Emerachem Power, LLC v. David Gerregano

06/01/2020

IN THE COURT OF APPEALS OF TENNESSEE

AT KNOXVILLE

October 16, 2019 Session

EMERACHEM POWER, LLC, ET AL., v. DAVID GERREGANO

Appeal from the Chancery Court for Knox County

No. 190097-1 John F. Weaver, Chancellor

___________________________________

No. E2019-00292-COA-R3-CV

___________________________________

This appeal was filed by the plaintiffs pursuant to the provisions of Tennessee Code

Annotated section 67-1-1801 to challenge assessments rendered against them by the

Commissioner of Revenue for the State of Tennessee. The dispute involves the

plaintiffs’ challenge to Tennessee’s assessments of excise tax for the period 2010 through

2012. After cross motions for summary judgment were filed, the trial court found in

favor of the Commissioner. The plaintiffs appeal. We affirm.

Tenn. R. App. P. 3 Appeal as of Right; Judgment of the Chancery Court

Affirmed; Case Remanded

JOHN W. MCCLARTY, J., delivered the opinion of the court, in which ANDY D. BENNETT

and THOMAS R. FRIERSON, II, JJ., joined.

Wayne R. Kramer and Bryce E. Fitzgerald, Knoxville, Tennessee, for the appellants,

EmeraChem Power, LLC, EmeraChem Holdings, LLC, and EmeraChem, LLC.

Herbert H. Slatery, III, Attorney General and Reporter, Andreé S. Blumstein, Solicitor

General, and Brian J. Ramming, Assistant Attorney General, Nashville, Tennessee, for

the appellee, Commissioner of Revenue for the State of Tennessee.

OPINION

I. BACKGROUND

EmeraChem Power, LLC, EmeraChem Holdings, LLC, and EmeraChem, LLC,

(collectively, “the Entities”) are all limited liability companies (“LLCs”) organized and

existing under and by virtue of the laws of the State of Delaware and qualified to do

business in the State of Tennessee. The primary business offices for the Entities are

located in Knoxville, Tennessee. The Entities are affiliated, in that EmeraChem Holdings

is the sole owner and member of EmeraChem and is likewise the sole owner and member

of EmeraChem Power. Put another way, EmeraChem and EmeraChem Power are wholly

owned subsidiaries of EmeraChem Holdings, the parent company. EmeraChem Holdings

is treated as a partnership for federal tax purposes.

EmeraChem is the operating company that does the manufacturing and selling. It

manufactures catalytic converters and other products. EmeraChem Power provides

engineering, design, and testing services. EmeraChem Holdings was created as a holding

company; it holds and manages patents and the purchase of precious metals used by

EmeraChem in the manufacturing process. The Entities were (and continue to be) leaders

in nanophase chemistry and catalysis for the control of air emissions from power

generating facilities, natural gas compression stations, and motor vehicles.

On November 16, 2009, EmeraChem Holdings submitted a Consolidated Net

Worth Election Registration Application, which the Tennessee Department of Revenue

(“Department”) approved effective January 1, 2008. This allowed the Entities to

compute their franchise tax using consolidated net worth. However, each member of the

group was still required to compute its excise tax on a separate-entity basis and file a

separate excise tax return.

EmeraChem Holdings filed its initial franchise-and-excise (“F&E”) return as a

consolidated return, including the net worth, assets, and income for EmeraChem Power

and EmeraChem, while EmeraChem Power and EmeraChem both filed minimum returns

reporting no net worth, assets, and no income. The Department disallowed the filing of

such initial returns on a consolidated basis asserting that it was prohibited by Tennessee

Code Annotated section 67-4-2007(d) because EmeraChem Holdings, the parent and sole

member of EmeraChem Power and EmeraChem, was a limited liability company, not a

corporation. Subsequently, the Entities each produced separate amended F&E tax returns

and delivered them to the auditors. This time, the Entities filed separate returns (rather

than a consolidated return as EmeraChem Holdings had done initially), but on the

amended returns the Entities eliminated certain intercompany transactions in computing

their excise tax liability. The Department, however, determined that the Entities had

again failed to compute their tax liabilities correctly because they were still computing

their excise tax on a consolidated basis.

As noted, EmeraChem Holdings was created to hold and manage multiple

operating companies, patents, and the purchasing of precious metals used by EmeraChem

in the manufacturing process. The holding of patents is important and necessary for the

Entities to carry out their business and produce their products. In the tax year 2011,

EmeraChem Holdings received $1,401,689 from the settlement of a legal malpractice

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claim against a New York law firm.1 The funds received by EmeraChem Holdings arose

out of the legal representation by the defending law firm in connection with a particular

patent relevant to EmeraChem Holdings’ European business activity. EmeraChem

Holdings claimed that attorneys for the law firm failed to properly register Patent No.

08028252 in Europe. The fundamental basis upon which the amount of damages was

paid to EmeraChem Holdings for the New York law firm’s malpractice was lost

European revenue as a result of potential patented products or patented licensing in

Europe.

In filing its F&E tax return for 2011, EmeraChem Holdings reported the receipt of

the legal malpractice settlement proceeds. It classified the proceeds as “non-business”

earnings for excise tax purposes and subtracted them as sourced outside of Tennessee.

The Department conducted F&E tax audits of the Entities in 2014 for the period

January 1, 2010, through December 31, 2012. During the audit period, the Entities did

business in numerous states and foreign countries. EmeraChem had less than 50

employees. Neither EmeraChem Power nor EmeraChem Holdings had any employees

during the audit period. They all filed Tennessee F&E tax returns for the years 2010,

2011, and 2012.

During the audit period, transfers of industrial materials2 (“Industrial Materials”)

took place between EmeraChem Holdings and EmeraChem. The transfers by

EmeraChem Holdings were not to the general public nor were the products ultimately

sold by EmeraChem to the general public or to the end user. Rather, EmeraChem

Holdings procured the Industrial Materials and then transferred them to EmeraChem for

future processing and incorporation into catalysts manufactured by EmeraChem. Title to

the Industrial Materials passed from the supplier to EmeraChem Holdings and then

passed to EmeraChem. The Industrial Materials were procured by EmeraChem

employees using EmeraChem funds. In addition, the volume, purchase price, and timing

of the purchase of the Industrial Materials were at the direction of EmeraChem, again

through its employees. EmeraChem Holdings had no employees and had no funds during

the audit period other than those provided by EmeraChem. After processing and

incorporating the Industrial Materials into the catalysts, EmeraChem would, in turn, sell

the manufactured catalysts to a third-party subcontractor or other dealer who then sold

the same to the end user (such as a power plant). Furthermore, the amount of funds

which EmeraChem Holdings received from EmeraChem (which represented more than

80% of EmeraChem Holdings’ revenue) did not include a markup and did not exceed

1

Receipt of the legal malpractice settlement proceeds in 2011 by EmeraChem Holdings was the

first and only time either it or any other EmeraChem entity had received proceeds of such a nature. The

total amount of malpractice proceeds paid was $2,250,000. After payment of $848,311 in attorneys’ fees,

the amount received by EmeraChem Holdings was $1,401,689.

