Tuesday, May 5, 2015

Since When is Doing Business in California a Hot Topic?

Since When is Doing Business in California a Hot Topic?

By Mark Muntean[1]

§ 1.01  Introduction

I never thought I would see the time when “doing business in California” became a hot topic of debate and litigation.  The issue centers around whether out-of-state members of a limited liability company (“LLC”) electing to be taxed as partnership, must file California franchise or income tax returns and pay California taxes and fees in connection with the LLC’s income, where such members have no other contact with California other than as a member in such LLC.

§ 1.02   FTB Legal Ruling 2014-01

As previously reported in this publication, the California Franchise Tax Board (“FTB”) issued FTB Legal Ruling 2014-01 which provides that out-of-state businesses entities that are members of multiple-member LLCs must file a tax return and pay any applicable taxes and fees based on the fact that the LLC is doing business in California.[2]  An LLC is doing business in California if the LLC:  (i) is organized or commercially domiciled in California, or (ii) has California property, payroll or sales which exceed the minimum amounts applicable under Cal. Rev. and Tax. Code Section 23101(b)(2), (b)(3), or (b)(4).

[1]        What Does Doing Business in California Mean

While “doing business” might be a straight forward concept in many states, nothing is really straight forward in California.  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.”[3]
            Under a 2001 Legal Ruling, the FTB issued guidance stating that the activities of a disregarded entity (disregarded under the Internal Revenue Service (“IRS”) check-the box rules) doing business in California will be attributed to the owner of the entity for state income and franchise tax purposes.[4]  Thus, the in-state activities of a LLC or a qualified Subchapter S qualified subsidiary, which is treated as a disregarded entity for federal and state income tax purposes, will be treated as the activities of a branch or division of its corporate owner.  Accordingly, if the entity’s California activities are sufficient to create nexus with the state, then its corporate owner will automatically be deemed to be doing business in California. 
            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.  The same holds true for shareholders in a Subchapter S corporation.  S corporation shareholders are taxable on their share of S income earned in California or attributable to services performed in California.

[2]        General Partnerships Doing Business in California.

The FTB determined that in the case of general partnership, and LLCs taxable as partnerships, the business of the partnership is the business of each partner, and the activities of the partnership are attributed to each partner, with the consequence that in geographic locations where the partnership is “doing business,” the partners are also ‘doing business’ in California.  The FTB relies on Internal Revenue Code (“IRC”) Section 702(b).  However, this is not the rule in California for limited partners.
            In the case of a limited partnership, the FTB points out an exception for limited partners in California Board of Equalization (“BOE”) decision Appeal of Amman & Schmid Finanz AG, et al.[5]  In Amman, the BOE held that limited partners of limited partnerships were not doing business in California even if the limited partnership was doing business in California.  Notable here is that if a business entity anticipates investors which are out of state business entities, a limited partnership may be a better vehicle that a LLC.
            The BOE 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.”[6]  On this basis, the BOE concluded that such limited partners are not doing business in California.

[3]        LLCs Doing Business in California.

For purposes of this discussion, there are two different basic types of LLCs: member-managed LLCs, and manager-managed LLCs.   Member-managed LLCs are managed by their members and in that respect are similar to general partnerships.  On the other hand, manager-managed LLCs designate an LLC member or members as manager(s) 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.  In the case of a member-managed LLC and a member-managed LLCs, a non-managing member cannot bind the LLC, does not own LLC property, and is not jointly liable for obligations of the LLC.  The non-managing members are in nearly the same position as limited partners of a limited partnership.  However, the FTB reasons that non-managing members have made a decision or election to surrender the management to another party who is either member manager or a nonmember manager.
FTB Legal Ruling 2014-01 treats every kind of LLC, and every LLC member, in the same manner.  The FTB ignores the legal distinctions and various features of a manager-managed LLCs and a member-managed LLC, for example, which go to the very heart of whether a non-managing member is doing business in California.  As stated above, non-managing members are nearly the same as limited partners in a limited partnership and as such, should be treated as limited partners.

[4]        So What’s the Big Deal Here? The Unitary Aspect.

