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.”

About the author

Lee is an attorney at the California office of Kyler Kohler Ostermiller & Sorensen located in Irvine, California. Lee focuses his practice on real estate and business transactional/ litigation, debtor/creditor law, IRS negotiations, business planning, asset protection and estate planning. Lee’s practice includes advising clients on the formation of business entities, partnerships, and general tax planning relating to business entity formations. Lee also provides advice on structuring real estate investment deals and asset protection issues arising from investments in real estate. He also regularly advises and assists clients in IRS matters including audits, collections, installment agreements and offers in compromise.