2

Precious metal raw materials.

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EmeraChem Holdings’ costs (including any freight, storage, and/or transportation costs).

More than 50% of EmeraChem’s revenues during the audit period were from sales of

catalysts to the subcontractors and dealers.

As a result of the audit, the Department determined that in 2010, 2011, and 2012,

the Entities should not have computed their excise tax on a consolidated basis and should

not have filed consolidated tax returns. The Department asserted that under the

applicable statute, only a single-member LLC that is wholly owned by a corporation may

be disregarded by its parent company for excise tax purposes. EmeraChem and

EmeraChem Power are single member LLCs, but EmeraChem Holdings, their single

member, is treated as a partnership for federal income tax purposes.

By Notice of Assessment dated May 5, 2014, EmeraChem Power was advised that

as a result of the audit conducted by the Department, it was liable for F&E tax, plus

interest and penalties. The Department claimed that EmeraChem Power was liable for

F&E tax of $1,240, a penalty of $124, and interest of $271.16, for a total amount assessed

of $1,635.16. On May 28, 2014, pursuant to Tennessee Code Annotated section 67-1-

1801(c)(3) and Tenn. Comp. R & Regs. 1320-1-2-.05(1), EmeraChem Power requested

an Informal Conference.

By Notice of Assessment dated May 9, 2014, EmeraChem Holdings was advised

that it was liable for F&E tax of $106,601, a penalty on the F&E tax of $10,660, and

interest attributable to the F&E tax of $17,307.09. The Department further asserted that

EmeraChem Holdings was liable for County Business tax of $7,864, a penalty in

connection with the County Business tax of $1,965, and interest attributable to the

County Business tax of $1,221.80. Finally, the Department asserted that EmeraChem

Holdings was liable for City Business tax of $7,795, as well as interest thereon of

$1,207.74. The Department claimed the assessed F&E tax was due largely to the receipt

by EmeraChem Holdings of the legal malpractice settlement proceeds and the assessed

Business tax was due as a result of the transactions described above. The Department

rejected EmeraChem Holdings’ classification of the proceeds as nonbusiness earnings

and reclassified the proceeds as “business earnings” to be included as gross income for

calculation of the excise tax. Of the total excise tax assessed against EmeraChem

Holdings ($104,477), most of it ($91,109.79) represented the tax resulting from including

the settlement proceeds as part of the company’s business earnings for the 2011 tax year.

The total amount the Department claimed to be due from EmeraChem Holdings, as

reflected in the EmeraChem Holdings Notice and after applying various credits and

payments, was $154,621.63. On May 28, 2014, EmeraChem Holdings requested an

Informal Conference.

By Notice of Assessment dated June 13, 2014, EmeraChem was advised that it

was found liable for F&E tax of $23,103.36, $2,310 in penalty, and $3,688.19 in interest

relative to the F&E tax. The Department further asserted that EmeraChem was liable for

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$9,760.19 in Sales & Use tax and $1,428.36 in interest resulting from the Sales & Use tax

assessment. Finally, the Department noted that EmeraChem was entitled to a County

Business tax credit of $9. Overall, as a result of the audit, the Department claimed that

the total amount due from EmeraChem to the Department, after applying various credits

and payments, was $40,281.10.3 On June 24, 2014, EmeraChem requested an Informal

Conference.

In the auditors’ report for EmeraChem, the Department made the following

statement:

Tennessee law makes no provision for consolidated

franchise/excise tax returns except in the instance of a single

member LLC whose single member is a corporation. The

single member of EmeraChem, LLC, and EmeraChem Power,

is not a corporation rather, it is a limited liability company

treated as a partnership for federal tax purposes. Nor have

any of these entities been merged out of existence.... The

consolidation work papers provided by the Taxpayer

demonstrates that all three entities had activity both with each

other as well as outside the affiliated group. Tenn. Code Ann.

§ 67-4-2007(d) specifically prohibits disregarding any of

these entities for the purpose of filing Tennessee Franchise

and Excise Tax Returns.

When asked about Tennessee Code Annotated section 67-4-2007(d), the auditor agreed

that if EmeraChem Holdings had been a corporation instead of an LLC, “none of this

would have been a problem.” The auditor stated that if EmeraChem Holdings had been a

corporation, then reporting the income and business activity of the Entities on a

consolidated basis would have been permitted under the statute. According to the

auditor, had EmeraChem Holdings been an S Corporation and had EmeraChem Power,

EmeraChem Holdings, and EmeraChem filed their F&E tax returns for the years at issue

on a consolidated basis, the result would have been exactly the same as that reflected on

the initial F&E returns filed on behalf of the Entities.

According to the Department, it is appropriate for EmeraChem Power,

EmeraChem Holdings, and EmeraChem to compute their net worth for franchise tax

purposes on a consolidated basis but not their income or business activity for excise tax

purposes. The Department asserted that the legal malpractice settlement proceeds of

$1,401,689 should have been included in the EmeraChem Holdings’ 2011 F&E tax return

as business earnings based upon Tennessee Code Annotated section 67-4-2004(4). In its

audits of the Entities, and specifically in the audit of EmeraChem Holdings for tax year

3

EmeraChem does not contest the Sales & Use tax assessment.

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2011, the Department claimed that the proceeds received by EmeraChem Holdings from

the legal malpractice claim were subject to the F&E tax and must be included on the 2011

return resulting in a “tax due” of $91,109.79. In making such a claim, the Department

stated, among other things, that “the holding of patents is an integral and essential part of

the business of EmeraChem Holdings, LLC and its subsidiaries and [therefore the

malpractice proceeds] falls within the definition of “business earnings” found in Tenn.

Code Ann. §67-4-2004(4)....” As a result, the auditors (i) asserted that such proceeds

were includable in EmeraChem Holdings’ 2011 F&E tax return, (ii) disallowed the

deduction, and (iii) stated that the proceeds were subject to the F&E tax.

