Posts in: January

Court Rules Against California Franchise Tax Board on Overreaching Franchise Tax

January 24, 2017 Business planning, Small Business, Tax Planning Comments Off on Court Rules Against California Franchise Tax Board on Overreaching Franchise Tax

On January 12, 2017, an appeals court in California ruled, in a closely watched case of Swart Enterprises, Inc. v. Franchise Tax Board (Appeals Case F070922), that a non-resident of CA was not “doing business in California” and therefore not liable for California Franchise Taxes merely because it owned a passive investment in California.   Although this ruling may not have much impact on California residents who own and direct investments from California, it does signify the Court’s willingness to impose some limitations on California’s ability to tax under its expansive definition of “doing business in” California.

California imposes a minimum franchise tax of $800 for every corporation (or LLC) “doing business within …this state.”   Revenue and Tax Code § 23101 defined doing business as “actively engaging in any transaction for the purpose of financial or pecuniary gain or profit.”

Beginning in 2011, the California Franchise Tax Board (“FTB”), adopted a policy whereby it would impose the minimum $800 franchise tax for any LLC or corporation outside of California if they were deemed to be “doing business in California.”  The policy was summarized in Publication 689 from the Franchise Tax Board, and used the example of a California resident (Paul), who formed a Nevada LLC owning property in Nevada, would nonetheless be subject to the annual LLC franchise tax because he could (from California) (1) hire and fire the Nevada management company, (2) have telephone conversations from California with the management company, and (3) was ultimately responsible for and oversees the management company from California.   The FTB need not consider the frequency or continuity of the California activities as a single activity tied to California could be sufficient to impose the Franchise Tax. This was considered by many experts to be an aggressive stance to tax out of state corporations and LLCs that had any connection with California.

In July 2014, the Franchise Tax Board doubled down on this policy and issued its Legal Ruling 2014-01 that if an LLC doing business in California was classified as a partnership for tax purposes, ALL of its members were also deemed to be doing business in California even if the individual LLC member never stepped foot into California or performed any transactions in California.  The rationale was that in an LLC taxed as a general partnership, each partner has the right to participate in the management of the partnership business, and it made no difference if the partner/member never actually participated in the management of the business.  In a general partnership, all partnership’s activities are attributable to each partner, and so if the partnership were doing business in California, then all the partners were also doing business in California.  Contrast that with the situation of a limited partner which the California Board of Equalization recognized in a 1996 decision of Amman & Schmid Finanz AG, did not have the right to manage or conduct the business of the limited partnership, and therefore, would not be considered doing business in California merely because of its limited partner interest in a California Limited Partnership.

The Swart Enterprises case was the test case for an out of state entity whose only connection to California was a passive investment in an LLC that happened to be taxed like a partnership.  Legal Ruling 2014-1 made clear that if an LLC doing business in California was owned in part by a corporation that had no independent presence or activities in California, the corporation would still need to register and pay the minimum annual $800 franchise tax fee (Situation 4 in Legal Ruling 2014-1).   Swart Enterprises was an Iowa corporation operating a farm in Kansas who had no physical connection to California except that it invested $50,000 for a .2% interest in Cypress LLC which was a California LLC.  Swart had no involvement in any of Cypress’ operations or management, and the Cypress LLC documents specified that the Cypress LLC was “manager managed,” and that no member could take part in the control, conduct or operation of the business, or bind the LLC or act on its behalf unless it was the “manager.”   Despite the fact that Swart had no independent business activities in California, the FTB concluded that that Swart owed the $800 minimum tax because the Cypress LLC elected to be taxed as a partnership, and all of its members would be considered doing business in California if the LLC itself was doing business in California.  In other words, the FTB applied its rationale in Situation 4 of Legal Ruling 2014-1 to conclude that Swart owed the $800 minimum franchise tax in California.

The Court of Appeals rejected the conclusion of the FTB and, focusing on the language in § 23101 requiring “actively engaging” in a transaction in California and following the rationale in Amman & Schmid, concluded that Swart’s purely passive investment did not meet the standard for doing business in California.  The Court concluded that an LLC electing to be taxed as a partnership does not make each LLC member a “general partner” for purposes of the franchise tax.  Among the other factors considered by the Court in favor of Swart included the following:

  1. Swart had no interest in any of the specific assets of Cypress LLC;
  2. Swart had no right to act, bind, or be liable for the obligations of the LLC, was specifically prohibited from management and control of the LLC which was reserved only for managers, and these limitations were specifically referenced in the LLC’s Articles and/or Operating Agreement;
  3. Cypress LLC was a “manager-managed” LLC, and under California law, a member who is not a manager in a “manager-managed” LLC has no authority to manage or conduct LLC activities; and
  4. There was no evidence that Swart actually conducted any management activities for the LLC.

