The California Franchise Tax Board (“FTB”) has taken an increasingly aggressive stance in recent years regarding its ability to tax out-of-state taxpayers with tenuous connections to California. The FTB has focused in particular on limited liability companies (“LLCs”), taking the position that the unique nature of LLCs can cause out-of-state passive members to be subject to California taxes even in the absence of any California-source income. One out-of-state investor challenged the FTB in court and recently won at the summary judgment stage of litigation.
“Doing Business” in California
Any entity that is “doing business” in California must file an annual tax return and pay a minimum $800 annual tax “for the privilege of doing business in this state”. Failure to comply can result in interest and penalties, including an annual $2,000 failure-to-file penalty under certain circumstances. The annual minimum tax is due even from entities with zero net income from California sources.
The statutory definition of “doing business” seems straightforward: “actively engaging in any transaction for the purpose of financial or pecuniary gain or profit”. In 2011, various factors were added to the statute to clarify that it applies to any entity formed under California law or having in-state sales, property, or payroll exceeding certain thresholds.
The FTB has interpreted the “doing business” concept broadly, particularly as applied to LLCs. The FTB’s stated positions extend to non-California business entities and their owners in unexpected ways.
The Swart Case
One such business was Swart Enterprises, Inc. (“Swart”), an Iowa corporation that owned a 0.2% interest in a California investment fund formed as an LLC (the “Fund”). Swart’s only connection to California was its passive interest in the Fund. The Fund was managed by a California corporate manager and invested in capital equipment in various states, including in California.
While the Fund filed California tax returns, Swart did not, presumably because it had no California-source income (either directly or through allocation from the Fund). The FTB demanded a return from Swart and imposed the $800 minimum tax, interest, and penalties.
Swart paid the tax and filed a claim for refund as required under California law, and ultimately sued for a refund in a California state court. Swart argued that it had not actively engaged in business in California as required by the statute, and that its mere passive membership interest in the Fund should not subject it to California taxation.
Swart cited a 1996 opinion of the California State Board of Equalization, which concluded that an out-of-state corporation was not subject to California income tax merely because of its limited partnership interest in a partnership doing business in California. This opinion had distinguished between limited and general partners, concluding that the business activities of a partnership could be attributed to the general partner but not the limited partners, due to limited partners’ passive role and lack of management rights.
The FTB argued that because state law gives all members of an LLC the authority to manage its operations, passive members in an LLC are different than limited partners in a partnership. It is irrelevant whether an LLC’s members have delegated managerial authority to an external manager, as inSwart. The business activities of an LLC are attributed to its members, who are considered to be engaged in those activities directly — meaning that if an LLC is “doing business” in California, so are all of its members.
On November 14, 2014, the court issued an order granting Swart’s motion for summary judgment, holding that Swart was not doing business in California and was not subject to the $800 minimum tax. The court disagreed with the FTB’s narrow focus on LLC members’ management authority under state law, and instead discussed the realities of the situation. Swart was a small, inactive investor in the Fund and the operating agreement dictated a manager-managed LLC with punitive consequences for removal of the manager. Swart did not have the authority to manage or control the Fund’s decision-making, and therefore it was akin to a limited partner rather than a general partner.
FTB Legal Ruling 2014-01
The FTB issued a legal ruling during the Swart litigation, outlining its position on LLC and member taxation under various scenarios. The following table summarizes the FTB’s positions stated in the ruling. In each scenario, the LLC member is assumed to be a corporation holding a 15% interest in the LLC. The member is not incorporated in California, has no activities outside of its membership interest that would constitute “doing business” in the state, and has no California-source income.
Click here to view the table.
Why should taxpayers care about an $800 victory for Swart?
The LLC in which Swart invested had hundreds of other investors, most of whom were outside of California. The FTB’s position would have turned all of these investors into California taxpayers. Investments such as this are frequently made through special purpose vehicles and multi-tier pass-through structures. Under the FTB’s aggressive interpretation, it is possible that one entity deemed to be “doing business” within California could trigger annual filing requirements for many parties, resulting in both tax costs and disclosure costs.
Despite the favorable outcome in Swart, out-of-state taxpayers should proceed with caution. The order is unpublished and therefore cannot be relied upon as precedent in a legal action, although it is instructive and could be persuasive in dealings with the FTB. The FTB generally has a 60-day window in which to appeal.
Moreover, the Swart ruling is limited to manager-managed LLCs, and does not address various other scenarios that might cause non-California investors to become subject to California taxation. For example, it appears that the FTB believes that if a Delaware LLC is member-managed and has at least one California member, all of the LLCs members are “doing business” in California. It is unclear how far the FTB would extend this approach, particularly where multi-tier structures are involved. Until more clarity is developed on these issues, non-California taxpayers might consider adopting limited partnership structures instead of LLC structures if there are not compelling business reasons to choose one form of entity over the other, in order to limit the attribution of activities from the entity to its owners and vice versa.
Confusion often arises because the FTB and the California Secretary of State have different interpretations of the level of in-state business activity that triggers their respective filing requirements. It is quite possible that a non-California business entity might be exempt from registration requirements because it is not “transacting intrastate business” in the view of the Secretary of State, but is nevertheless required to file California tax returns because it is “doing business” in the view of the FTB.