For unitary businesses with operating primarily outside of California, FTB Legal Ruling 2014-01 could unexpectedly result in the exposure of the income from those out-of-state business operations to California tax.  Where one of the entities in the unitary group is a member of an LLC with business in California, the FTB could assert that the entire unitary group is “doing business” in California.  This subjects the entire unitary group’s income to tax in California subject to apportionment.  The FTB could take the position that where the connection to the LLC was a non-managing membership – for example, where an out-of-state investor invest excess working capital in a California LLC, or where a LLC is in a line of business related to that of the unitary group.
            Notwithstanding the adverse impact of FTB Legal Ruling 2014-01 on LLCs, FTB Legal Ruling 2014-01 makes an exception for certain LLCs.  Under FTB Legal Ruling 2014-01 members of LLCs organized or registered in California, but either (i) is not engaged in an actual business activity or (ii) has no significant factor presence in California, are not considered to be “doing business” in the state, and have no obligation to file tax 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.

§ 1.03  Not So Fast FTB – Swart Enterprises Inc. v. California Franchise Tax Board.
The FTB’s position in FTB Legal Ruling 2014-01 was subject to criticism by commentators.  Also, FTB Legal Ruling 2014-01 was issued while the FTB’s position was being litigated in a California Superior Court.
            In November 2014, a California Superior Court ruled that an out-of-state corporation whose only connection with California was its 0.02% ownership interest in a LLC was not “doing business” in California, and therefore was entitled to a refund of the $800 annual franchise tax, interest, and penalties imposed by the FTB.[7]  In Swart Enterprises Inc. v. California Franchise Tax Board (“Swart”), the court found that because Swart’s interest in the LLC was an investment interest, and Swart had no ability or right to manage the affairs of the LLC, Swart’s interest was not comparable to a general partnership interest and did not give rise to doing business in California.
            In Swart, the taxpayer was an Iowa corporation with no business activities and no physical presence in California.  In 2007, Swart invested $50,000 in Cypress Equipment Fund XII LLC, a manager managed LLC.  The only manager for the LLC was Cypress Equipment Management Corporation III, a California corporation with exclusive and complete authority to manage and control the business of the LLC.  Swart was prohibited from taking part in the control or operation of the LLC.
            The FTB argued in Swart that an entity owning an interest in a LLC that is operating in California causes such entity/LLC member to be doing business in California.  The FTB argued that the term “partnership,” for purposes of the Internal Revenue Service check the box regulations[8] means a traditional general partnership, where all of the partners are general partners.  Thus, where an LLC elects to be taxed as a partnership under the check the box regulations, it elects to be treated as a general partnership for all purposes.[9]  The court noted that the FTB cited no authority for this position and the court rejected the FTB’s logic.[10]  The court looked to the BOE decision in Amman, discussed above, holding that Swart was not doing business in California because Swart (i) had no interest in specific LLC property; (ii) was not personally liable for LLC debts; (iii) played no role in the LLC management and had no right to do so; and (iv) could not act as an agent for the LLC or bind the LLC in any way.[11]
            The court analyzed the FTB Legal Ruling 2014-1 and the FTB’s position that a LLC member has the right to delegate the power to manage the LLC to a third party manager or another  member, and the power to revoke such delegation of power to manage the LLC at any time.[12]  Section 17704.07(c)(5) provides that “[a] manager may be removed at any time by the consent of a majority of the members without notice  or cause.”  The FTB argues that the decision not to manage the LLC or to hire a third party manager for the LLC is an exercise of the right to control the LLC by the LLC member.[13]  However, the court disagreed and held that without a majority interest there is no such control (Swart’s interest in the LLC at issue was 0.2%).[14] 

§1.04  Conclusion

The FTB may appeal the decision in Swart.  However, even if the decision is not appealed, the decision in Swart is not binding on other California Superior Courts as precedent.  That notwithstanding, the take-away from this may be that in all events out-of-state limited partners are not considered to be doing in business in California by the FTB and the courts and as such is the safest choice of entity while the issues in FTB legal Ruling 2014-1 get resolved.  Additionally, at the other end of the spectrum, LLC members with a majority interest in an LLC likely cannot make the same arguments as Swart.

[1]  Mark Muntean, J.D. LL.M. Taxation (Georgetown) is a business and tax lawyer in the San Francisco/Bay Area  of California with over 30 years’ experience in federal, state and international tax matters.  He represents clients in connection with corporate, real estate, mergers and acquisitions, private equity, business law and criminal tax issues.
[2]  While the specific language of FTB Legal Ruling 2014-1 applies to business entries as out-of-state members in a LLC doing business in California, it is not unreasonable to expect that the holding of FTB Legal Ruling 2014-1 to be applied to individual investors as well.
[3]  Cal. Rev. & Tax. Code § 23101.
[4]  California Franchise Tax Board, Legal Ruling 2011-01 (Jan. 11, 2011).
[5]  96-SBE-008, April 11, 1996 (hereafter “Amman”).
[6]   Id. at 4.
[7]  Swart Enterprises, Inc. v. California Franchise Tax Board, Fresno Superior Court, No. 13CECG02171, Order on Cross-Motions for Summary Judgment, November 14, 2014.
[8] Treas. Reg. Section 301.7701-2; Cal. Code Regs. Section 23038(b)-3(c).
[9] Swart Enterprises, Inc. v. California Franchise Tax Board, Fresno Superior Court, No. 13CECG02171, Order after Hearing (hereafter “Order after Hearing”) at page 1.
[10] Order after Hearing at 2.
[11] Id.
[12] See Cal. Corp. Code Section 17704.07(c)(5).
[13] See Moulin v. DerZakarious (1961) 191 Cal. App. 2d 184, 190.
[14] Order after Hearing at 4.


