LCP VII Holdings LP was a foreign partnership with interests in entities both inside and outside of the United States, and it had California-source income from pass-through entities. It did not file tax returns in California on the basis it was not doing business in California.
After the Franchise Tax Board (FTB) sent the partnership a demand for tax return and the partnership did not timely respond, the FTB issued a notice of proposed assessment of tax, penalties, and interest. The partnership then filed tax returns for the years 2011 through 2014. Those tax returns reported California-source income of $667,798 from pass- through entities for 2011 and California-source income of more than $5 million for the years 2012 through 2014. After the partnership paid the $800 annual tax as well as the late-filing penalty with interest, it filed a claim for refund for the penalties and interest, which the FTB denied. The partnership appealed to the Office of Tax Appeals. 2019 OTA 399 (Nov. 19, 2019).
The partnership asserted that it was only a limited partner in pass-through entities, it was not registered to do business in California, and it did not operate any California trade or business. The partnership therefore claimed that the failure to timely file was due to reasonable cause in that it believed that it was not “doing business” in California within the meaning of Revenue & Taxation Code section 23101 and under the California Court of Appeals decision in Swart Enterprises, Inc. v. Franchise Tax Bd. (2017) 7 Cal.App.5th 497. (The Swart case was discussed in this blog, and the reader can click on the link at the end of this post to go to that blog post.)
While the partnership was not “doing business” in California within the meaning of Swart, the case was based upon the test for “doing business” in Revenue & Taxation Code section 23101(a). The Revenue & Taxation Code contains an alternative test in section 23101(b) (sometimes called the economic nexus test), which Swart did not address.
Under Revenue & Taxation Code section 23101(b)(2), if a taxpayer has sales in California for the applicable tax year that exceed the lesser of $500,000 or 25% of the taxpayer’s total sales, the taxpayer is deemed to be “doing business” in California. The $500,000 figure is adjusted annually for inflation after 2011.
As the Office of Tax Appeals found that the partnership had California-source income that exceeded the $500,000 level (as adjusted for inflation), it held that the partnership should have known that it was subject to filing in California. It said that the partnership “did not exercise ordinary business care and prudence when it failed to acquaint itself with the California tax law requirements.” The Office of Tax Appeals found the partnership did not show reasonable cause for filing its tax returns late and upheld the penalties.
In addition to the sales test, Revenue & Taxation Code section 23101(b) contains a property test and a compensation test, either of which is also sufficient to constitute doing business in California.
If the value of the taxpayer’s real property and tangible personal property in California exceeds 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.
The figures above for the property test and the compensation test are as of 2011. As is the case with the sales test, the statute provides for annual adjustment of these figures for inflation. The 2019 figures are $601,967 for the sales test, $60,197 for the property test, and $60,197 for the compensation test.