After the holding of an Informal Conference pursuant to Tennessee Code

Annotated section 67-1-1801(c)(3), the Commissioner adjusted the assessments. He

issued an Adjusted Notice to EmeraChem Power, adjusting the applicable interest amount

accruing prior to the issuance of the informal conference letter, resulting in a total

adjusted amount due of $1,671.09, including excise tax in the amount of $1,240, penalty

in the amount of $124, and interest in the amount of $307.09. The Commissioner also

issued an Adjusted Notice to EmeraChem, adjusting the applicable interest amount

accruing prior to the issuance of the informal conference letter and applying a $1,035.59

credit from a previous return, resulting in a total adjusted amount due of $39,933.13,

including excise tax in the amount of $23,103, penalty in the amount of $2,310, and

interest in the amount of $4,168.87. He issued an Adjusted Notice to EmeraChem

Holdings, adjusting the applicable interest amount accruing prior to the issuance of the

informal conference letter and applying a $12,000 credit from a previous return, resulting

in a total adjusted amount due of $143,328.77, including excise tax in the amount of

$104,477, business tax in the amount of $15,659, penalties in the amount of $12,625, and

interest in the amount of $22,567.77. The overall total amount the Department claimed

was $184,932.99 as of June 15, 2015.4

4

EmeraChem paid the adjusted Sales and Use tax assessed against it ($9,760.19), plus applicable

interest; thus, EmeraChem’s Sales and Use tax Assessment is not at issue in this suit.

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The Entities filed suit in August 2015. The case was heard on cross-motions for

summary judgment. In a final judgment entered on January 18, 2019, the trial court

upheld the excise tax assessments, upheld the penalties against EmeraChem and

EmeraChem Power, and upheld the penalty against EmeraChem Holdings except for the

portion attributable to the malpractice settlement proceeds ($9,110.97).

The trial court agreed with the Commissioner that EmeraChem Holdings’

malpractice settlement proceeds were business earnings subject to Tennessee excise tax.

It determined that the proceeds represented lost revenues related to the company’s

patents, which, if they had not been lost because of the malpractice of the New York law

firm, would have been taxable as business earnings. The court also found no basis upon

which to allow EmeraChem Holdings to apportion any of the proceeds to New York or

elsewhere because it had failed to demonstrate a presence or business activities in New

York. The Entities failed to show any business activities that were taxable both inside

and outside Tennessee. The trial court further determined that the Entities were not

entitled to file consolidated excise tax returns or compute their excise tax on a

consolidated basis. The court rejected the Entities’ constitutional challenge to section 67-

4-2007(d), finding that they had failed to prove an equal-protection violation and that the

Commissioner had demonstrated a rational basis for the statute’s different treatment of

corporations and LLCs. Finally, the court upheld the negligence penalties imposed by

the Commissioner with respect to the consolidated tax returns because the Entities had

been given prior warnings against the filing of consolidated returns.5 The Entities filed

this timely appeal.

II. ISSUES

We restate the issues raised in this appeal as follows:

1. Whether the Entities were properly assessed additional

excise tax for the years 2010 to 2012 because EmeraChem

Holdings filed consolidated excise-tax returns on behalf of

itself and EmeraChem and EmeraChem Power, instead of the

Entities filing separate returns under Tennessee Code

Annotated section 67-4-2007(d).

2. Whether Tennessee Code Annotated section 67-4-

2007(d)’s requirement for the filing of separate returns is

constitutional because there is a rational basis for excepting

5

The court observed that the Commissioner had withdrawn the claim for the business tax

assessment. The amounts related to that issue are $15,659 in business tax, $1,965 in penalty, and interest

of $2,870.91.

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LLC’s whose single member is a corporation.

3. Whether the proceeds received by EmeraChem Holdings in

2011 from the settlement of a legal-malpractice claim were

properly subject to Tennessee excise tax because they were

“business earnings.”

4. Whether the Entities were properly assessed negligence

penalties for failing to file separate returns under Tennessee

Code Annotated section 67-4-2007(d), when the Entities had

prior notice of that requirement.

III. STANDARD OF REVIEW

This case was decided by summary judgment. Summary judgment is appropriate

when “the pleadings, depositions, answers to interrogatories, and admissions on file,

together with the affidavits, if any, show that there is no genuine issue as to any material

fact and that the moving party is entitled to a judgment as a matter of law.” Tenn. R. Civ.

P. 56.04. We review a trial court’s ruling on a motion for summary judgment de novo,

without a presumption of correctness. Rye v. Women’s Care Center of Memphis,

MPLLC, 477 S.W.3d 235, 250 (Tenn. 2015); Dick Broad. Co., Inc. of Tenn. v. Oak Ridge

FM, Inc., 395 S.W.3d 653, 671 (Tenn. 2013). In doing so, we make a fresh

determination of whether the requirements of Rule 56 of the Tennessee Rules of Civil

Procedure have been satisfied. Rye, 477 S.W.3d at 250 (citing Estate of Brown, 402

S.W.3d 193, 198 (Tenn. 2013); Hughes v. New Life Dev. Corp., 387 S.W.3d 453, 471

(Tenn. 2012)).

To the extent that the issues raised in this appeal require us to interpret and apply

statutes, we note that statutory interpretation is a question of law, which we review de

novo, affording no presumption of correctness to the conclusions of the trial court. State

v. Crank, 468 S.W.3d 15, 21 (Tenn. 2015); In re Baby, 447 S.W.3d 807, 817 (Tenn.

2014); Mansell v. Bridgestone Firestone N. Am. Tire, LLC, 417 S.W.3d 393, 399 (Tenn.

2013) (citing Waters v. Farr, 291 S.W.3d 873, 882 (Tenn. 2009)). The principles of

statutory interpretation are well established. When reading “statutory language that is

clear and unambiguous, we must apply its plain meaning in its normal and accepted use,

without a forced interpretation that would limit or expand the statute’s application.”

Eastman Chemical Co. v. Johnson, 151 S.W.3d 503, 507 (Tenn. 2004).

“[W]e presume that every word in a statute has meaning and purpose and should

be given full effect if the obvious intention of the General Assembly is not violated by so

doing.” SunTrust Bank v. Burke, 491 S.W.3d 693, 695 (Tenn. Ct. App. 2015), perm. app.

denied (Tenn. June 15, 2015) (quoting Lind v. Beaman Dodge, 356 S.W.3d 889, 895

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(Tenn. 2011)). “When a statute is clear, we apply the plain meaning without

complicating the task.” In re Baby, 447 S.W.3d 807, 817 (Tenn. 2014). However, when

a statute is ambiguous, “we may reference the broader statutory scheme, the history of the

legislation, or other sources.” Colonial Pipeline Co. v. Morgan, 263 S.W.3d 827, 836

(Tenn. 2008).