© Mark Muntean*
                        As the title implies, below is a summary of the 2014 significant California tax law changes through judicial decisions, legislative and regulatory changes; and administrative pronouncements.
A.        Judicial Decisions.
                        1.         FTB of Cal. v. Hyatt, 130 Nev. Adv. Op. 71 (Nevada Supreme Court September 18, 2014).  In the 1991 Gilbert P. Hyatt Hyatt moved from California to Nevada.  He filed a “part-year” resident income-tax return in California for 1991and reported only part of his licensing fees to California.  In 1993, California audited Hyatt.  The audit focused on claim that he had changed residency to Nevada shortly before receiving substantial licensing fees for certain patented inventions related to computer technology. 
                        In auditing Hyatt, the FTB sent letters to third parties that included Hyatt’s social security number and home address.  The FTB also interviewed Mr. Hyatt’s ex-wife and estranged brother and daughter.  Hyatt sued the FTB in Nevada District Court.  The FTB sought complete immunity based on the U.S. Constitution’s Full Faith and Credit Clause (Art. IV, § 1) and comity.  The Nevada Supreme Court ruled for Hyatt.  The U.S. Supreme Court upheld the Nevada Supreme Court’s ruling that the FTB was only entitled to partial immunity under comity principles. Franchise Tax Bd. of Cal. v. Hyatt, 538 U.S. 488 (2003).
                        A jury returned a verdict awarding Hyatt $85 million in damages for emotional distress, $52 million for invasion of privacy, $1 million as special damages for fraud, and $250 million in punitive damages.  The FTB appealed the verdict to the Nevada Supreme Court.  On September 18, 2014, the Nevada Supreme Court affirmed the special damages award for fraud and the finding of liability for intentional infliction of emotional distress.  FTB of Cal. v. Hyatt, 130 Nev. Adv. Op. 71 (2014).   However, the court remanded the case for a new trial on damages on the emotional distress claim.  The court reversed Hyatt’s other causes of action.  The court also ruled that the FTB, as a government agency, is immune from punitive damages under Nevada law.  The court’s opinion highlights numerous instances of misconduct on the part of the FTB.
                        2.         Cutler v. Franchise Tax Board, B248270 C.A. 2nd Dist., September 2, 2014 (Cutler II).  Previously, in 2012 the Court of Appeal held that the QSBS statute (Cal. Rev. & Tax. Code Section 18152.5) discriminated on its face in violation of interstate commerce under the federal commerce clause.  Cutler v. FTB (2012) 208 Cal.App.4th 1247 (Cutler I).  Cutler sought attorney fees under CCP Section 1021.5.  The trial court denied his application.  The trial court concluded that Cutler did not meet two statutory prerequisites: (1) he did not confer "a significant benefit, whether pecuniary or nonpecuniary, . . . on the general public or a large class of persons," and (2) the "necessity and financial burden of private enforcement" were not "such as to make the award appropriate. . . ." CCP Section 1021.5.
                        On the first point, the trial court found it was "speculative" that the lawsuit conferred any benefit on the general public or a large class of people. On the second point, the court found an award was not appropriate because Cutler sought a refund of "a significant sum of money" ($442,000), so — even though he incurred attorney fees of more than $685,000 — he had an incentive to bring the litigation, and any benefit he conferred on the public was incidental.  The Court of Appeal reversed holding the trial court erred on both points. The court remand the case for a determination of the amount of fees to be awarded.
                        3.         Comcast v. Cal. Franchise Tax Bd.  In ComCon Prod. Servs. I Inc. v. Cal. Franchise Tax Bd., Cal., Super. Ct., No. BC489779 (3/6/2014) (“Comcast”) two issues were before the court:  (1) whether Comcast and its subsidiary QVC formed a unitary business for California franchise tax law purposes, and (2) whether the termination fee Comcast received from MediaOne as the result of a failed merger generated business income apportionable to California, or nonbusiness income allocable outside California.  In Comcast, the judge ruled that (1) Comcast was not unitary with QVC, which was a victory for Comcast, and (2) Comcast’s $1.5 billion termination fee is taxable business income to Comcast, a loss for the taxpayer.  The $1.5 billion in income would be apportionable such that it would only be partially taxed in California.
                        There is no written decision at this time.  The judge ordered the FTB and the California Attorney General to draft a written decision, using text from Comcast's closing brief as the court's findings on the unity issue and text from FTB's closing brief for the termination fee issue findings.  Since there is real money at stake, it is likely Comcast will appeal.
                        4.         Property Tax.  SHC Half Moon Bay v. County of San Mateo (A137218), May 22, 2014.   A decision issued by the California Court of Appeal is significant for hotel owners and operators, and for any commercial real property owners where the the property includes intangible assets. After many years of litigation, there now appears to be a definitive ruling on whether the "Rushmore approach" may be used to value hotel properties in California. SHC Half Moon Bay v. County of San Mateo (A137218), May 22, 2014. The Rushmore approach is a technique employed by appraisers to remove the value of intangible assets and rights that are used in conjunction with hotels such as workforce and hotel management and franchise agreements. In its decision, the Court of Appeal specifically held that "the deduction of the management and franchise fee from the hotel's projected revenue stream pursuant to the income approach did not – as required by California law – identify and exclude intangible assets" such as workforce and other intangibles. The court also said that the taxing authority had not explained how the deduction of the management and franchise fee captured the value of the intangible property.
B.        Legislation.
                        1.         Enterprise Zones.       The California legislature terminated the Enterprise Zone program and replaces it with a new three-part program.  AB 93 also limits the application of hiring and sales and use tax credits to employees hired, or purchases made prior to January 1, 2014. Taxpayers may utilize any carryforward hiring or sales and use tax credits generated prior to 2014 through 2024. The bill also limits the net interest deduction for lenders making loans to businesses in Enterprise Zones to interest received before January 1, 2014.
