United States: California Court Holds Non-Managerial Interest In LLC Did Not Constitute Doing Business In State

A California Superior Court granted an out-of-state corporation's motion for summary judgment and determined that the corporation's ownership interest in a manager-managed limited liability company (LLC) did not constitute doing business in the state for purposes of the corporation franchise tax.¹ Although the LLC was treated as a partnership for federal and state income tax purposes, the corporation was not doing business in the state by reason of its ownership interest in the LLC, because it did not have the right to manage or control the LLC's decision-making process.

Background

Swart Enterprises, Inc., an Iowa corporation, invested $50,000 in a manager-managed California LLC in 2007. This $50,000 investment represented an ownership interest in the LLC of approximately 0.2 percent, and was the only business connection that Swart had with the state of California. A separate California corporation had exclusive and complete authority in the management and control of the LLC. The LLC's operating agreement provided that members other than the manager were prohibited from taking part in the control or operation of the LLC.

The California Franchise Tax Board (FTB) required that Swart file a California corporation franchise tax return for the tax year ending June 30, 2010. According to the FTB, Swart was doing business in California and subject to the $800 minimum corporation franchise tax due to its ownership interest in an LLC operating in the state. After paying the tax, interest and penalties under protest, Swart filed a refund claim for these amounts. Swart and the FTB both filed motions for summary judgment.

Out-of-State Corporation Could Not Manage or Control LLC

Under California law, an $800 minimum corporation franchise tax is imposed on every corporation that is: (i) incorporated under the laws of the state; (ii) qualified to transact intrastate business in the state; or (iii) doing business in the state.² There was no dispute that the only basis for imposing tax on Swart was that it was doing business in California, and the only basis for concluding that Swart was even doing business in California was its investment in the LLC. A California statute defines "doing business" as "actively engaging in any transaction for the purpose of financial or pecuniary gain or profit."³ A regulation further provides that the definition includes the "purchase and sale of stocks or bonds."⁴ According to the California Supreme Court, "actively" means active participation in any transaction for the purpose of financial or pecuniary gain or profit.⁵ Because Swart invested in the LLC over two years before the relevant tax year, Swart's only connection with California in the relevant tax year was the holding of its investment in the LLC.

In considering the statutory definition of "doing business," the Court explained that passively holding an investment does not constitute doing business or actively engaging in a transaction for gain or profit. The fact that the definition includes the purchase and sale of stocks or bonds does not mean that every investment of a security falls within the meaning of "doing business." This regulation did not support the FTB's argument that Swart was doing business in the state because it had previously purchased an interest in the LLC. Furthermore, the regulation provides that "[t]he mere receipt of dividends and interest by a corporation and the distribution of such income to its shareholders does not constitute 'doing business.'"⁶ This supported a finding that passively holding an investment in an LLC made in prior years does not constitute active participation in a transaction in 2010.

The Court held that Swart was not doing business in the state even though the LLC elected to be treated as a partnership for income tax purposes. Due to this election, the FTB argued that Swart should be considered a partner in the LLC for all state and federal tax purposes. Under the FTB's argument, "partnership" refers to a traditional general partnership in which the partners have the right to manage and conduct partnership business. The FTB argued that the distinction between "active" and "passive" LLC members did not apply to general partnerships. In rejecting this argument, the Court agreed with Swart that the LLC should be treated as a partnership only for purposes of computing income taxes. The Court relied on a case, Appeals of Amman & Schmid Finanz AG,⁷ in which the California State Board of Equalization (SBE) held that foreign corporations were not subject to the minimum corporation franchise tax where their only connection with the state was a limited partnership interest. In Amman, the SBE found that limited partners were not actively engaging in a business because the foreign corporations had no interest in specific limited partnership property, had no right to participate in partnership management, were powerless to bind the partnership, and were not liable for the partnership's obligations. Based on Amman, the Court determined that Swart was not doing business in California.

The holding was further supported by a Technical Advice Memorandum (TAM) issued by the FTB in 2000.⁸ In this document, the FTB determined that a non-California corporation that was the sole owner of a single member California LLC was exempt from federal income tax.⁹ The corporation was required to submit a California application for tax-exempt status because it received California source income from the LLC and was subject to California income tax.¹⁰ However, the corporation was not subject to corporation franchise tax because it was not doing business in California.

While the instant litigation was pending, the FTB issued a ruling, Legal Ruling 2014-01, which indicated a change in its position by explaining that the members of an LLC classified as a partnership are doing business in the state.¹¹ This approach is based on the default rules in California's LLC Act¹² that the members, who are considered general partners for tax purposes, have the right to participate in the management of the business. The FTB explained in the legal ruling that Amman was based on a narrow exception that a limited partner has a reduced right to manage or control the entity.

