpose of buying, holding, or selling qualifying investment securities, on its own behalf and not as a broker. "Qualifying investment securities" includes: (a) common and preferred stock, or debt securities convertible into stock; (b) bonds, debentures, and other debt securities; (c) foreign and domestic currency deposits or equivalents and securities convertible into foreign securities; (d) mortgage or asset-backed securities secured by federal, state, or local governmental agencies; (e) repurchase agreements and loan participations; (f) foreign currency exchange contracts and forward and futures contracts on foreign currencies; (g) stock and bond index securities and futures contracts, and other similar financial securities and futures contracts on those securities; (h) options for the purchase or sale of any of the securities, currencies, contracts, or financial instruments; (i) warrants to purchase stock or an ownership interest in an entity; (j) an ownership interest in an LLC, LLP or LP; and (k) an ownership interest in a general partnership that would otherwise qualify as a diversified investing partnership were it not for its legal status as a general partnership. The capital of the fund must be primarily (i.e., over 50 percent) derived from investments by entities or individuals that are not affiliated with the fund. In addition, at least 90 percent of the fund's gross income must consist of interest, dividends and gains from the sale or exchange of qualifying investment securities and at least 90 percent of the fund's cost of its total assets must consist of qualifying investment securities, deposits at banks or other financial institutions, and office space and equipment reasonably necessary to carry on the fund's activities as a diversified investing fund. One of the benefits of the diversified investment fund exemption, is that it permits the fund to invest primarily in publicly traded securities. Investment primarily in publicly traded securities while maintaining an exemption from franchise and excise taxes is a benefit that was not previously available under Tennessee law.
If a fund qualifies under either of the above exemptions, then the fund itself, whether formed as an LLC or LP, will be exempt from franchise and excise taxes. In cases where the fund is an LP, however, the general partner will not be exempt. In order to minimize the tax affect to the general partner, additional planning and structuring may be recommended.
In the event that the fund does not qualify for either of the above exemptions, then the fund may be subject to franchise and excise taxes. The minimization of these taxes may depend on the location of the fund and, if organized as an LP, the general partner, or if organized as an LLC, the manager. If the fund is located in Tennessee, it will be subject to franchise and excise taxes. If the fund and the general partner/manager are located outside of Tennessee and the management decisions are made outside of Tennessee, then it is likely that Tennessee taxes can be minimized or eliminated. If the fund is located outside of Tennessee, but the general partner or its managers are doing business in or from Tennessee, it is likely that the fund will be deemed to be doing business in Tennessee and, therefore, subject to Tennessee taxes. There are a few alternative structures that, in limited situations, can be utilized to minimize the tax impact when a fund is subject to franchise and excise taxes.