Because Swart was deemed to be the “quintessential passive investor” akin to a limited partner who never performed any activities in California, the mere fact it was a member of an LLC in California did not result in imposition of California Franchise Taxes.

This case is most relevant for out of state entities seeking to invest in California.  Unfortunately, it does not provide any real assistance for California residents seeking to invest in entities outside of California.  Appellate decisions typically go to great lengths to limit the impact of rulings only to the specific facts of the case, and therefore, it is unknown if the outcome would be different if any of the factors 1-4 listed above were different.   In the opinion of this author reviewing the Court’s analysis in Swart, if the Court were presented with a situation similar to Paul from FTB Publication 689, the Court would likely agree with the Franchise Tax Board that Paul was “actively engaged in transactions” in California, and therefore, owes the minimum $800 Franchise Tax.  Nevertheless, Swart should settle the issue that merely passively investing in an entity in California will not, by itself, constitute “doing business in California.”

“Piercing the Veil” – Are you Appropriately Maintaining your LLC or Corporation?

January 17, 2017 Asset Protection, Business planning Comments Off on “Piercing the Veil” – Are you Appropriately Maintaining your LLC or Corporation?

Our law firm takes the position that an entity (such as an LLC or corporation, etc.), if properly maintained and used, can serve an important function in terms of liability protection, in addition to other forms of risk management such as insurance. This may be a business owner looking to put some distance between him and his business operations, or it may be an entity which forms subsidiaries or has sister companies setup for legitimate operational reasons.

However, there are limits to how much liability protection an entity can serve to provide. Even though the presumption is that a legal entity such as an LLC or corporation is separate from the owners and management, i.e., “veil piercing” is rare, don’t shoot yourself in the foot by doing things, such as commingling business and personal funds, or failing to do things such as entity maintenance or appropriately title assets that would rebut this presumption.

With that in mind, here is a brief snapshot of a few recent court cases throughout the country that have discussed “piercing the veil” and some of the factors that were considered:

In a case called Knopf v. Phillips (S.D.N.Y., 2016), which was decided last month (December 2016), the number one factor as to whether or not the “veil” of corporate/entity protection should be “pierced” was the disregard of corporate formalities. The court ruled that the plaintiff’s adequately pleaded a claim for veil piercing/alter ego because the defendant had “abused the corporate form” to defraud the plaintiffs. Another factor which is often analyzed in these cases, including this one, is the fact that the defendant has “undercapitalized” his business as evidenced by the inability to pay debts, in conjunction with the fact that the defendant had diverted thousands of dollars from one entity to another entity despite the inability to pay its debts. The takeaway from this case is that if you’re going to setup an entity, take the time to treat it as a separate entity and be sure you have enough funds inside the business to service debts of the business.

A few months earlier (October 2016), 5th Circuit Federal Court of Appeals, a case called Janvey applied some of the same analysis as in Knopf yet because of the facts, reached a different conclusion. In Janvey, it involved a parent company and a subsidiary and whether the parent company should be liable for the actions of the subsidiary. Here, the outcome was in favor of the parent company that the “veil” should not be pierced between the subsidiary and the parent company, and one of the factors the court looked at was how assets of the subsidiary were titled and how the subsidiary was operated. Had there been a disregard and failure to appropriately hold title of the subsidiaries assets in the name of the subsidiary rather than the parent company, or had the overall operations of the subsidiary collapsed into the parent company where it would have been indistinguishable to differentiate between the subsidiary’s business operations and the parent company’s operations, the court might have more seriously considered allowing the veil to be pierced. This is one reason why in the real estate context it is important to ensure that if a parent company with subsidiary’s is going to be utilized, that assets are appropriately held and maintained by the subsidiaries rather than everything in the name of the parent company.

A case in Ohio in November 2016 called Premier Therapy v. Childs, provides further instruction. Some of the factors the court looked at were “lack of corporate records” and “disregard of corporate roles”, as well as the entity’s inability to pay its debts to due siphoning of funds for personal use. In this case, the business had been unable to pay its debts and was essentially insolvent at the time the plaintiff was injured by the acts of the business, so the court (appellate court) decided there was more than enough facts to allow a jury trial to make a determination whether to pierce the LLC/corporate veil. This case highlights the importance to keep corporate records such as annual minutes.

