United States: California Court Holds Non-Managerial Interest In LLC Did Not Constitute Doing Business In State

A California Superior Court granted an out-of-state corporation's motion for summary judgment and determined that the corporation's ownership interest in a manager-managed limited liability company (LLC) did not constitute doing business in the state for purposes of the corporation franchise tax.1 Although the LLC was treated as a partnership for federal and state income tax purposes, the corporation was not doing business in the state by reason of its ownership interest in the LLC, because it did not have the right to manage or control the LLC's decision-making process.

Background

Swart Enterprises, Inc., an Iowa corporation, invested $50,000 in a manager-managed California LLC in 2007. This $50,000 investment represented an ownership interest in the LLC of approximately 0.2 percent, and was the only business connection that Swart had with the state of California. A separate California corporation had exclusive and complete authority in the management and control of the LLC. The LLC's operating agreement provided that members other than the manager were prohibited from taking part in the control or operation of the LLC.

The California Franchise Tax Board (FTB) required that Swart file a California corporation franchise tax return for the tax year ending June 30, 2010. According to the FTB, Swart was doing business in California and subject to the $800 minimum corporation franchise tax due to its ownership interest in an LLC operating in the state. After paying the tax, interest and penalties under protest, Swart filed a refund claim for these amounts. Swart and the FTB both filed motions for summary judgment.

Out-of-State Corporation Could Not Manage or Control LLC

Under California law, an $800 minimum corporation franchise tax is imposed on every corporation that is: (i) incorporated under the laws of the state; (ii) qualified to transact intrastate business in the state; or (iii) doing business in the state.2 There was no dispute that the only basis for imposing tax on Swart was that it was doing business in California, and the only basis for concluding that Swart was even doing business in California was its investment in the LLC. A California statute defines "doing business" as "actively engaging in any transaction for the purpose of financial or pecuniary gain or profit."3 A regulation further provides that the definition includes the "purchase and sale of stocks or bonds."4 According to the California Supreme Court, "actively" means active participation in any transaction for the purpose of financial or pecuniary gain or profit.5 Because Swart invested in the LLC over two years before the relevant tax year, Swart's only connection with California in the relevant tax year was the holding of its investment in the LLC.

In considering the statutory definition of "doing business," the Court explained that passively holding an investment does not constitute doing business or actively engaging in a transaction for gain or profit. The fact that the definition includes the purchase and sale of stocks or bonds does not mean that every investment of a security falls within the meaning of "doing business." This regulation did not support the FTB's argument that Swart was doing business in the state because it had previously purchased an interest in the LLC. Furthermore, the regulation provides that "[t]he mere receipt of dividends and interest by a corporation and the distribution of such income to its shareholders does not constitute 'doing business.'"6 This supported a finding that passively holding an investment in an LLC made in prior years does not constitute active participation in a transaction in 2010.

The Court held that Swart was not doing business in the state even though the LLC elected to be treated as a partnership for income tax purposes. Due to this election, the FTB argued that Swart should be considered a partner in the LLC for all state and federal tax purposes. Under the FTB's argument, "partnership" refers to a traditional general partnership in which the partners have the right to manage and conduct partnership business. The FTB argued that the distinction between "active" and "passive" LLC members did not apply to general partnerships. In rejecting this argument, the Court agreed with Swart that the LLC should be treated as a partnership only for purposes of computing income taxes. The Court relied on a case, Appeals of Amman & Schmid Finanz AG,7 in which the California State Board of Equalization (SBE) held that foreign corporations were not subject to the minimum corporation franchise tax where their only connection with the state was a limited partnership interest. In Amman, the SBE found that limited partners were not actively engaging in a business because the foreign corporations had no interest in specific limited partnership property, had no right to participate in partnership management, were powerless to bind the partnership, and were not liable for the partnership's obligations. Based on Amman, the Court determined that Swart was not doing business in California.