                                    (a)        New Sales Tax Exemption for Manufacturing Equipment.  Effective July 1, 2014, AB 93 adds a new, state-level sales tax exemption for manufacturing equipment. The exemption is also available for purchases of certain equipment primarily used for manufacturing and in research and development. The legislation caps the exemption at $200 million in purchases per taxpayer per year. This cap applies to the cumulative purchases of a single entity or the aggregated purchases of all members of a combined group. The exemption is set to expire January 1, 2021 for purchases of equipment to be used within a former Enterprise Zone or certain designated census tracts, and January 1, 2019 for purchases of equipment to be used elsewhere in California.
                                    (b)        New Hiring Credit.  AB 93 also adds a new hiring credit to replace the old EZ hiring credit. The credit is available on 35 percent of wages between $12 - $28 per hour for companies that employ “hard to hire” workers in certain defined geographic areas of the state. Hard to hire workers include individuals who have been unemployed for six months, previously unemployed veterans, recipients of the federal Earned Income Tax Credit, and ex-offenders. To continue to qualify for the credit, an employer must increase the number of full-time employees employed in the state from one year to the next. The credit may only be claimed on a timely filed original return. Temporary help services, retail trade services, food services, and employers in certain NAICS services are not eligible for the hiring tax credit. The new hiring tax credit applies to tax years beginning on or after January 1, 2014, and before January 1, 2021.
                                    (c)        New California Competes Credit.  The third new incentive is the California Competes Tax Credit, which is negotiated through and administered by the Governor’s Office of Business and Economic Development (GO-Biz). The pool of credits available under the California Competes Credit is limited to a specified sum each fiscal year ($30 million for fiscal year 2013-2014). Businesses compete for the credit based on a number of factors, including the number of jobs to be created, the amount of investment in the state, incentives available to the taxpayer within and outside of California, and the duration of the proposed project. Priority is to be given to taxpayers whose project or business is located or proposed to be located in an area of high unemployment or poverty.  The California Competes Tax Credit is applicable for tax years beginning on or after January 1, 2014 and before January 1, 2025.
D.        Regulations.
                        1.         Regulation 17942,  On May 14, 2014, California adopted regulation 17942, which provides guidance regarding an LLC’s total income from all sources derived from or attributable to California.  The regulation provides guidance on: (1) the treatment of flow-through income from partnerships, (2) special assignment rules for total income from certain passive holdings and occasional sales, (3) an alternative method for assigning total income, and (4) disregarding the assignment rules if all business activities are conducted in California.
                        2.         Section 25106.5-1.      Amended California Code of Regulations (Reg.) section 25106.5-1, regarding the treatment of Deferred Intercompany Stock Accounts (DISA), was approved by the Office of Administrative Law on January 8, 2014, and will become effective April 1, 2014.The FTB amended its regulations under Section 25106.5-1 “Intercompany Transactions” to provide additional guidance regarding its treatment of Deferred Intercompany Stock Accounts (“DISAs”).  Four notable changes were made by the amendments to the Regulation (“Amendments”) discussed below. All California taxpayers with a federal Excess Loss Account should be aware of these Amendments and consider their implications.
                        California tax law conforms to Internal Revenue Code Sections 301 and 311 (distributions) and Section 312 (earnings and profits), which may give rise to non-dividend distributions.  When current and accumulated earnings and profits have been depleted, additional (non-dividend) distributions will reduce the shareholder’s basis in the stock. Distributions in excess of both earnings and profits and the shareholder’s basis in the stock are treated as a capital gain.  However, under the federal consolidated return group rules, a shareholder may have a negative basis in the stock as a result of such intercompany distributions. Under California law the portion of an intercompany distribution that exceeds California earnings and profits and the parent’s basis in the stock creates a DISA which is deferred income.  The deferral continues until a triggering event results in the distribution is
excluded from the unitary group by a water’s-edge election) or until the a sale, liquidation, redemption or any other disposition of shares of the stock.  Under the amended law, where the distributor is merged out of existence, the deferred gain will not be triggered if the majority of the voting shares of the stock of each are owned by other members of the combined reporting group.  The amount of DISA attributable to the non-surviving member’s stock will be included (proportionately) with any DISA attributable to the surviving member’s stock and will be taken into income when the surviving member’s stock is sold. The amended law further provides that taxpayers must now annually report any reductions to DISAs brought about by such capital contributions.
                        The amended law provides that if a parent transfers stock with a DISA attributable to it to another member of the combined reporting group and the transferee already possesses shares of that stock that do not have a DISA attributable to them, the DISA will continue to be deferred and the transferee’s basis in its existing stock can reduce the DISA attributable to the shares of the stock transferred.  If an excess distribution that ordinarily would result in a DISA was allowed to create earnings and profits, the second distributee would not have a DISA when that distributee distributed the same amount of money or the same property to another member of the combined reporting group. However, prior to amendment, the Regulation did not allow intercompany transactions to create earnings and profits.

