The California Franchise Tax Board (“FTB”) has issued Legal Ruling 2014-01, which addresses the taxation of out-of-state members of limited liability companies classified as partnerships. The Ruling asserts that where such an LLC is doing business in California, its members must file California returns and pay all applicable taxes and fees, even if the members have no contact with California other than membership in that LLC. By its terms, Legal Ruling 2014-01 is limited to LLC members that are business entities, however, based on the FTB’s reasoning it is not clear why business entities would be treated differently from individuals. The FTB’s position is questionable, and was the subject of an ongoing legal challenge in California Superior Court even before the Ruling was issued. Nevertheless, failure to comply with it would leave members exposed to penalties.
California’s Revenue & Taxation Code imposes tax and filing obligations on entities “doing business” in California, which is defined as “actively engaging in any transaction for the purpose of financial or pecuniary gain or profit.” Cal. Rev. & Tax. Code § 23101. For tax years beginning on or after January 1, 2011, Section 23101 provides that a taxpayer can also be “doing business” based on certain threshold amounts of sales, property, or payroll. Although for LLC members these threshold amounts are applied to the member’s distributive share, a member below these thresholds is still “doing business” in California if it is actively engaging in transactions for financial gain.
LLCs doing business in California must file returns, pay a minimum annual tax of $800, and may be subject to an additional LLC fee on a graduated scale depending on income derived from or attributable to California. LLCs also must pay the tax of any of their members who do not sign a consent to California’s jurisdiction to tax their distributive share of income attributable to California.
Where a general partnership is doing business in California, each of its partners are deemed to be doing business in California as well because the partnership’s activities are attributed to each of its constituent partners. In contrast, where a corporation is doing business in California, owners of shares in that corporation are not deemed to be doing business in California.
Notably, in Appeal of Amman & Schmid Finanz AG, No. 96-SBE-008 (Apr. 11, 1996) the State Board of Equalization (“SBE”) examined whether limited partners are doing business in California simply because of their status as limited partners in a limited partnership doing business there. The SBE explained that while a general partner has the right to possess specific partnership property, the right to participate in management, and is jointly liable for the obligations of the partnership, a limited partner has no such rights or liabilities, the “limited partner’s interest in the partnership is considered intangible personal property, which ordinarily is located in the domicile of the limited partner.” Amman at 4. On this basis, the SBE concluded that such limited partners are not doing business in California.
Under the law of many jurisdictions, including California, there are different types of LLCs. As their name suggests, member-managed LLCs are managed by their members and in that respect are similar to general partnerships. In contrast, manager-managed LLCs, which are formed pursuant to certain requirements in the California Corporations Code (or analogous provisions under the law of other states), designate managers with the exclusive authority to decide “any matter relating to the activities of the limited liability company” except matters outside of the ordinary course of business. Non-managing members of member-managed LLCs cannot bind the LLC, do not own LLC property, and are not jointly liable for obligations of the LLC. Such non-managing members are in a position very much like limited partners of a limited partnership.
FTB Legal Ruling 2014-01
With one exception, the FTB’s position in Legal Ruling 2014-01 essentially is that LLCs are like general partnerships. According to the FTB, when an LLC is doing business in California, all of its members also are doing business in California. So, an out-of-state entity with no links to California except a fractional interest in an LLC doing business there is required to file returns and pay tax, even if the LLC makes no profit in California.
One questionable aspect of Legal Ruling 2014-01 is its attempt to treat all kinds of LLCs as identical. Arguably, the distinctive features of manager-managed LLCs are directly relevant to the question of whether their non-managing members are doing business in California. Such members are like limited partners of a limited partnership and as such, should be treated as limited partners are under Amman & Schmid.
The FTB has long disliked Amman & Schmid, and seeks to limit it in Legal Ruling 2014-01. Although the decision relied on multiple factors, Legal Ruling 2014-01 characterizes it as grounded on limited partners’ inability “to manage or control the decision making process of the entity.” While this has some relevance to the analysis of members of member-managed LLCs, non-managing members of manager-managed LLCs, like limited partners, do not control the decision making process of their LLCs. Thus, by the FTB’s own reasoning, they should not be subject to filing requirements or tax. The FTB seeks to get around this by claiming that LLC members can “revoke” their delegation of management authority “at any time.” But, the extent of such authority will vary from one LLC to the next, and, in California, will generally require a majority vote of all members. By the FTB’s logic, corporate shareholders also “manage” a corporation because a majority of a corporation’s shareholders can effect a change of management. Yet, no one thinks corporate shareholders are doing business everywhere a corporation has activity. Ultimately, the California courts will decide whether the FTB’s logic can be upheld.
For unitary businesses, Legal Ruling 2014-01 could result in exposure to California tax. If one of the entities in the unitary group was a member of an LLC with business in California, the FTB could assert that the entire unitary group was “doing business” in California and therefore owed tax based on an apportioned share of the group’s income. The FTB could take this position even if the connection to the LLC was a non-managing membership – for example, if the investment in the LLC was of excess operating capital, or if the LLC was in a line of business related to that of the unitary group.
Notwithstanding the generally aggressive nature of Legal Ruling 2014-01, it has one exception that actually favors taxpayers. The Ruling states that members of LLCs merely organized or registered in California, but not engaging in any actual business activities or significant factor presence there, are not considered to be “doing business” in the state and have no obligation to file returns or pay tax or fees on that basis. Accordingly, taxpayers should examine the activities of LLCs in which they are members. If returns have been filed solely because the LLC was organized or registered in California, the members may no longer have to file California income tax returns and may be eligible for refunds of taxes or fees paid in prior years. This can be of particular benefit in tiered flow-through entity structures. LLC members in such LLCs that receive notices or inquiries from FTB should explain that they have no obligation to pay California LLC taxes or fees.
Taxpayers also should verify that manager-managed LLCs organized under California law still qualify as “manager-managed” under new requirements that came into effect as of January 2014. They also could consider reincorporating in another jurisdiction where non-managing members’ position is even closer to that of a limited partner. They should manage the risk of exposure to tax on a unitary group based on any of its members’ being found to be “doing business” in California based on passive membership in an LLC. Finally, they should keep abreast of pending litigation challenging the FTB’s new, aggressive position.