The holding was further supported by a Technical Advice Memorandum (TAM) issued by the FTB in 2000.8 In this document, the FTB determined that a non-California corporation that was the sole owner of a single member California LLC was exempt from federal income tax.9 The corporation was required to submit a California application for tax-exempt status because it received California source income from the LLC and was subject to California income tax.10 However, the corporation was not subject to corporation franchise tax because it was not doing business in California.

While the instant litigation was pending, the FTB issued a ruling, Legal Ruling 2014-01, which indicated a change in its position by explaining that the members of an LLC classified as a partnership are doing business in the state.11 This approach is based on the default rules in California's LLC Act12 that the members, who are considered general partners for tax purposes, have the right to participate in the management of the business. The FTB explained in the legal ruling that Amman was based on a narrow exception that a limited partner has a reduced right to manage or control the entity.

In the instant case, the FTB argued that the members of the LLC had the right to delegate the power to manage the business in favor of a manager, and the power to revoke that delegation at any time. Under the FTB's argument, the result was the same even though the LLC was manager-managed. The Court determined that the FTB's conclusion was not supported by legal authority and based on the erroneous assumption that Swart, a member that owned 0.2 percent of the membership interest in the LLC, actually had the power to exercise control or designate the LLC as member-managed. The LLC's articles of organization providing that the LLC would be manager-managed were issued 16 months before Swart made its investment. Only the manager had authority to manage or control the LLC's business. The narrow exception in Amman based on the limited partner's lack of control to manage or control the decision-making process would apply to Swart because it never had managerial authority. Furthermore, the check-the-box regulations are not intended to control whether an LLC is doing business for purposes of California corporation franchise tax.13

Commentary

This decision limits the FTB's ability to impose corporation franchise tax on out-of-state corporations that have a passive investment in a California LLC. Even though this decision is non-precedential and may be appealed by the FTB, it is a step toward limiting the FTB's ability to impose corporation franchise tax on out-of-state corporations that have no ability to control or manage the decision-making process of the California entity. This decision precluded the FTB from expanding nexus based on Legal Ruling 2014-01, a document prepared in part with this controversy in mind. Despite the FTB's argument, the fact that an LLC is classified as a partnership for income tax purposes does not automatically treat an out-of-state owner as a general partner subject to California corporation franchise tax. A determination must be made whether the owner has the ability to manage or control the LLC. If the out-of-state owner does not have the right to manage the LLC and has a very small ownership interest in the LLC, there is a strong argument to distinguish such passive ownership interest (held by Swart) from an ownership interest in which the out-of-state owner actively controls and manages the LLC.

This decision potentially could affect many out-of-state entities that own an interest in a California LLC treated as a partnership if the entity lacks the ability to control the LLC. Entities in this situation should evaluate whether they have authority to exert control over the LLC.

It should be noted that this decision concerned a corporation franchise tax year that ended on June 30, 2010. For tax years beginning on or after January 1, 2011, California significantly expanded its "doing business" statute to include an economic nexus standard.14 Therefore, out-of-state entities may have nexus with California for tax years beginning after 2010 under this new broader nexus standard. It is unlikely that the new nexus standard would have changed the outcome of the instant case because Swart probably did not meet any of the economic nexus thresholds due to its very small ownership interest in the LLC. However, out-of-state companies that meet the statutory sales, property or payroll thresholds will now be subject to California tax.

Footnotes

1 Swart Enterprises, Inc. v. California Franchise Tax Board, California Superior Court, Fresno County, No. 13CECG02171, Nov. 14, 2014.

2 CAL. REV. & TAX. CODE § 23153(a), (b).

3 CAL. REV. & TAX. CODE § 23101(a); CAL. CODE REGS. tit. 18, § 23101(a).

4 CAL. CODE REGS. tit. 18, § 23101(a).

5 Hise v. McColgan, 148 P.2d 616 (Cal. 1944).

6 CAL. CODE REGS. tit. 18, § 23101(b).

7 No. 96-SBE-008, California State Board of Equalization, April 11, 1996.

8 Technical Advice Memorandum 200658, California Franchise Tax Board, Dec. 22, 2000.

9 The corporation was exempt under IRC Section 501(c).

10 As explained by the Court, the California corporation income tax is imposed on corporations receiving income from a California source.