In response, the Amendments eliminate multiple DISAs from arising in this situation. The Amendments provide that where the same property or the same amount of money is being distributed through various tiers of members of a combined reporting group, the DISA that results at the initial level from the initial distribution is treated as creating earnings and profits.24 The Amendments add an example illustrating a situation where the same amount of money is distributed and also provide an example illustrating the effect of an additional amount of money subsequently being distributed.
E.        Administrative.
                        1.         Legal Ruling 2014-01.  The FTB issued Legal Ruling 2014-01 which provides that businesses entities that are members of multiple-member limited liability companies (LLCs) must file a tax return and pay any applicable taxes and fees based on the fact that the LLC is doing business in California.  An LLC is doing business in California if the LLC (i) is organized or commercially domiciled in California, or (ii) has California property, payroll or sales which exceed the amounts applicable under Cal. Rev. and Tax. Code Section 23101(b) (2), (3), or (4), of subdivision (b).
                        The FTB has determined that the “business of the partnership is the business of each partner,” and “the activities of the partnership are attributed to each partner, with the consequence that in geographic locations where the partnership is ‘doing business,’ the partners are also ‘doing business.’” The FTB relies on Internal Revenue Code Section 702 (b).  However, this is not the rule in California for limited partners.  The FTB pints out the exception for limited partners in Appeals of Amman & Schmid FinanzAG, et al., 96-SBE-008, April 11, 1996.  In Amman, the California State Board of Equalization held that limited partners of limited partnerships were not doing business in California even if the limited partnerships were doing business in California.  Thus, the take away here is that if a business entity anticipates investors which are out of state business entities, a limited partnership may be a better vehicle that a LLC.
                        2.         Chief Counsel Ruling 2014-2.  Occasional Sales Rule.  Taxpayer's asset sales in implementing its Plan of Reorganization under Chapter 11 of the Bankruptcy Code are within Taxpayer's normal course of business and occurred frequently thus are not "occasional sales" within the meaning of Regulation section 25137(c)(1)(A) and the resulting gross receipts must be included in Taxpayer's sales factor for apportionment purposes.