Tax Analysts Blog

California’s Aggressive Position on Passive Income

Posted on Aug 14, 2013

It’s not hard for taxpayers to find themselves subject to California’s franchise tax. Take for example Swart Enterprises Inc., which operates a farm in Kansas. According to a Dunn & Bradshaw report, Swart Enterprises was established in 2003 and provides farm labor contractors. The company is incorporated in Iowa, has estimated annual revenues of $280,000, and has three employees.

Swart has no physical presence in California. It does not have employees in California and it does not own real or personal property in California. Swart did, however, own a 0.02 percent interest in a California limited liability company that invested and traded in capital equipment. Swart was not the manager of the fund and was not involved in the management or operation of the fund. Yet, its status as a member is enough for the California Franchise Tax Board (FTB) to allege that Swart is doing business in California.

After the FTB required Swart to file a California tax return and pay the $800 minimum franchise tax (along with interest and penalties) required under Rev. and Tax Code section 25153, it filed a claim for refund. After the FTB denied the claim, Swart filed a complaint seeking a refund and declaratory relief. (Swart Enterprises Inc. v. California Franchise Tax Bd., Fresno County Superior Court, Case No. 13 CE CG 02171 (July 9, 2013).) In the complaint, Swart argues against the FTB’s interpretation of section 25153 and that the FTB’s imposition of the tax is unconstitutional.

This the first challenge to an aggressive position taken by the FTB with regard to passive income. RTC section 23101 provides that a taxpayer is “doing business” in the state if it is “actively engaging in any transaction for the purpose of financial or pecuniary gain or profit.” But, for taxable years beginning on or after January 1, 2011, there is an add-on. A taxpayer will be deemed to be doing business in the state if it engages in any transaction for the purpose of financial or pecuniary gain or profit in the state or if certain conditions are satisfied, including that:

    • The sales of the taxpayer in California exceed the lesser of $500,000 or 25 percent of the taxpayer’s total sales; or
    • The real and tangible personal property of the taxpayer in California exceed the lesser of $50,000 or 25 percent of the taxpayer’s total real and tangible personal property.

It sounds innocuous enough, but California has indicated (and now established in this lawsuit) that included in the taxpayer’s sales, property, and payroll will be the taxpayer’s pro rata or distributive share of pass-though entities. “Pass-through entities” include partnerships, LLCs treated as partnerships, or S corporations.

This will be an interesting case to follow. While the litigation is in the very early stages, the FTB’s position is tenuous and arguably misguided. While states are always on the lookout for each and every dollar of tax revenue, taxing investments in California serves as a big disincentive for out-of-state companies to invest in the state.

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