11 California Franchise Tax Board, July 22, 2014. For further discussion of this document, see GT SALT Alert: California Issues Legal Rulings Addressing Nexus and Apportionment Issues.

12 CAL. CORP. CODE §§ 17701.01 et seq.

13 Because the Court determined that Swart was not doing business in California, the Court did not need to consider Swart's argument that the "doing business" statute violated the Due Process Clauses of the U.S. and California Constitutions.

14 CAL. REV. & TAX. CODE § 23101(b). 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: (i) the taxpayer is organized or commercially domiciled in the state; (ii) the taxpayer's sales applicable for the taxable year exceed the lesser of $500,000 or 25 percent of the taxpayer's total sales; (iii) 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 (iv) the amount of compensation paid by the taxpayer in the state exceeds the lesser of $50,000 or 25 percent of the total compensation paid by the taxpayer.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
 
In association with
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Registration
Mondaq Ltd requires you to register and provide information that personally identifies you, including what sort of information you are interested in, for three primary purposes:
  • To allow you to personalize the Mondaq websites you are visiting.
  • To enable features such as password reminder, newsletter alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our information providers who provide information free for your use.
  • Mondaq (and its affiliate sites) do not sell or provide your details to third parties other than information providers. The reason we provide our information providers with this information is so that they can measure the response their articles are receiving and provide you with information about their products and services.
    If you do not want us to provide your name and email address you may opt out by clicking here
    If you do not wish to receive any future announcements of products and services offered by Mondaq you may opt out by clicking here

    Terms & Conditions and Privacy Statement

    Mondaq.com (the Website) is owned and managed by Mondaq Ltd and as a user you are granted a non-exclusive, revocable license to access the Website under its terms and conditions of use. Your use of the Website constitutes your agreement to the following terms and conditions of use. Mondaq Ltd may terminate your use of the Website if you are in breach of these terms and conditions or if Mondaq Ltd decides to terminate your license of use for whatever reason.

    Use of www.mondaq.com

    You may use the Website but are required to register as a user if you wish to read the full text of the content and articles available (the Content). You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these terms & conditions or with the prior written consent of Mondaq Ltd. You may not use electronic or other means to extract details or information about Mondaq.com’s content, users or contributors in order to offer them any services or products which compete directly or indirectly with Mondaq Ltd’s services and products.

    Disclaimer

    Mondaq Ltd and/or its respective suppliers make no representations about the suitability of the information contained in the documents and related graphics published on this server for any purpose. All such documents and related graphics are provided "as is" without warranty of any kind. Mondaq Ltd and/or its respective suppliers hereby disclaim all warranties and conditions with regard to this information, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. In no event shall Mondaq Ltd and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use or performance of information available from this server.

    The documents and related graphics published on this server could include technical inaccuracies or typographical errors. Changes are periodically added to the information herein. Mondaq Ltd and/or its respective suppliers may make improvements and/or changes in the product(s) and/or the program(s) described herein at any time.

    Registration

    Mondaq Ltd requires you to register and provide information that personally identifies you, including what sort of information you are interested in, for three primary purposes:

    • To allow you to personalize the Mondaq websites you are visiting.
    • To enable features such as password reminder, newsletter alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
    • To produce demographic feedback for our information providers who provide information free for your use.

    Mondaq (and its affiliate sites) do not sell or provide your details to third parties other than information providers. The reason we provide our information providers with this information is so that they can measure the response their articles are receiving and provide you with information about their products and services.

    Information Collection and Use

    We require site users to register with Mondaq (and its affiliate sites) to view the free information on the site. We also collect information from our users at several different points on the websites: this is so that we can customise the sites according to individual usage, provide 'session-aware' functionality, and ensure that content is acquired and developed appropriately. This gives us an overall picture of our user profiles, which in turn shows to our Editorial Contributors the type of person they are reaching by posting articles on Mondaq (and its affiliate sites) – meaning more free content for registered users.