Courts must liberally construe statutes that impose a tax in favor of the taxpayer

and strictly construe them against the taxing authority. Eastman Chemical, 151 S.W.3d

at 507. “[W]here there is doubt as to the meaning of a taxing statute, the doubt must be

resolved in favor of the tax payer.” Commercial Standard Ins. Co. v. Hixson, 133 S.W.2d

493, 494 (Tenn. 1939). This construction, however, must be fair and give effect to the

language of the statute. See, e.g., International Harvester Co. v. Carr, 466 S.W.2d 207,

214 (Tenn. 1971); United Inter-Mountain Tel. Co. v. Moyer, 426 S.W.2d 177, 181 (Tenn.

1968).

IV. DISCUSSION

Additional Excise Tax

Under Tennessee law, neither EmeraChem nor EmeraChem Power are permitted

to file consolidated F&E tax returns with EmeraChem Holdings, their parent company,

because EmeraChem Holdings is treated as a partnership for federal tax purposes.6 The

language of Tennessee Code Annotated section 67-4-2007(d) makes the separate filing

requirement clear:

For purposes of the excise tax levied by this part, a business

entity shall be classified as a corporation, partnership, or other

type business entity, consistent with the way the entity is

classified for federal income tax purposes, and subject to tax

in accordance with this part. Notwithstanding any law to the

contrary, 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 excise tax purposes.

Tenn. Code Ann. § 67-4-2007(d).

6

Under the federal “check-the-box” tax scheme, LLCs with 2 or more members (owners) are

treated as partnerships by default. If an LLC wishes to be treated as a corporation, they may elect such

treatment so long as they are an eligible entity under 26 C.F.R. § 301.7701-3(a).

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For Tennessee F&E tax purposes, businesses are classified according to their

federal income tax classification. Id. Under the general rule, businesses classified as

disregarded entities for federal income tax purposes will not be disregarded for Tennessee

F&E tax purposes. Id. Since Tennessee is a separate reporting state for excise-tax

purposes, business entities must calculate their excise-tax liability separate from any

parent company or affiliate, and they must file their own separate return.

The legislature created one exception to the general rule, and that exception only

applies to business entities that are: (1) single-member LLCs, (2) classified as

disregarded entities under the federal income tax system, and (3) their single-member

parent is a corporation. If a business entity meets all three requirements, it is disregarded

for Tennessee F&E tax purposes. This exception is the only instance in which a business

entity may file a consolidated excise-tax return with its parent company.

Tenn. Comp. R. & Regs. 1320-06-01-.40 further clarifies the language in

Tennessee Code Annotated section 67-4-2007(d):

(1) Disregarded Limited Liability Companies. A limited liability

company is disregarded for franchise and excise tax purposes only if it is

disregarded for federal income purposes and its single member is classified

as a corporation for federal income tax purposes. If a limited liability

company does not meet both of these requirements, it will be treated

separately for franchise and excise tax purposes and must file its own

separate franchise and excise tax return.

(2) Other Federally Disregarded Entities. Only a limited liability

company meeting the requirements of (1) will be disregarded for franchise

and excise tax purposes. All other taxpayers subject to the franchise or

excise tax will be treated separately, regardless of whether they are

otherwise disregarded for federal income tax purposes.

Tenn. Comp. R. & Regs. 1320-06-01-.40. The regulation repeats the plain language of

Tennessee Code Annotated section 67-4-2007(d) and explains that the parent company’s

federal income tax classification determines whether the subsidiary LLC will be

disregarded for Tennessee F&E tax purposes. The exception to the general rule applies

to LLCs “whose single member is a corporation,” but the “corporation” requirement is

satisfied when “the single member is classified as a corporation for federal income tax

purposes.” Tenn. Code Ann. § 67-4-2007(d). Therefore, non-corporate parents satisfy the

corporation requirement so long as the non-corporate parent is classified as a corporation

for federal income tax purposes.7

7

For example, a subsidiary whose single-member/parent is an LLC will fall within the exception

to the general rule if the parent LLC is classified as a corporation for federal tax purposes. This result is

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EmeraChem and EmeraChem Power are not disregarded entities for Tennessee

F&E tax purposes because neither fall within the exception to the general rule set out in

Tennessee Code Annotated section 67-4-2007(d). Although EmeraChem and

EmeraChem Power are single-member LLCs and disregarded entities under the federal

income tax system, their parent–EmeraChem Holdings–is classified as a partnership for

federal income tax purposes. Since EmeraChem Holdings is not classified as a

corporation, EmeraChem and EmeraChem Power are not disregarded entities for

Tennessee F&E tax purposes. Accordingly, EmeraChem and EmeraChem Power must

calculate their own separate excise-tax liability and file their own separate returns.

“Doing business in Tennessee by any person or taxpayer . . . is declared to be a taxable

privilege.” Tenn. Code Ann. § 67-4-2005. The Entities must conform to the laws of

Tennessee, and they cannot compute their excise tax on a consolidated basis or file

consolidated excise-tax returns with their parent, EmeraChem Holdings.

Constitutionality

We affirm the trial court’s determination that Tennessee Code Annotated section

67-4-2007(d) is constitutionally valid under both the United States Constitution and the

Tennessee Constitution. Rational basis scrutiny is the appropriate level of equal

protection review in this case. Dr. Pepper Pepsi-Cola Bottling Co. of Dyersberg, LLC v.

Farr, 393 S.W.3d 201, 209 (Tenn. Ct. App. 2011). “If any possible reason can be

conceived to justify the classification, or if the reasonableness be fairly debatable, then

the legislation will not be struck down.” Id. at 210. It is well settled that the appellant

bears the burden in proving that a tax statute is unconstitutional and must meet this

burden by establishing that either: (1) the state’s objective is not legitimate, or (2) the

statutory classification does not rationally advance a legitimate state objective.

Nolichucky Sand Co. v. Huddleston, 896 S.W. 2d 782, 788 (Tenn. Ct. App. 1994); see

also Admiralty Suites and Inns v. Shelby County, 138 S.W.3d 233, 240 (Tenn. Ct. App.

2003). In this case, the Entities have failed to meet their burden for the reasons addressed

below.

1.

Tennessee Code Annotated section 67-4-2007(d) has a rational basis because it

captures business earnings that are subject to the Tennessee F&E tax and which may

otherwise go unreported (or be under-reported) by certain parent companies.

In Tennessee, for F&E tax purposes, the starting point in determining a business

entity’s tax classification is its federal tax return and federal tax classification. Newell

proper despite the fact that an LLC is not a corporation.

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Window Furnishing, Inc. v. Johnson, 311 S.W.3d 441, 455 (Tenn. Ct. App. 2008).

Analyzing the purpose of Tennessee Code Annotated section 67-4-2007(d) requires an

understanding of how the federal government taxes different business entities based on

their status as a corporation, partnership, or disregarded entity.

