Tax Analysts Blog

Doing Business in California

Posted on Aug 6, 2014

The California Franchise Tax Board recently issued Legal Ruling 2014-01, which addresses when a business entity with a membership interest in a limited liability company is required to file a California return and pay applicable taxes. The ruling comes while a case is pending on that very issue.

The case is Swart Enterprises Inc. v. California Franchise Tax Bd. (Fresno County Superior Court, Case No. 13 CE CG 02171 (July 9, 2013)). Swart operates a farm in Kansas 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 doesn’t have employees in California and it doesn’t own real or personal property there. 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 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, Swart filed a claim for refund. After the FTB denied the claim, Swart filed a complaint seeking a refund and declaratory relief.

Although the case is still pending,the FTB didn’t want to wait until the litigation was complete before announcing its position. In the legal ruling, the FTB explains that “wherever a partnership does business, 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.’” This isn’t a problematic statement, since a partner is generally seen as deriving a share of the partnership’s income and loss from where the partnership has business activities.

The FTB then addressed what it considers a limited exception to the well-established rule that a partner is considered to be doing business in California if the partnership is doing business in California. The exception is described in the Board of Equalization’s opinion in Appeal of Amman & Schmid Finanz AG et al., in which the board ruled that an out-of-state corporate limited partner whose only contact with California was its ownership of an interest in a limited partnership is not considered to be doing business in the state. The board reached that conclusion because limited partners do not manage the partnership or generally conduct its business.

While acknowledging that exception, the FTB nonetheless indicates in Legal Ruling 2014-01 that it is not applicable to members of an LLC. Under California’s LLC Act, members of an LLC have the right to manage and conduct the business of the LLC. Because of those rights, the FTB says, members of an LLC that is classified as a partnership for federal tax purposes are considered general partners for purposes of the doing business standard even though the members have limited liability protection. In a footnote, however, the FTB indicates that if an LLC holds a limited partnership interest in a limited partnership doing business in the state and the LLC has no other activities in the state, it will not be considered to be doing business in California.

The doing business standard in California is aggressive. Keith Paul Bishop of Allen Matkins LLP sums it up quite aptly in a recent blog post.

But what concerns me is that the FTB is announcing its position while the Swart litigation is ongoing. By doing so, it is opening itself up to the possibility that the position it took in Legal Ruling 2014-01 will ultimately be struck down. I suppose only time will tell. Until then, interested taxpayers will undoubtedly be getting protective refund claims ready.

Read Comments (1)

Rodger Regele, mba, eaNov 18, 2014

The Superior Court ruled 11/18/2014 in favor of Swart Enterprises. This should
start the stampede of claims, mine included as the representative of an Idaho
LLC with less than a .05% interest in a CA LLC.

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