An out-of-state corporation, whose sole connection to California was a 0.2% interest in a manager-managed California limited liability company, was not “doing business” in California for purposes of the California corporate franchise tax according to the California Court of Appeal for the Fifth Appellate District in its recently-issued decision, Swart Enterprises, Inc. v. Franchise Tax Board, Case No. F070922. The appellate court’s decision affirmed the judgment of the California Superior Court and overturned the rationale articulated by the Franchise Tax Board (“FTB”) in FTB Ruling 2014-01 (July 22, 2014), which was issued by the FTB while the Swart case was pending.

Swart Enterprises, Inc. (“Swart”) was a closely-held Iowa corporation engaged in the business of operating a Kansas farm. In 2007, Swart acquired a 0.2% membership interest in a California limited liability company investment fund (“Investment LLC”). Investment LLC was manager-managed, and the manager was given “full, exclusive and complete authority in the management and control of the business of [Investment LLC].” Swart was not involved in the operations or management of Investment LLC, and was expressly prohibited under Investment LLC’s operating agreement from “[taking] part in the control, conduct or operation of [Investment LLC].” Investment LLC was taxed as a partnership for federal income tax purposes for the 2009 and 2010 tax years.

The FTB contended Swart was doing business in California by virtue of its membership interest in Investment LLC and therefore was subject to the California corporate franchise tax. Specifically, the FTB contended that Investment LLC’s election to be treated as a partnership caused Investment LLC’s activities to be attributed to its out-of-state investors, including Swart, as if the members were general partners.

The California corporate franchise tax is imposed on a corporation “doing business” in California, and during the years at issue, “doing business” was defined as “actively engaging in any transaction for the purpose of financial or pecuniary gain.” Cal. Rev. & Tax Cd. § 23101. Likening Swart’s receipt of investment income from Investment LLC to a shareholder’s receipt of dividends and interest, the appellate court found that Swart was “merely passively [holding] onto its investment.” Such an activity, the court found, did not rise to the level of “actively engaging in any transaction for the purpose of financial or pecuniary gain,” as is required under Cal. Rev. & Tax Cd. § 23101.

The court also declined to impute the activities of Investment LLC to Swart, finding that there is no authority to support the proposition that “an LLC member is rendered a general partner of the LLC as a result of an LLC’s election to be treated as a partnership for federal taxation purposes.” The court noted that the federal taxation election does not apply for all tax purposes and that such a conclusion “draws no distinction between general and limited partners,” the latter of which has been recognized by the California State Board of Equalization as not “‘doing business’ merely by virtue of its ownership interest in a limited partnership.”

The court also analogized Swart’s interest in Investment LLC to a limited partnership interest based on Investment LLC’s operating agreement. Specifically, the operating agreement empowered the manager of Investment LLC with the exclusive authority to control the conduct of Investment LLC’s activities and prohibited the members from taking any part in Investment LLC’s operations. The court rejected the state’s argument, which was derived from the FTB guidance issued while the Swart case was pending before the Superior Court (i.e., FTB Ruling 2014-01), that members of an LLC that is classified as a partnership for tax purposes are “doing business” in California. The guidance noted that a member of a manager-managed LLC, through the relinquishment of its control to the manager, effectively controls such LLC. As applied to Swart, the court stated such an argument “fails to acknowledge [Investment LLC] was established as a manager-managed LLC two years before [Swart] became an investor.” Therefore, Swart “had no right to control or influence the designation of [Investment LLC] as a manager-managed fund.” The court made such a finding notwithstanding the ability of the members to remove the manager, because such action can only be taken with a majority vote and Swart, with a 0.2% interest, could only exert minimal influence over such a decision.

The court’s decision was based solely on its interpretation of “doing business” under Cal. Rev. & Tax Cd. § 23101, and thus the court did not consider Swart’s constitutional challenges to the tax imposition.

The FTB has issued a notice (FTB Notice No. 2017-01) indicating that it will not appeal the Swart decision and will follow the decision in situations with the same facts. Therefore, taxpayers who have previously filed and paid California corporate franchise tax based on a passive, minority investment in a limited liability company should consider whether they have a viable refund claim as a result of the Swart decision. When filing a refund claim based on the Swart decision, taxpayers should cite the holding in Swart and explain how their factual situation is the same as the facts in Swart.

Additionally, although the court’s decision in Swart was based on California’s “doing business” statute, several aspects of the court’s decision (for example, the court’s likening a passive LLC investor to a shareholder receiving dividends and interest and the court’s conclusion that an LLC’s election to be treated as a partnership for federal income tax purposes is not controlling for all taxation purposes) may be useful to passive investors facing similar nexus assertions in other states.