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.
[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.