United States: California Tax Developments (3rd Quarter 2014)

Last Updated: December 4 2014
Article by Marty Dakessian, Brian W. Toman, John R. Messenger, Mike Shaikh, Shirley J. Wei, Erin J. Mariano and Jenny J. Choi

Most Read Contributor in United States, October 2017

Case Updates

Court finds ownership of LLC membership interest does not constitute doing business in California

On November 14, the Fresno County Superior Court determined that Swart, an Iowa-based corporation with a tangential investment in California, did not meet the statutory requirement for doing business in California.1 Swart invested $50,000, amounting to approximately 0.02% ownership, in a California LLC. Swart had no physical presence in California; it had no employees in California, and did not own real or personal property in California. Its only connection to California was its ownership interest in the LLC. In granting Swart's motion for summary judgment, the court stated that passively holding an investment does not constitute "doing business" or actively engaging in a transaction for gain or profit.

In reaching the decision, the court relied heavily on a State Board of Equalization decision from 1996, Appeal of Amman & Schmid Finanz AG.2 In Amman, the SBE held that foreign corporations were not subject to the California minimum tax where their only connection with California was holding limited partnership interests in partnerships engaged in business in California. Applying the law of limited partnerships, the SBE noted that limited partners were inactive participants in the partnerships and, therefore, were not actively engaging in profit-seeking transactions. As limited partners, the foreign corporations had no interest in specific limited partnership property, had no right to participate in the management of the partnership, were powerless to bind the partnership, and were not liable for the obligations of the partnership.

Applying Amman, the court pointed to the fact that Swart also had no interest in specific property of the California LLC; was not personally liable for the California LLC's obligations; played no role in the California LLC's management and had no right to do so; and could not act as an agent for the California LLC or bind it in any way.

Takeaway: The Swart decision is significant because it curbs the FTB's efforts in Legal Ruling 2014-01 to limit the application of Amman to investors in limited partnerships. While it is the FTB's position is that Amman does not apply in the LLC context because LLC members generally have the right to participate in the management of the business, the Swart decision instructs that if a member lacks the ability to participate in the management of an LLC doing business in California, it cannot be deemed to be "doing business" in California merely by virtue of holding a membership interest in the LLC.

Victory secured: Reed Smith wins attorney fee award in Cutler case

On September 2, a California Court of Appeal ruled that a taxpayer who successfully challenged the constitutionality of California's qualified small business stock ("QSBS") incentive was entitled to receive attorney fees under the state's private attorney general statute.

In 2012, the Court of Appeal held that the California QSBS incentive favored in-state businesses over out-of-state businesses, and therefore unfairly discriminated in violation of the Commerce Clause.3 When the taxpayer, who had been represented by Reed Smith, requested attorney fees under Code of Civil Procedure section 1021.5, the trial court denied the application. The trial court denied the application because the taxpayer's suit, in its opinion, did not confer a significant benefit on the general public or a large class of persons, and because the burden of private enforcement did not make the award appropriate under section 1021.5.

The Court of Appeal overruled the trial court on both points, and found that the taxpayer met all elements for an award of attorney fees under section 1021.5. It reversed the order denying attorney fees and remanded the case to the trial court to determine the amount of fees to be awarded.

Reed Smith State Tax partner Marty Dakessian represents the taxpayer and argued the attorney fees motion.

Takeaway: The Court of Appeal's decision is a significant taxpayer victory that makes it clear that the economic resources of an individual taxpayer should not be a factor in considering whether an attorney fee award is appropriate under section 1021.5.

Preliminary taxpayer victory in unclaimed property case

Judge Goldsmith of the San Francisco Superior Court issued an order September 2 in a case that could have a significant impact on the scope of the Controller's unclaimed property audit authority. The judge denied California Controller John Chiang's motion for a preliminary injunction in Thrivent Financial for Lutherans v. Chiang.4 The requested preliminary injunction would have ordered Thrivent to comply with unclaimed property audit requests that it contended went well beyond the scope of what California unclaimed property law permits.

California engaged third-party auditor Kelmar Associates, LLC to conduct an unclaimed property audit of Thrivent. Thrivent sells life insurance policies. During the course of the audit, the guidance in the Controller's Unclaimed Property Holder Handbook regarding the trigger for the dormancy period for life insurance policies was revised to be the date of the insured's death, rather than upon actual proof of death, as provided in Civ. Proc. Section 1515. Kelmar requested information from the taxpayer on almost 6 million life insurance policies.

Thrivent filed a complaint for declaratory and injunctive relief October 30, 2013. On May 14, 2014, the Controller filed a motion for preliminary injunction to get Thrivent to comply with the audit requests and continue the audit. Oral argument took place August 28. Ultimately, the court determined that the Controller did not sufficiently establish a likelihood of success on the merits or irreparable harm, and denied the motion.