Subchapter C of the Internal Revenue Code applies to businesses organized as

corporations. Corporate profits are subject to double taxation because corporations must

report their earnings, file federal tax returns with the Internal Revenue Service, and pay

taxes. When a corporation distributes corporate profits to its shareholders, the

shareholders must report the amount they receive and pay the corresponding taxes.8

Thus, the corporate profits are reported and taxed twice: once at the corporate level, and

once by the individual shareholders.

Subchapter K of the Internal Revenue Code applies to partnerships. Unlike

corporations, partnerships do not file federal tax returns at the entity level or pay taxes on

partnership profits. Instead, a partnership simply tracks its profits and losses and, at the

end of its tax year, allocates the total profit or loss to the individual partners based on the

partnership agreement. The individual partners, rather than the partnership, are

responsible for reporting the partnership’s earnings and paying the corresponding taxes.

The Internal Revenue Code labels this style of taxation as “pass-thru” because business

earnings pass through the business entity without being taxed. Sole proprietorships and

single-member LLCs, both of which are classified as disregarded entities by default, also

have the benefit of pass-thru taxation. On the whole, this pass-thru system can make it

more difficult to administer certain tax laws and trace business income.

LLCs are a hybrid business entity, and–unlike corporations or partnerships–the

Internal Revenue Code does not contain a specific subchapter addressing LLC taxation.

Instead, LLCs are given considerable flexibility and may be categorized as corporations,

partnerships, or disregarded entities. Under the default rules, LLCs with a single-

member–such as EmeraChem and EmeraChem Power–are classified as disregarded

entities, and LLCs with more than one owner–such as EmeraChem Holdings–are

classified as partnerships for federal income tax purposes. In both scenarios, the LLCs

are pass-thru entities that do not file federal tax returns.9

In this case, both EmeraChem and EmeraChem Power are disregarded entities.

Both companies generate income, and the profits are passed through to their mutual

8

The amount the taxpayer reports/pays varies considerably and typically depends on whether the

distribution is a dividend, non-liquidating distribution, or liquidating distribution.

9

LLCs do have the ability to opt-in to subchapter C tax treatment in lieu of the default rules. If an

LLC makes this election, the business entity must file a federal tax return with the IRS and pay any

corresponding taxes. As with corporations, the LLCs profits will be taxed a second time when they

distribute those profits to their individual members.

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parent company–EmeraChem Holdings–without being taxed. Since EmeraChem

Holdings is classified as a partnership for federal tax purposes, its profits (including the

income it receives from EmeraChem and EmeraChem Power) are passed through to its

individual members/owners without being taxed. When EmeraChem Holdings allocates

profits to its members, the individual members are the only parties responsible for

reporting the profits and paying taxes.

The Entities’ business structure illustrates why Tennessee does not follow federal

tax classification or allow single-member LLCs to automatically retain their disregarded

entity status. A series of pass-thru business entities, none of which file federal tax

returns, increases the risk that taxpayers will under-report earnings that are subject to the

Tennessee F&E tax. Further, following the federal system would make administration of

the tax laws more difficult. As argued by the Commissioner:

Tenn. Code Ann. § 67-4-2007(d) reaches earnings that might otherwise be

lost if they were allowed to be passed through to a nontaxable parent.

Because Tennessee excise tax law is tied initially to federal tax returns, if

the federal rule were followed, single-member LLCs could pass their

earnings through to a partnership that is not subject to Tennessee excise tax.

And because an LLC that is [treated as] a partnership [for federal income

tax purposes] does not report its income for federal purposes at all there

would be no way that the Commissioner could know, much less tax, the

income. There is the very real possibility that the disregarded LLC’s

earnings, and the resulting Tennessee excise tax, could be altogether

avoided by the nontaxable parent. It is certainly reasonable for the State to

seek to recover excise tax from a business based on its Tennessee earnings,

and the statute accomplishes this goal.

The State’s objective is to reduce the risk of under-reporting and hold business

entities increasingly accountable for reporting their business earnings. This objective is

undoubtedly legitimate, and the federal government frequently enacts proactive tax

regulations to reduce the risk of under-reporting. Tennessee Code Annotated section 67-

4-2007 rationally advances the state’s legitimate objective because it decreases the

number of LLCs classified as disregarded entities and thereby increases the overall

number of businesses that must file separate tax returns for Tennessee F&E tax purposes.

This structure increases transparency and reduces the overall risk of abuse or

underreporting.

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2.

Section 67-4-2007(d) rationally advances the state’s legitimate objective despite

the fact that the statute fails to capture income that may otherwise go unreported by S

corporations.

The Entities bear the burden of proving that the statute is unconstitutional. Since

the state’s purpose is legitimate, the constitutional challenge fails unless the Entities

demonstrate that the statutory classification in Tennessee Code Annotated section 67-4-

2007 is irrational or arbitrary. Nolichucky Sand Co., 896 S.W. 2d at 788. A state is free

to categorize entities, and in doing so, the grouping may result in a law that is either

under-inclusive or overinclusive. CALVIN MASSEY & BRANNON P. DENNING, AMERICAN

CONSTITUTIONAL LAW: POWERS AND LIBERTIES 639 (6th ed. 2019). “A law is enacted to

achieve a legislative objective, but the classification employed by the law may not

perfectly achieve that objective.” Id. at 637. “A statutory classification is said to be

under-inclusive when it includes (or excludes) fewer people or things than necessary to

perfectly achieve the objective.” Id. at 638. However, the under-inclusive or over-

inclusive nature of a statutory classification rarely renders the statute arbitrary or

irrational. Id.

Although the statutory classification in section 67-4-2007(d) helps achieve the

State’s legitimate purpose, the Entities have demonstrated that the language of the statute

may fail to capture income from one type of pass-thru parent company: S corporations.10

S corporations are unique because they are classified as corporations for federal tax

purposes, but they have the benefit of pass-thru taxation and allocate their earnings to

shareholders in the same manner that partnerships pass their earnings to partners.11 See

I.R.C. §1363(b) (2019). The Entities are correct in their assertion that LLCs whose

single-member is an S corporation receive preferential treatment under Tennessee Code

Annotated section 67-4-2007(d) despite the pass-thru nature of the S corporation parent:

S corporations are corporations that elect to pass corporate

income, losses, deductions, and credits through to their

shareholders for federal tax purposes. Shareholders of S

10

S corporations are typically much smaller than C corporations. In order to become an S

corporation, the corporation must submit Form 2553 Election by a Small Business Corporation and meet

several requirements. Subchapter S of the Internal Revenue Code provides guidelines and rules for S

corporations in addition to the rules set out in Subchapter C.

11

Every business has owner(s), but the title of the owner(s) depends on the type of business entity.