Lastly, a case out of California last year (2016) called Boeing v. Energia highlights the importance of properly maintaining entities with the state, holding annual meetings, and keeping corporate records. The defendant was a parent company which had setup multiple subsidiaries to hold various assets such as licenses, etc., and some of the main reasons the court disregarded the corporate veil was because the subsidiaries were not properly maintained (Delaware) in terms of annual filings and payment of franchise taxes, and also because there was a dearth of corporate meetings and records held and maintained by the subsidiary. In applying Delaware law, despite a court’s reluctance to pierce the veil, it may do so when a “parent and subsidiary operate as a single economic entity” and there is an “overall element of injustice or unfairness that is present”.

Although a typical requirement for the veil of your entity to be pierced by a plaintiff or injured party is that the entity was used to perpetuate fraud, illegal acts, or unlawful behavior, and certainly we hope you aren’t committing such acts, you nevertheless don’t want to open up yourself to a “pierce the veil” claim for failure to appropriately maintain your entity.

For more on this general issue in the LLC context, which would receive the about the same analysis for “veil piercing” as a corporation, please read http://kkoslawyers.com/llcs-and-limited-liability-protection-a-primer-for-the-small-business-owner/ . For a brief list of our suggestions for best practices in operating your entity, please read http://markjkohler.com/piercing-the-corporate-veil-what-you-need-to-know-that-t/ . Our office not only sets up entities for clients, but just as important, we offer services such as our company maintenance program, “corporate cleanup”, registered agent services, and mail forwarding services, all of which can to varying degrees provide support to a small business owner in terms of entity maintenance.  In fact, the New Year is a good time to consider setting up annual company maintenance with our office through our discounted rates that are being offered right now.

5 New Year’s Resolutions to Make Your Business Great (or Great Again)

January 9, 2017 Business planning Comments Off on 5 New Year’s Resolutions to Make Your Business Great (or Great Again)

The dawn of a new year is traditionally a time for self-reflection on what we need to do to improve our lives.  Many of us focus on goals to make ourselves better physically, mentally, spiritually, and yes – even financially.  For those of you who own a small business, it’s also a great time to apply some mental capital to figuring out ways to improve that business.  In that vein, here are five ideas for New Year’s resolutions that will help you make your small business great (or great again):

1) Get Started! – This resolution has lots of possible applications.  If you don’t have a small business yet, but believe you have the concept, the determination, and the skills to make it on your own – then don’t procrastinate any longer!  Make 2017 the year you at least get on the path to making those dreams a reality.  If you already own a small business, make 2017 the year you take things to the next level.  Develop that idea you have into a profitable product or service.  Find your niche.  Your business will never get off the ground or take that next big leap if you don’t get started doing something you weren’t doing before.

2) Develop a Strategic Plan – My colleague and friend, Mark Kohler wrote about this last week.  In a nutshell, your Strategic Plan is your roadmap for how to get from where you are now to where you want to be.  It’s hard to make just about anything work without a plan.  Read Mark’s article from last week, listen to the podcast, and take the time to establish and adapt your Strategic Plan throughout the year and beyond.  If you do, I can promise you will find that taking your business to the next level will be a much smoother and shorter trip than it would be without it.

3) Get Serious about Limiting Your Liability – You may not be aware of this, but sometimes small businesses and/or their owners get sued!  Maybe it’s a disgruntled ex-employee, or a former partner, or a vendor or a client who thinks you breached a contract.  Regardless of the source of the lawsuit, there are steps you can take to limit both your personal liability and the liability of the business itself.  Speaking generally, these steps may include:

1)   Incorporating your business.

2)   Making sure your business has the correct underlying documents and state filings to maintain the protection you already think you have.

3)   Looking into additional insurance.

4)   Making sure all contracts related to the business are in writing, and that the language accurately reflects the nature of the contractual relationship.

4) Learn Something New – Without a doubt, it can be easy to get caught up in the day-to-day of running your business, but you should also set aside time to learn new skills or strategies that could make your business an even bigger success.  It may be as simple as learning QuickBooks so you can get your financial house in order. Or maybe it’s learning a new industry skill, such as becoming a licensed realtor, so you can take commissions on some of those real estate deals you come across.  While there are plenty of resources on the internet, you can also attend seminars, workshops or industry training events to pick up your new skill (depending what you learn, you may even be able to get a certification).  When you invest in yourself in this way, you are also investing in your business.

5) Make the Difficult Decisions – Making these decisions is hard, and putting them off may make things easier in the short term.  But, at the end of the day, putting off difficult decisions just makes them harder/ for your business. Is there an employee that’s just not working out? It’s usually best to let them go before the situation gets worse.  Is a new product just not generating the revenue you expected?  It may be the time to revamp it or get rid of it.  A huge part of being a successful business owner or entrepreneur is facing these types of trials as they come and making honest, informed decisions for the long-term health of your business.

Making (and keeping) these resolutions will go a long way to making your business great in 2017!