Takeaway: The denial of the preliminary injunction indicates that the court is in agreement that the Controller is overreaching what is authorized by statute. It appears that by denying the motion, the court recognized the aggressiveness of the third party auditors and questionable policy change by the Controller.

In fact, the order states that the denial of the motion for preliminary injunction will not prevent the Controller from ever performing an audit. The case may result in guidance and set precedent for the scope of unclaimed property audits in California. We will continue to monitor the case. Please reach out to members of our team if you have questions about unclaimed property audits.

California Court of Appeal issues shaky opinion in documentary transfer tax case

On September 22, a California Court of Appeal filed a certified decision in a documentary transfer tax case that has sent ripples through the tax community. In 926 North Ardmore Avenue, LLC v. County of Los Angeles,5 the court held that in situations in which there is a change in control of a legal entity directly or indirectly owning real property, the sale of the ownership interests in the legal entity constitutes realty sold for purposes of the documentary transfer taxes imposed by Los Angeles County and the City of Los Angeles.

The documentary transfer tax is rooted in the Federal Stamp Act, which was repealed effective January 1, 1968. The purposes of both laws were to impose a tax upon deeds for the transfer of real property. Thus, the imposed documentary transfer tax is on deeds, instruments or writings by which lands, tenements or other "realty sold" is granted, assigned, transferred or otherwise conveyed. However, in its decision, the court interpreted "realty sold" for documentary transfer tax purposes, based on the concept of "change in ownership" for property tax purposes. The court relied on prior case law stating that property tax rules can provide guidance in interpreting the term "realty sold" to determine that the two terms are sufficiently similar to have the same meaning.

Although the court's decision specifically addressed documentary transfer taxes imposed by Los Angeles County and the City of Los Angeles, it creates precedent for other counties and cities to impose their documentary transfer taxes to transfers of ownership interests in legal entities that directly or indirectly hold California real property.

Takeaway: Practitioners have expressed concern about both the reasoning and the legal conclusion reflected in the Court of Appeals published decision. For example, in the published decision, the court supports its interpretation of the documentary stock tax statute by citing property tax legislation that was enacted almost a decade after the enactment of the documentary transfer tax. The court thus conflated the property tax concept of "change of ownership" with the completely different documentary transfer tax concept of "realty sold."

The taxpayer has filed a petition for review with the California Supreme Court, and several parties have filed requests for the depublication of the Court of Appeal's decision.

Tax Analysts sues Franchise Tax Board to compel disclosure of agency documents

In June, Reed Smith State Tax attorneys Marty Dakessian, Kyle Sollie, and Shirley Wei, on behalf of Tax Analysts, filed a petition for writ of mandate and complaint for declaratory and injunctive relief against the California Franchise Tax Board (the "FTB").6 In its complaint, Tax Analysts asserts that it submitted a written request under the California Public Records Act (the "PRA") requesting the disclosure of two documents: (1) FTB Form 6861, which is used by the FTB to estimate the materiality of potential adjustments to a taxpayer's income or apportionment factors, and (2) FTB Form 6685, which is used to the tax effect of requiring affiliated companies to file a combined corporate income tax return. Both forms are referenced in the FTB's Multistate Audit Techniques Manual and thus fall within the meaning of the PRA. The matter is still pending.

Regulatory Updates

GO-Biz tax credit emergency regulations re-adopted; proposed regulation in place

As reported in our alerts for the 1st Quarter and 2nd Quarter of 2014, the Governor's Office of Business and Economic Development ("GO-Biz") is up and running. The application periods for the new California Competes tax credit for fiscal year 2014-2015 were updated in September. One of the application periods ran from September 29 through October 27, with $45 million in credits available. The next period will run from January 5, 2015, through February 2, 2015, with $75 million in credits available. The last period will run from March 09, 2015, through April 6, 2015, and have $31.1 million available, plus any unallocated amounts from the previous application periods.

On August 18, the GO-Biz readopted its emergency regulations (originally adopted in February), just before they were set to expire August 20. On September 12, GO-Biz published notice of its intent to adopt proposed regulations. These proposed regulations are identical to the emergency regulations readopted in August. On October 18, GO-Biz readopted the emergency regulations for a second time, to allow time for the proposed regulations to make their way through the normal administrative approval process.

Takeaway: During the first application period, GO-Biz received just under 300 applications, requesting a total of $329 million in credits – almost seven times the amount allotted for the period. GO-Biz will announce the successful applicants on its website in early January. The response from taxpayer applicants indicates this is a very coveted credit. Contact a member of Reed Smith's California team if you have any questions concerning the California Competes Tax credit.