Partnerships pass their income to partners, LLCs pass their income to the members of the LLC, and S

corporations pass their income to corporation’s shareholders. When an LLC or S corporation is classified

as a partnership for tax purposes, the members or shareholders should retain the title associated with their

ownership rather than being referred to as partners.

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corporations report the flow-through of income and losses on

their personal tax returns and are assessed tax at their

individual income tax rates. This allows S corporations to

avoid double taxation on the corporate income.12

Income passes through S corporation parent companies in the exact same manner

that it passes through other types of pass-thru parents companies, but an S corporation’s

subsidiary may nonetheless fall within the exception to the general rule in Tennessee

Code Annotated 67-4-2007(d). Since S corporations are still classified as corporations

for federal income tax purposes, LLCs whose single-member parent is an S corporation

will retain their status as a disregarded entity and have the benefit of filing consolidated

excise-tax returns with their pass-thru parent company. The Entities argue that the

statutory classification in Tennessee Code Annotated section 67-4-2007(d), and its

inclusion of S corporation parents in the exception to the general rule, renders the statute

irrational and arbitrary.

The Entities are correct that Tennessee Code Annotated 67-4-2007(d) would be

even more effective if the exception to the general rule was limited to LLCs whose

single-member parent is a C corporation rather than all corporations in general. If the

language excluded S corporation parents, then fewer LLCs would retain their disregarded

entity status. Such change would increase the number of business entities that are

required to file their own returns and calculate their own separate excise-tax liability.

This may increase transparency and further reduce the risk of under-reporting, but such

change must be made by the legislature, not the judiciary.

If the purpose of Tennessee Code Annotated 67-4-2007(d) is to track business

income that could be under-reported by pass-thru parent companies, then the statutory

classification seems ineffective when it is applied to LLCs whose single-member parent

is an S corporation. Treating S corporations like regular corporations seems to

undermine the purpose of the statute because S corporations, like other pass-thru entities,

appear equally likely to engage in underreporting. However, this reasoning is unsound.

Unlike other pass-thru entities, S corporations must file informational tax returns with the

Internal Revenue Service. RICHARD L. DOERNBERG, FEDERAL INCOME TAXATION OF

CORPORATIONS AND PARTNERSHIPS 523 (5th ed. 2014). This reduces the risk that S

corporations will engage in abusive under-reporting because the Commissioner can trace

an S corporation’s income by obtaining the informational filing. Overall, there is more

transparency and less difficulty administering tax laws when a pass-thru parent is an S

corporation. This helps explain why the Tennessee legislature gives LLCs whose single-

12

Internal Revenue Service, S Corporations, DEPARTMENT OF TREASURY (Apr. 08, 2020),

https://www.irs.gov/businesses/small-businesses-self-employed/s-corporations

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member parent is an S corporation preferential treatment as compared to LLCs with other

types of pass-thru parents.

The Entities failed to establish that the statute is unconstitutional. The statutory

classification has a rational basis because it captures a significant portion of income that

is difficult for the Commissioner to track. Furthermore, the exception to the general rule

does not undermine section 67-4-2007(d)’s legitimate purpose because S corporations are

less likely to engage in abusive underreporting.

3.

Tennessee Code Annotated section 67-4-2007(d)’s preferential treatment of

subsidiary LLCs whose single-member parent is an S-corporation does not violate the

Equal Protection Clause.

The Entities’ equal protection argument is based on the fact that Tennessee Code

Annotated section 67-4-2007(d) treats two similarly situated business entities differently:

subsidiary LLCs whose single-member parent is an S corporation, and subsidiary LLCs

whose single-member parent is an LLC that is classified as a partnership for federal

income tax purposes. In both scenarios, the subsidiary LLCs are pass-thru entities with

pass-thru parents. Although they are similarly situated for federal tax purposes,

Tennessee distinguishes between the subsidiary LLCs based on whether their single-

member parent is classified as a corporation for federal income tax purposes.13

Both the United States Constitution and the Tennessee Constitution contain an

Equal Protection Clause that guarantees, “all persons similarly circumstanced shall be

treated alike.” State v. Robinson, 29 S.W.3d 476, 480 (Tenn. 2000). However, “it is well

settled that the equal protection clause does not require absolute equality from the State.”

Posey v. City of Memphis, 164 S.W.3d 575, 578-79 (Tenn. Ct. App. 2004) (citing to

Gray’s Disposal Co. v. Metro Gov’t of Nashville, 122 S.W. 3d 148, 162-63 (2002).

“Legislative classifications are presumed to be valid unless there is some reason to be

suspicious of the classifying device or its effect.” CALVIN MASSEY & BRANNON P.

DENNING, AMERICAN CONSTITUTIONAL LAW: POWERS AND LIBERTIES 639 (6th ed.

2019). Any statutory classification related to the application of certain tax laws

necessarily divides people into two classes, but that is not enough to invalidate the law as

violative of the equal protection clause. Id at 638. Statutory classifications are not in

13

The differential treatment begins at the federal level because the Internal Revenue Service

categorizes S corporations as corporations for federal income tax purposes despite the fact that they are

pass-through entities. If the Internal Revenue Service classified S corporations as partnerships (their

function equivalent), then the statutory classification in Tennessee Code Annotated section 67-4-2007(d)

would not give rise to unequal treatment.

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themselves improper, and the legislature is not required to treat all businesses the exact

same. Christ Church Pentecostal v. Tenn. State Bd. of Equalization, 428 S.W.3d 800,

822 (Tenn. Ct. App. 2013) (citing Plyler v. Doe, 457 U.S. 202, 216 (1982)). Further, the

legislature is allowed considerable latitude in establishing categorical classifications. Id.

Here, the Entities failed to overcome the presumption that Tennessee Code

Annotated section 67-4-2007(d) is valid. The unequal treatment of two business

structures does not equate to unlawful discrimination in violation of the Equal Protection

Clause in the 14th Amendment to the United States Constitution or Article XI, Section 8

of the Tennessee Constitution. A statutory classification based on a business’s structure

and the federal tax classification of their parent company is not inherently suspicious.

The Tennessee legislature is allowed considerable latitude in establishing categorical

classifications, and the federal filing requirement associated with S corporations justifies

the differential and preferential treatment of subsidiary LLCs whose single-member pass-

thru parent is an S corporation.

Business entities are free to organize their enterprise in a manner that affords them

the benefit of consolidated filing for federal income tax purposes and Tennessee F&E tax

purposes. It would be improper to construe Tennessee Code Annotated section 67-4-

2007(d) as violating Equal Protection since business entities are ultimately responsible

for determining how the statute affects their filing status. If the Entities wanted to file

consolidated tax returns, they should have read the Tennessee laws and structured their

enterprise accordingly. Even after EmeraChem Holdings was formed, the LLC could

have elected to be classified as a corporation for federal tax purposes so that the Entities

could have the benefit of consolidated filing. The Entities did not make such election,

and they should not expect special treatment.