In the instant case, the FTB argued that the members of the LLC had the right to delegate the power to manage the business in favor of a manager, and the power to revoke that delegation at any time. Under the FTB's argument, the result was the same even though the LLC was manager-managed. The Court determined that the FTB's conclusion was not supported by legal authority and based on the erroneous assumption that Swart, a member that owned 0.2 percent of the membership interest in the LLC, actually had the power to exercise control or designate the LLC as member-managed. The LLC's articles of organization providing that the LLC would be manager-managed were issued 16 months before Swart made its investment. Only the manager had authority to manage or control the LLC's business. The narrow exception in Amman based on the limited partner's lack of control to manage or control the decision-making process would apply to Swart because it never had managerial authority. Furthermore, the check-the-box regulations are not intended to control whether an LLC is doing business for purposes of California corporation franchise tax.¹³

Commentary

This decision limits the FTB's ability to impose corporation franchise tax on out-of-state corporations that have a passive investment in a California LLC. Even though this decision is non-precedential and may be appealed by the FTB, it is a step toward limiting the FTB's ability to impose corporation franchise tax on out-of-state corporations that have no ability to control or manage the decision-making process of the California entity. This decision precluded the FTB from expanding nexus based on Legal Ruling 2014-01, a document prepared in part with this controversy in mind. Despite the FTB's argument, the fact that an LLC is classified as a partnership for income tax purposes does not automatically treat an out-of-state owner as a general partner subject to California corporation franchise tax. A determination must be made whether the owner has the ability to manage or control the LLC. If the out-of-state owner does not have the right to manage the LLC and has a very small ownership interest in the LLC, there is a strong argument to distinguish such passive ownership interest (held by Swart) from an ownership interest in which the out-of-state owner actively controls and manages the LLC.

This decision potentially could affect many out-of-state entities that own an interest in a California LLC treated as a partnership if the entity lacks the ability to control the LLC. Entities in this situation should evaluate whether they have authority to exert control over the LLC.

It should be noted that this decision concerned a corporation franchise tax year that ended on June 30, 2010. For tax years beginning on or after January 1, 2011, California significantly expanded its "doing business" statute to include an economic nexus standard.¹⁴ Therefore, out-of-state entities may have nexus with California for tax years beginning after 2010 under this new broader nexus standard. It is unlikely that the new nexus standard would have changed the outcome of the instant case because Swart probably did not meet any of the economic nexus thresholds due to its very small ownership interest in the LLC. However, out-of-state companies that meet the statutory sales, property or payroll thresholds will now be subject to California tax.

Footnotes

1 Swart Enterprises, Inc. v. California Franchise Tax Board, California Superior Court, Fresno County, No. 13CECG02171, Nov. 14, 2014.

2 CAL. REV. & TAX. CODE § 23153(a), (b).

3 CAL. REV. & TAX. CODE § 23101(a); CAL. CODE REGS. tit. 18, § 23101(a).

4 CAL. CODE REGS. tit. 18, § 23101(a).

5 Hise v. McColgan, 148 P.2d 616 (Cal. 1944).

6 CAL. CODE REGS. tit. 18, § 23101(b).

7 No. 96-SBE-008, California State Board of Equalization, April 11, 1996.

8 Technical Advice Memorandum 200658, California Franchise Tax Board, Dec. 22, 2000.

9 The corporation was exempt under IRC Section 501(c).

10 As explained by the Court, the California corporation income tax is imposed on corporations receiving income from a California source.

11 California Franchise Tax Board, July 22, 2014. For further discussion of this document, see GT SALT Alert: California Issues Legal Rulings Addressing Nexus and Apportionment Issues.

12 CAL. CORP. CODE §§ 17701.01 et seq.

13 Because the Court determined that Swart was not doing business in California, the Court did not need to consider Swart's argument that the "doing business" statute violated the Due Process Clauses of the U.S. and California Constitutions.

14 CAL. REV. & TAX. CODE § 23101(b). Under this standard, a taxpayer is considered to be doing business in California for a taxable year if any of the following conditions are satisfied: (i) the taxpayer is organized or commercially domiciled in the state; (ii) the taxpayer's sales applicable for the taxable year exceed the lesser of $500,000 or 25 percent of the taxpayer's total sales; (iii) the taxpayer's real property and tangible personal property in California exceed the lesser of $50,000 or 25 percent of the taxpayer's total real property and tangible personal property; or (iv) the amount of compensation paid by the taxpayer in the state exceeds the lesser of $50,000 or 25 percent of the total compensation paid by the taxpayer.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.