Franchise Tax Board adopts its own form for reporting like-kind exchanges

On September 29, the FTB issued a public service bulletin announcing that it had adopted its own form for the reporting of like-kind exchanges involving property located in California (Form 3840). New Revenue and Taxation Code sections 18032 and 24953 require annual reporting for taxpayers that claim non-recognition of gain or loss under Internal Revenue Code section 1031 in connection with the exchange of property located in California for property located outside of California, effective for tax years beginning on or after January 1, 2014. Taxpayers must file Form 3840 with the FTB for the taxable year of exchange and all following years for which the taxpayer claims deferral of gain or loss.

The annual reporting requirement is imposed on taxpayers regardless of residency status or commercial domicile. For taxpayers that are California filers, Form 3840 is attached to the return, and is due on the same date as the return. For taxpayers that would not otherwise be required to file a return with California, Form 3840 is due on the same date that the taxpayer's California return would have been due, if the taxpayer did have a California filing requirement.

Takeaway: The FTB's guidance indicates that the failure to file Form 3840 can result in the issuance of a Notice of Proposed Assessment plus penalties and interest. However, the filing requirement seems particularly burdensome on taxpayers who would not otherwise have a filing requirement in California and would not otherwise know of the new filing obligation. As the new law gets enforced, it will be interesting to see how the FTB deals with such taxpayers.

Election Update

The following are highlights of the California general election as it relates to the tax world.7

State Board of Equalization

We have a new State Board of Equalization ("BOE"). The members who were elected are as follows:

  • District 1. George Runner (R). Mr. Runner defeated Democratic challenger Chris Parker, an attorney from the FTB Legal Division by a healthy margin (58.8% - 41.2%). Mr. Runner was elected to his second four-year term and is termed out in 2019. His vast district includes many of the northern inland counties, Sacramento County, most of the Central Valley, San Bernardino County, and northern Los Angeles County.
  • District 2. Fiona Ma (D). Ms. Ma easily defeated Republican James Theis 68.5% to 38.5%. She is a former Assemblymember from San Francisco. Ms. Ma's district consists of most of coastal California from the Oregon border down to Santa Barbara.
  • District 3. Jerome Horton (D). The current BOE Chairman handily won against Republican challenger Rick Marshall (61.5% - 38.5%). Mr. Horton was elected to his second four-year term and is termed out in 2019. His district includes most of Los Angeles and Ventura Counties.
  • District 4. Diane Harkey (R). The former Assemblymember defeated Democratic candidate Nader Shahatit (61.8% - 38.2%). Ms. Harkey's district includes Orange County, Riverside County, San Diego County and part of San Bernardino County.
  • State Controller. Betty Yee (D). Ms. Yee defeated moderate Republican Ashley Swearengin in the mostly closely watched statewide campaign. The final tally was Yee 53.3% (3,197,558) - Swearengin 47.2% (2,798,902).

The members will assume office in January.

Outgoing BOE Members

  • District 1. Betty Yee (D). Ms. Yee is the new State Controller.
  • District 4. Michelle Steel (R). Ms. Steel was overwhelmingly elected to the Orange County Board of Supervisors. She defeated former Assemblymember Allan Mansoor by a margin of 62.6% - 37.4%.8
  • State Controller. John Chiang (D). Mr. Chiang won the election for State Treasurer against nominal opposition.

Franchise Tax Board

Beginning in January 2015, the FTB members will be as follows:

  • BOE Chairman Jerome Horton (D)
  • State Controller-elect Betty Yee (D)
  • Finance Director Michael Cohen (D). Mr. Cohen is Governor Brown's current appointee. Brown cruised to re-election over Neel Kashkari, defeating the Republican challenger by a 59.3% - 40.7% spread (more than 1 million vote-margin statewide out of 6.2 million votes cast).


Democrats lost supermajority control of both houses of the Legislature. Republicans now have a say in whether to approve tax-increase legislation, which requires a two-thirds vote of both the Assembly and the Senate. Here is the breakdown before and after the election:

Notable races included the 39th Assembly District (Pacoima) where Democrat Patty Lopez defeated Assembly Revenue and Taxation Chair Raul Bocanegra in a close race, and the 66th Assembly District (Torrance), where Democrat incumbent Al Muratsuchi lost to Republican challenger David Hadley.


1. Fresno County Superior Court Case No. 13CECG02171.

2. 96-SBE-008.

3. Cutler v. Franchise Tax Board, 208 Cal. App. 4th 1247 (2012).

4. San Francisco Sup. Ct. Dkt. No. CGC-13-535156.

5. 229 Cal. App. 4th 1335 (2014).

6. Tax Analysts v. Franchise Tax Board, LASC No. BS149089.

7. The results are those reported on the California Secretary of State's website as of November 10, 2014.

8. As reported on the Orange County Registrar of Voters website, November 10, 2014.

This article is presented for informational purposes only and is not intended to constitute legal advice.

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