Business Earnings

An issue before us is whether the proceeds from a legal malpractice action should

be categorized as business earnings subject to the Tennessee excise tax. The damages

from the malpractice action arose when EmeraChem Holdings’ New York attorneys

improperly filed a European patent. Although the European patent filing was

unsuccessful, the damages awarded in settlement of the malpractice claim were

nonetheless based on profits that would have been earned if the patent had been properly

filed.14 We agree with the Commissioner and affirm the trial court’s holding that the tax

classification of the settlement proceeds should be determined by looking to the nature

and basis of the settled action, with those settlement proceeds having the same nature as

14

EmeraChem Holdings stipulated that the damages paid in its legal malpractice action

represented lost revenues from potential patented products or patent licensing in Europe (The

fundamental basis upon which the amount of damages was paid . . . was lost European Revenue.”).

- 17 -

the right that was compromised. See Freda v. Comm’r, 656 F.3d 570, 573-577 (7th Cir.

2011).

1.

Any income that falls within Tennessee’s statutory definition of business earnings

will be subject to the Tennessee Excise tax. “Business earnings” under Tennessee Code

Annotated section 67-4-2004 are:

Earnings arising from transactions and activity in the regular

course of the taxpayer’s trade or business or earnings from

tangible and intangible property, if the acquisition, use,

management or disposition of the property constitutes an

integral part of the taxpayer’s regular trade or business

operations. In essence, earnings that arise from the conduct of

the trade or trades or business operations of a taxpayer are

“business earnings,” and the taxpayer must show by clear and

cogent evidence that particular earnings are classifiable as

nonbusiness earnings. A taxpayer may have more than one (1)

regular trade or business in determining whether income is

“business earnings.”

Tenn. Code Ann § 67-4-2004(4).

In examining the definition of business earnings under Tennessee Code Annotated

section 67-4-2004(4), two tests have been identified. The section of the statute defining

“business earnings” as “[e]arnings arising from transactions and activity in the regular

course of the taxpayer’s trade or business” has been referred to as the “transactional test,”

whereas earnings “from tangible and intangible property, if the acquisition, use,

management or disposition of the property constitutes an integral part of the taxpayer’s

regular trade or business operations” has been called the “functional test.” See Newell

Window Furnishing, 311 S.W.3d at 446-47.

Relevant here is the functional test, business earnings that, “arise from either the

management, use, acquisition, or disposition of property that constitutes an integral part

of the taxpayer’s trade or business.” Id. at 447. The phrase, “acquisition, use,

management or disposition of the property,” has been interpreted to mean that, “the

taxpayer must control, but not necessarily own, the property in order for the earnings

arising from that property to qualify as business earnings.” Blue Bell Creameries v.

Roberts, 333 S.W.3d 59, 65 (Tenn. 2011). If the property is incidental or unrelated to the

taxpayer’s business operations, earnings from that property will not fall within the

definition of business earnings. Id. Earnings from the disposition of intangible property

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are properly classified as business earnings subject to the Tennessee excise tax if the

intangible property was an integral part of the taxpayer’s business. Id. In determining

whether the property was an integral part of the taxpayer’s business, courts determine

whether the property itself was an integral part of the corporation’s regular business, not

whether the act of selling that property is an integral part of the corporation’s business.

Id.

The issue of classifying malpractice settlement proceeds for tax purpose has been

settled in other courts, and those opinions are instructive for determining whether

EmeraChem Holdings’ settlement proceeds should be categorized as business earnings.

The Seventh Circuit held that, for purposes of determining the tax classification of

settlement proceeds, “the amounts received in compromise of a claim must be considered

as having the same nature as the right compromised.” Freda, 656 F.3d at 573-574. The

court must assess the nature and basis of the action settled. Id. If the settlement proceeds

represent damages for lost profits or earnings, then those proceeds should be classified as

business earnings and taxed as if they had been earned in the regular course of business.

Id.

EmeraChem Holdings argues that the underlying basis of the settlement was legal

malpractice, and the settlement proceeds were paid in consideration of EmeraChem

Holdings giving up its right to move forward with its lawsuit. However, EmeraChem

Holdings stipulated that the settlement amount was calculated based on lost revenues

from potential patented products or patent licensing in Europe. Thus, the settlement

payment EmeraChem Holdings received in compromise of its claim actually represents

two rights: (1) the right to receive income that would have been generated from the

European patents, and (2) the right to move forward in its malpractice lawsuit. If the

attorneys had not committed malpractice by improperly filing the European patents, the

revenue generated by those patents would have been taxable as business earnings.

Overall, the nature and basis of the settled action is akin to a business transaction in

which EmeraChem Holdings was compensated for lost business earnings. Since the

amount received in settlement takes on the same nature as the right that was

compromised, the earnings that represent lost business revenue must be categorized as

business earnings for Tennessee excise-tax purposes. Freda, 656 F.3d at 573-574.

Under the functional test, the settlement proceeds are business earnings because

they arose from EmeraChem Holdings’ management, use, or acquisition of its U.S.

patents, all of which is controlled exclusively from the office in Tennessee. Furthermore,

the patents are an integral part of EmeraChem Holdings’ business, and holding patents is

neither incidental or unrelated to EmeraChem Holdings’ business operations.15 In light

of the foregoing, the trial court and Commissioner properly classified the settlement

15

EmeraChem Holdings owns approximately seventeen U.S. patents, most of which are also

registered abroad.

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payment as business earnings.

EmeraChem Holdings argues that, if the settlement proceeds are indeed business

earnings, they should be apportioned because EmeraChem Holdings does business in

numerous states and in Europe. Specifically, EmeraChem Holdings wants the proceeds

to be apportioned based on the business it conducts in New York. The Commissioner

apportioned the entire amount of settlement proceeds to Tennessee based on their finding

that EmeraChem Holdings had no nexus of business elsewhere:

EmeraChem Holdings had no employees, property, activities,

operations, offices, or other facilities in New York,

California, or elsewhere. Indeed, the only activities in which

EmeraChem Holdings is engaged are conducted from its

office in Knoxville, Tennessee. The company performs only

two functions: (1) holding and managing patents, and (2)

purchasing precious metals in or order to immediately sell

them to EmeraChem, which is also located only in Tennessee.

Even the malpractice claim against the New York law firm

was handled by Tennessee attorneys and the settlement

agreement specifically states that it was made “in accordance

with the law of the State of Tennessee” and can be enforced

only in Tennessee. EmeraChem Holdings’ connections to

Tennessee are extensive and exclusive. No operations are

conducted elsewhere.

