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.

No comments:

Post a Comment