United States: California Issues Legal Rulings Addressing Nexus And Apportionment Issues

The California Franchise Tax Board (FTB) has recently issued its first legal rulings in almost 24 months, dealing with complex nexus and apportionment concepts. In the first ruling, the FTB concluded through a series of examples that a business entity with a membership interest in a multiple-member limited liability company (MMLLC) that is classified as a partnership for tax purposes may have California return filing requirements and may be subject to the LLC tax and fee based solely upon the actions of the MMLLC.¹ In the second ruling, the FTB concluded that proceeds from asset sales transactions which took place during a Chapter 11 bankruptcy plan of reorganization were not "occasional sales" and were includible in the taxpayer's sales factor.²

Tax Treatment of Membership Interests in MMLLCs Treated as Partnerships

The first ruling addressed the issue of when business entities holding membership interests in MMLLCs treated as partnerships have nexus for California franchise tax purposes. Despite their existence under civil law, LLCs generally are not recognized as an entity choice for tax purposes. Thus, the FTB applied in its ruling tax law principles that flow from the entity choice the LLC makes for tax purposes under the federal entity classification election system³ to reach a conclusion.

California tax law conforms to the federal entity classification election system by mandating that an eligible business entity be either classified or disregarded for California tax purposes.⁴ If an LLC with two or more members chooses to be treated as a corporation for tax purposes, then its members will be treated as shareholders of the corporation for tax purposes. However, if an LLC with two or more members does not check the box to be treated as a corporation, it is treated as a partnership for tax purposes by default and its members are treated as partners in that partnership for tax purposes.⁵

California Nexus

"Doing business" in California is defined as "actively engaging in any transaction for the purpose of financial or pecuniary gain or profit."⁶ For taxable years beginning on or after January 1, 2011, California significantly expanded its "doing business" statute to include an economic nexus standard. 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:

(1) The taxpayer is organized or commercially domiciled in California;

(2) The taxpayer's sales applicable for the taxable year exceed the lesser of $500,000 or 25 percent of the taxpayer's total sales;

(3) 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

(4) The amount of compensation paid by the taxpayer in California exceeds the lesser of $50,000 or 25 percent of the total compensation paid by the taxpayer.⁷

At issue in the first ruling was whether a business entity which is a member of an MMLLC classified as a partnership had nexus in California. Specific rules regarding a nexus determination for members of an LLC are not included in California statutes, so the FTB turned to general partnership concepts, as well as related federal statutes, to apply the "doing business" standard to the business entities and activities considered.

For federal tax purposes, the character of any item of income, gain, loss, deduction, or credit included in a partner's distributive share is determined as if the item were realized directly from the source from which it was realized by the partnership, or incurred in the same manner as incurred by the partnership.⁸ California generally conforms to this provision for franchise tax purposes.⁹ The activities of the partnership are attributed to each partner, and the partners are generally "doing business" in the geographic locations where the partnership is "doing business."¹⁰

The FTB applied these principles to an LLC treated as a partnership for tax purposes. Thus, the FTB found that if an MMLLC classified as a partnership for tax purposes is "doing business" in California, the members of the MMLLC are themselves "doing business" in California for franchise tax purposes.

The FTB noted in its first ruling that "whether or not members participate in the management of an LLC or appoint a manager to do so is irrelevant. The members' rights to participate in the management of the business arise out of the statutory relationship between an LLC and its members."¹¹ California courts have recognized that the execution of an agreement relinquishing control is itself an exercise of the requisite right of control over the conduct of the partnership business.¹² Thus, the distinction between membermanaged LLCs and manager-managed LLCs was irrelevant for making a California "doing business" determination for a member of an LLC.

In an exception to the general rule that partners of a partnership are "doing business" in California if the partnership is "doing business" in the state, the California State Board of Equalization had ruled in 1996 that out-of state corporations whose only California contacts were as limited partners in limited partnerships were not "doing business" in California even if the limited partnerships were "doing business" in California.¹³ Critical to that decision was the fact that a limited partner has a reduced right to manage or control the decision-making process of the entity. In the FTB's ruling, the limited liability position enjoyed by the limited partner in that decision was determined to be irrelevant to the previous determination. Based on this logic, if an LLC is classified as a partnership for tax purposes, the members, who are considered general partners for tax purposes, are "doing business" where the LLC (i.e., a general partnership for tax purposes) is "doing business," despite the LLC members' limited liability protection.

The following activities, if engaged in by an MMLLC treated as a partnership for tax purposes, were determined by the FTB to create a California filing requirement and obligation to pay applicable taxes and fees for its members, even if the members have no other connection to California (i.e., the members are not incorporated, organized, or registered to do business in California and have no other California activities or factor presence):

• The MMLLC is commercially domiciled in California;
• The MMLLC is "doing business" in California within the meaning of Cal. Rev. & Tax. Code Sec. 23101;
• The member-managed MMLLC is "doing business" in California within the meaning of Cal. Rev. & Tax. Code Sec. 23101; or
• The member's distributive share of the California sales of an MMLLC exceeds the threshold sales amount of $500,000 or 25 percent of total sales as indicated in Cal. Rev. & Tax. Code Sec. 23101(b)(2).

Conversely, the FTB indicated that the following California activities of an MMLLC classified as a partnership for tax purposes, absent any other activities or factor presence in California for the MMLLC or member, are not indicative of "doing business" in California for the LLC's members and do not lead to a California return filing requirement and obligation to pay applicable taxes and fees:

• The MMLLC is registered to do business in California; or
• The MMLLC is organized in California.