(Internal citations omitted). The trial court agreed with the Commissioner and concluded

that the record did not support the assertion that EmeraChem Holdings was entitled to

apportionment.

Apportionment applies to business earnings and it is intended to obtain a rough

approximation of the corporate income that is related to activities conducted in the taxing

state. Blue Bell Creameries, 333 S.W.3d at 65. The taxpayer, EmeraChem Holdings, has

the burden of establishing that it is entitled to apportionment. Navarre Corp. v. Tidwell,

524 S.W.2d 647, 649 (Tenn. 1975).

Reviewing the record, EmeraChem Holdings failed to establish that it is entitled to

apportionment. All of EmeraChem Holdings’ business is conducted in Tennessee.

EmeraChem Holdings asserted that it held some precious metals in New York or

California accounts, but it did not hold the title to those materials. When EmeraChem

Holdings purchased precious metals from their seller, it would immediately sell the

precious metals to EmeraChem and simultaneously transfer title to EmeraChem. Further,

the fact that EmeraChem Holdings does not have employees, property, operations,

offices, or facilities anywhere other than Tennessee indicates that it has no nexus of

- 20 -

business elsewhere. Accordingly, we affirm the trial court’s finding that the

Commissioner’s decision to apportion the entire amount of settlement proceeds to

Tennessee was proper.

Negligence Penalties

The Commissioner assessed a 10% negligence penalty on the excise tax due from

each entity. The trial court determined that: (1) the penalty was properly assessed with

respect to the excise tax attributable to the consolidated reporting, but (2) the penalty was

not properly assessed with respect to the malpractice settlement proceeds. See Tenn.

Code Ann. § 67-1-804(b)(5). We affirm the trial court’s finding.

The portion of negligence penalties attributable to the Entities’ consolidated filing

was properly assessed. Tennessee Code Annotated section 67-4-2007(d) plainly states

that a subsidiary LLC cannot be a disregarded entity unless its single-member parent is

classified as a corporation for federal income tax purposes. Further, the Commissioner

issued a general notice that a single-member LLC will not be disregarded for F&E tax

purposes if its single-member is not classified as a corporation for federal tax purposes.

See Tennessee Important Notice No.13-16, issued November 1, 2013.16

The Entities received specific warnings against the filing of the consolidated tax

return. Before the assessments in this case, EmeraChem Holdings also received a F&E

tax assessment for 2008 and consequently participated in an informal conference with the

Department. Afterward, the Department issued its informal conference decision, and

stated that EmeraChem was not a disregarded entity because its single-member,

EmeraChem Holdings, is an LLC that is treated as a partnership for federal income tax

purposes, not a corporation for federal income tax purposes, and, therefore, the single-

member LLC exception did not apply:

EmeraChem, LLC did not become a disregarded entity for the purposes of

franchise, excise tax. Under Tenn. Code Ann. § 67-4-2007(d), only LLC’s

with a single corporate member are disregarded. EmeraChem, LLC’s

single-member, the Taxpayer [EmeraChem Holdings] is an LLC that is

treated as a partnership for federal income tax purposes. The Taxpayer

[EmeraChem Holdings], therefore, is not a corporation for purposes of

Tenn. Code Ann. §67-4-2007(d). And since EmeraChem, LLC’s single-

member, the Taxpayer [EmeraChem Holdings] is not a corporation, the

16

The Commissioner’s notice is not evidence that the law was uncertain or that the Entities would

be reasonable in ignoring the plain language of the statute and rule. A notice can be issued for reasons

other than the lack of clarity in the law. For instance, the notice can be issued because of taxpayers

ignoring the eligibility requirement and subjecting themselves to penalties.

- 21 -

SMLLC [single-member limited liability company] exception ... does not

apply.

Considering the plain language of the statute, and the specific notices given to the

Entities, we cannot find that the Entities exercised due care in filing their consolidated tax

return for state excise tax or in failing to report their state excise tax separately.

Accordingly, the negligence penalty attributable to that failure was properly assessed and

will not be remitted.

However, as to the negligence penalty attributable to the legal malpractice

settlement, we agree with the trial court that the penalty was not properly assessed and

must be remitted. “A court of equity, hearing a controversy between the State and a

taxpayer who has been assessed a penalty, has the power of remitting the penalties

imposed upon the taxpayer when the equities of the case demand.” James v. Huddleston,

795 S.W.2d 661, 664 (Tenn. 1990). Neither the Entities nor the Commissioner had ever

entertained the issue of how to classify the receipt of proceeds from the settlement of a

legal malpractice claim from another state. The issue was novel, unsettled, and unclear.

In light of this, the Entities acted in good faith with good and reasonable cause.

The Commissioner’s decision to assess the excise tax required the Commissioner’s

auditor to consult with her office in Nashville and involved a number of people.

According to the auditor, she imposed the penalty on the entire amount of the assessment,

including the assessment arising from the filing of the consolidated tax return, the

assessment for the legal malpractice proceeds, and the assessment for the business tax,

because she was of the opinion that she had no alternative but to impose penalties on the

entire assessment. However, under Tennessee Code Annotated section 67-1-802 and -

803, the Commissioner’s authority to waive or abate penalties may be exercised to waive

or abate in “whole or in part, any statutory penalty imposed under any revenue laws

administered by the commissioner.” Tenn. Code Ann. § 67-1-802 and -803.

We find that “the taxpayer acted in good faith upon a reasonable though mistaken

application of [the] law” in incurring the deficiency and that the Commissioner acted

under a mistaken application of law in assessing the penalty on the entire assessment

including that attributable to the legal malpractice proceeds. Benson v. U.S. Steel Corp.,

465 S.W.2d 124, 130 (Tenn. 1971). EmeraChem Holdings showed “good and reasonable

cause” and the equities of the case require the remission of the penalty attributable to the

legal malpractice settlement proceeds. Benson, 465 S.W.2d at 130 (holding that

taxpayers retain traditional right to invoke jurisdiction of equity to void inequitable

penalties in alternative to Tennessee Code Annotated section 67-1-804(e)(1965)).

In summation, we affirm the judgment of the trial court as to both negligence

penalty issues. The negligence penalties attributable to the Entities’ consolidated filing

- 22 -

were properly assessed and will not be remitted. The negligence penalties attributable to

the malpractice settlement proceeds were not properly assessed and will be remitted.

V. CONCLUSION

The judgment of the trial court is affirmed, and the case is remanded for such

further proceedings as may be necessary. Costs of the appeal are assessed against the

appellants, EmeraChem Power, LLC, EmeraChem Holdings, LLC, and EmeraChem,

LLC.

_________________________________

JOHN W. MCCLARTY, JUDGE

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