A California state appeals court affirmed a state trial court decision, and concluded that a taxpayer / corporate member was not “doing business” in California merely by virtue of passively holding a 0.2% ownership interest in a manager-managed California limited liability company (LLC).
The court held the taxpayer was not personally liable for the obligations of the LLC; had no right to act on behalf of or to bind the LLC; and had no ability to participate in the management and control of the LLC. Thus, the court found that the taxpayer was akin to a limited partner, and because the business activities of a partnership cannot be attributed to limited partners, the taxpayer was not “doing business” in California.
The case is: Swart Enterprises Inc. v. Franchise Tax Board (January 12, 2017)
The taxpayer—an Iowa-organized, family-owned corporation—owned a farm in Kansas and engaged in a few other businesses outside California. The taxpayer’s sole connection to California was its passive ownership of a 0.2% interest in a California investment fund LLC that was managed by a California-based corporation.
For the tax year at issue, the LLC elected to be taxed as a partnership. Following an audit, the Franchise Tax Board asserted that the taxpayer—as an owner of the California LLC that had elected to be taxed as a partnership—was doing business in the state and was subject to the minimum franchise tax. For the tax year at issue, “doing business” was defined as “actively engaging in any transaction for the purpose of financial or pecuniary gain or profit.”
The taxpayer paid the minimum tax of $800, along with penalties and interest, and then filed suit seeking a refund of the tax and alleging that it was not “doing business” in California and that the imposition of franchise tax violated the nexus requirements of both the Due Process clause and the Commerce Clause of the U.S. Constitution.
After the trial court held in the taxpayer’s favor, the Franchise Tax Board appealed.
The appellate court first rejected the claims by the state that the term “doing business” is to be interpreted broadly to include the taxpayer’s passive investment. The appeals court considered the taxpayer to be a passive investor in the LLC that held its investment in the tax year the franchise tax was imposed.
“We are not persuaded such an investment, without more, is sufficient to conclude [the taxpayer] was doing business in California.”
The court next addressed the government’s argument that taxation was appropriate because the taxpayer was, in essence, a general partner in the LLC based on the LLC’s election to be treated as a partnership for federal income tax purposes. According to the state, if the LLC was treated as a partnership, then the taxpayer was a general partner in the LLC. If the taxpayer was a general partner, then the business of the partnership could be attributed to the taxpayer, and the taxpayer was “doing business” in California because the LLC was doing business in California.
The court, however, rejected the contention that the taxpayer’s interest in the LLC was transmuted into a general partnership interest by virtue of its election to be taxed as a partnership. The state’s argument, the court noted, failed to distinguish between general and limited partnership interests. Further, the California State Board of Equalization had recognized in the 1996 decision in Amman & Schmid that a limited partner is not “doing business” merely by virtue of its ownership interest in a limited partnership. The taxpayer’s interest, similar to the interests of the limited partners in Amman & Schmid, essentially was that of a “quintessential passive investor.”
Given these circumstances, the court concluded that the taxpayer’s interest in the LLC was akin to that of a limited partner, and the taxpayer could not be deemed to be “doing business” in California by virtue of the fact that the LLC was “doing business” in California.In the court’s view, the state appeared to have derived its conclusions about “doing business” from Franchise Tax Board (FTB) Legal Ruling 2014-01, issued at a time when the case was pending.
“To the extent the arguments on appeal were also derived from the FTB’s legal ruling, we disagree with its analysis and note it contradicts the position previously taken by the FTB.”
It remains to be seen whether the Franchise Tax Board will appeal in this matter. For other taxpayers, the case may present refund opportunities and adjustments for prior returns. In assessing potential refund opportunities, it will be important to examine closely the facts of the matter, including the ability to characterize an out-of-state corporation or LLC as a passive investor and whether the investor can participate in the management of the fund, is responsible for obligations of the fund, owns specific assets of the fund, and can act on behalf of the fund. Note that a class action suit was filed in September 2016 in Rasmussen Co. Inc. v. Franchise Tax Board, for taxpayers with Swart–type refund claims.
For more information, contact a KPMG State and Local Tax professional:
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