Sales Factor Implications of Asset Sales During Bankruptcy

The FTB's second ruling addressed the issue of whether a taxpayer should include sales proceeds received from post-bankruptcy asset sales to compute its apportionment sales factor.

For California apportionment purposes, the sales factor is an in-state to everywhere ratio of the taxpayer's total sales.14 For taxable years beginning on or after January 1, 2011, "sales" is defined to include all gross receipts not otherwise allocable under California law.¹⁵ Certain receipts, however, are excluded from the sales factor. Specifically, when a substantial amount of gross receipts arises from an occasional sale of assets used in that taxpayer's trade or business, those receipts are excluded from the sales factor.¹⁶ For this purpose, a sale is characterized as "substantial" if its exclusion results in a five percent or greater decrease in the sales factor denominator of the taxpayer or, if the taxpayer is part of a combined reporting group, a five percent or greater decrease in the sales factor denominator of the group as a whole.¹⁷ A sale will meet the requirements to be termed "occasional" if the transaction is outside the taxpayer's normal course of business and occurs infrequently.¹⁸ Both the substantial and occasional requirements must be met in order for the receipts to be excluded from the sales factor.

The taxpayer referenced in the FTB's second ruling had filed for bankruptcy under Chapter 11 of the U.S. Bankruptcy Code,¹⁹ which generally provides an opportunity for a debtor to reorganize its business or financial affairs or to engage in an orderly liquidation of its property either as a going concern or otherwise. Consistent with the policy of Chapter 11, the taxpayer's Plan of Reorganization was designed with the intent to achieve the goal of converting business assets to cash at the highest possible value by operating the business as a going concern. To accomplish this goal, negotiation and implementation of asset sale transactions became part of the taxpayer's normal course of business. Although the aggregate of the gross receipts from the post-bankruptcy asset sales met the definition of "substantial" as defined above, the receipts did not arise from transactions outside the taxpayer's normal course of business, so such receipts did not qualify as "occasional sales" and were not excludable from the sales factor. Accordingly, proceeds from these asset sales were determined to be includable in the taxpayer's sales factor, despite the fact that they arose from post-bankruptcy asset sales.

Commentary

In the first ruling, the FTB clarified and formalized its view that California has the ability to tax business entities with seemingly minimal connections to the state. Despite protests from the business community rebutting the FTB's nexus position for business entities holding membership interests in MMLLCs as stated in the ruling, it appears that the FTB intends to continue asserting its jurisdiction to impose tax on these entities to the fullest extent possible. It is interesting to note that the FTB relied on facets of both California's tax provisions and its LLC Act to support its conclusion, while rejecting any distinction between member-managed and manager-managed LLCs. Specifically, in distinguishing the facts considered in the ruling from those in the decision in Appeals of Amman & Schmid Finanz AG, the FTB inferred that a corporate entity with membership in an MMLLC treated as a partnership has the right to manage and conduct partnership business. In doing so, the FTB effectively determined that these entities should be treated in the same manner as general partners in all instances, regardless of any additional mitigating facts or status as a non-managing member of a manager-managed LLC. It will be interesting to see if this ruling has any impact on pending litigation that involves similar nexus issues.

With respect to the apportionment determination rendered in the second ruling, the guidance will serve to guide taxpayers engaged in asset sales as they emerge from bankruptcy, though the effect will be beneficial to some taxpayers, while detrimental to others. The timing of the ruling is convenient for affected taxpayers currently preparing 2013 calendar year returns.

Footnotes

1 Legal Ruling 2014-01, California Franchise Tax Board, July 22, 2014.

2 Chief Counsel Ruling 2014-02, California Franchise Tax Board, June 3, 2014.

3 Entity Classification Election (IRS Form 8832).

4 CAL. REV. & TAX. CODE § 23038(b)(2)(B)(ii), (iii); CAL. CODE REGS. tit. 18, § 23038(b)-3(c).

5 TREAS. REG. §§ 301.7701-2(a); 301.7701-3.

6 CAL. REV. & TAX. CODE § 23101(a).

7 CAL. REV. & TAX. CODE § 23101(b).

8 IRC § 702(b).

9 CAL. REV. & TAX. CODE § 17851.

10 See, e.g., Donroy, Ltd. v. United States, 301 F.2d 200 (9th Cir. 1962); Reed v. Industrial Accident Commission, 73 P.2d 1212 (Cal. 1937); Appeal of Estate of Marion Markus, 86-SBE-097, May 6, 1986; Appeal of Lore Pick, 85-SBE-066, June 25, 1985; Appeal of Custom Component Switches, Inc. 77-SBE-009, Feb. 3, 1977; Appeal of H.F. Ahmanson & Co., 65-SBE-013, April 5, 1965; see also Valentino v. Franchise Tax Board, 105 Cal. Rptr. 2d 304 (Cal. App. 4th Dist. 2001); Appeal of John Manter, 99-SBE-008, Dec. 9, 1999.

11 Id.

12 Moulin v. Der Zakarian, 12 Cal. Rptr. 572 (Cal. App. 4th Dist. 1961).

13 Appeals of Amman & Schmid Finanz AG, 96-SBE-008, April 11, 1996.

14 CAL. REV. & TAX. CODE § 25134.

15 CAL. REV. & TAX. CODE § 25120(f)(1).

16 CAL. REV. & TAX. CODE § 25137.

17 CAL. CODE REGS. tit. 18, § 25137(c)(1)(A)(1).

18 CAL. CODE REGS. tit. 18, § 25137(c)(1)(A)(2).

19 U.S. CODE §§ 1101 et seq.

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