The following is the text of an e-bulletin that I authored and that was published by the Corporations Committee of the Business Law Section of the State Bar of California.
In Swart Enterprises, Inc. v. Franchise Tax Board (Jan. 12, 2017), a California court of appeal held that an out-of-state corporation whose sole connection with California was a 0.2% ownership interest in a manager-managed California limited liability company was not obligated to file a California corporate franchise tax return and pay the $800 minimum franchise tax due on that return.
California imposes a franchise tax on every corporation that is incorporated in California, qualified to transact business in California, or actively doing business in California. The minimum liability for all corporations subject to the tax is $800 per year.
An out-of-state, or foreign, corporation is subject to the California franchise tax if it is “doing business” within California, whether or not it is incorporated, organized, qualified, or registered under California law. Rev. & Tax. Code § 23151(a). The phrase “doing business,” for purposes of the franchise tax, means “actively engaging in any transaction for the purpose of financial or pecuniary gain or profit.” Rev. & Tax. Code § 23101(a); Cal. Code Regs., tit. 18, § 23101 (Regulation 23101).
Swart Enterprises, Inc. (“Swart”), was a small family-owned corporation that operated a 60-acre farm in Kansas, where it occasionally fed cattle for beef sales in Nebraska. Its place of business and headquarters were located in Iowa. Swart had no physical presence in California, such as real or personal property or employees; it did not sell or market products or services to California. Swart was incorporated in Iowa and was not registered with the California Secretary of State to transact interstate business.
In 2007, Swart invested $50,000 in Cypress Equipment Fund XII, LLC (“Cypress LLC”) and acquired a 0.2% membership interest, Swart’s sole connection with California. Cypress LLC was manager-managed, as opposed to member-managed. Under Cypress LLC’s articles of organization and operating agreement, the sole manager of the company was given “full, exclusive and complete authority in the management and control of the business of the Fund ….”
Swart was not involved in any way in Cypress LLC’s operations or management. In fact, members other than the manager were prohibited from taking part in the conduct or operation of the company. Members had no authority to execute an instrument on behalf of Cypress LLC or to otherwise act in any way on its behalf.
The FTB concluded Swart was doing business in California based on the facts that it held an ownership interest in Cypress LLC, and that Cypress LLC, which was doing business in California, had elected to be treated as a partnership for purposes of federal income taxes. The FTB demanded that Swart file a California corporate franchise tax return and pay the $800 minimum franchise tax due on that return. Swart paid the tax (and penalties and interest). It then contested the obligation and sued for a refund.
The court of appeal rejected the argument that the LLC’s election to be classified as a partnership for federal income tax purposes resulted in all members of the LLC being considered general partners for all tax purposes.
The court of appeal cited Appeals of Amman & Schmid Finanz AG (1996) 96 SBE 008 [1996 Cal. Tax LEXIS 62] for the proposition that the business activities of a partnership cannot be attributed to limited partners. In Amman & Schmid, foreign corporations that were limited partners in partnerships were held not to be doing business in California simply because the general partners were doing business in California on behalf of the partnerships.
The Attorney General attempted to distinguish a limited partnership interest from a membership interest in a manager-managed limited liability company and cited a legal ruling issued by the FTB (Cal. Franchise Tax Bd., Legal Ruling No. 2014-01 (July 22, 2014) [2014 Cal. FTB LEXIS 2]. The court of appeal disagreed with the analysis in the FTB’s ruling and noted that the ruling contradicted a position previously taken by the FTB in Technical Advice Memorandum No. 200658 (Dec. 22, 2000) (TAM) [2000 Cal. FTB TAM LEXIS 28].
The court of appeal held that a corporation that passively holds a 0.2% membership interest in a manager-managed LLC, with no right to act for or control the LLC, is not “doing business” in California and therefore is not required to file a California corporate tax return or pay the California minimum franchise tax.
Having disposed of the case on the basis of statutory interpretation, the court did not address the constitutional arguments made by Swart.
The time for the FTB to appeal has expired, and the FTB is reported to be working on guidance to release to taxpayers.
As described below, the definition of “doing business” in Rev. & Tax. Code § 23101 was expanded, effective 2011, but because the franchise tax at issue in the case was imposed for Swart’s tax year ending June 30, 2010, the statutory expansion of the definition of “doing business” did not apply to Swart.
For tax years beginning in or after 2011, Rev. & Tax. Code § 23101(b) declares a taxpayer to be doing business in California if the taxpayer’s sales, property, or compensation paid exceed certain limits set forth in the statute (with the dollar amounts to be revised annually by the FTB).
If the taxpayer’s California sales for the taxable year exceed the lesser of $500,000 or 25% of the taxpayer’s total sales, the taxpayer is doing business in California. For this purpose, sales of the taxpayer include sales by an agent or independent contractor of the taxpayer.
If the taxpayer’s real property and tangible personal property in California exceed the lesser of $50,000 or 25% of the taxpayer’s total real property and tangible personal property, the taxpayer is doing business in California.
If the amount of compensation paid in California by the taxpayer exceeds the lesser of $50,000 or 25% of the total compensation paid by the taxpayer, the taxpayer is doing business in California.
It is doubtful that the expansion of the definition of “doing business” would have changed the result in Swart, but the expanded definition could ensnare out-of-state entities that are not actively engaging in any transaction in California for the purpose of financial or pecuniary gain or profit.