    We are only able to provide the material on the Mondaq (and its affiliate sites) site free to site visitors because we can pass on information about the pages that users are viewing and the personal information users provide to us (e.g. email addresses) to reputable contributing firms such as law firms who author those pages. We do not sell or rent information to anyone else other than the authors of those pages, who may change from time to time. Should you wish us not to disclose your details to any of these parties, please tick the box above or tick the box marked "Opt out of Registration Information Disclosure" on the Your Profile page. We and our author organisations may only contact you via email or other means if you allow us to do so. Users can opt out of contact when they register on the site, or send an email to unsubscribe@mondaq.com with “no disclosure” in the subject heading

    Mondaq News Alerts

    In order to receive Mondaq News Alerts, users have to complete a separate registration form. This is a personalised service where users choose regions and topics of interest and we send it only to those users who have requested it. Users can stop receiving these Alerts by going to the Mondaq News Alerts page and deselecting all interest areas. In the same way users can amend their personal preferences to add or remove subject areas.

    Cookies

    A cookie is a small text file written to a user’s hard drive that contains an identifying user number. The cookies do not contain any personal information about users. We use the cookie so users do not have to log in every time they use the service and the cookie will automatically expire if you do not visit the Mondaq website (or its affiliate sites) for 12 months. We also use the cookie to personalise a user's experience of the site (for example to show information specific to a user's region). As the Mondaq sites are fully personalised and cookies are essential to its core technology the site will function unpredictably with browsers that do not support cookies - or where cookies are disabled (in these circumstances we advise you to attempt to locate the information you require elsewhere on the web). However if you are concerned about the presence of a Mondaq cookie on your machine you can also choose to expire the cookie immediately (remove it) by selecting the 'Log Off' menu option as the last thing you do when you use the site.

    Some of our business partners may use cookies on our site (for example, advertisers). However, we have no access to or control over these cookies and we are not aware of any at present that do so.

    Log Files

    We use IP addresses to analyse trends, administer the site, track movement, and gather broad demographic information for aggregate use. IP addresses are not linked to personally identifiable information.

    Links

    This web site contains links to other sites. Please be aware that Mondaq (or its affiliate sites) are not responsible for the privacy practices of such other sites. We encourage our users to be aware when they leave our site and to read the privacy statements of these third party sites. This privacy statement applies solely to information collected by this Web site.

    Surveys & Contests

    From time-to-time our site requests information from users via surveys or contests. Participation in these surveys or contests is completely voluntary and the user therefore has a choice whether or not to disclose any information requested. Information requested may include contact information (such as name and delivery address), and demographic information (such as postcode, age level). Contact information will be used to notify the winners and award prizes. Survey information will be used for purposes of monitoring or improving the functionality of the site.

    Mail-A-Friend

    If a user elects to use our referral service for informing a friend about our site, we ask them for the friend’s name and email address. Mondaq stores this information and may contact the friend to invite them to register with Mondaq, but they will not be contacted more than once. The friend may contact Mondaq to request the removal of this information from our database.

    Emails

    From time to time Mondaq may send you emails promoting Mondaq services including new services. You may opt out of receiving such emails by clicking below.

    *** If you do not wish to receive any future announcements of services offered by Mondaq you may opt out by clicking here .

    Security

    This website takes every reasonable precaution to protect our users’ information. When users submit sensitive information via the website, your information is protected using firewalls and other security technology. If you have any questions about the security at our website, you can send an email to webmaster@mondaq.com.

    Correcting/Updating Personal Information

    If a user’s personally identifiable information changes (such as postcode), or if a user no longer desires our service, we will endeavour to provide a way to correct, update or remove that user’s personal data provided to us. This can usually be done at the “Your Profile” page or by sending an email to EditorialAdvisor@mondaq.com.

    Notification of Changes

    If we decide to change our Terms & Conditions or Privacy Policy, we will post those changes on our site so our users are always aware of what information we collect, how we use it, and under what circumstances, if any, we disclose it. If at any point we decide to use personally identifiable information in a manner different from that stated at the time it was collected, we will notify users by way of an email. Users will have a choice as to whether or not we use their information in this different manner. We will use information in accordance with the privacy policy under which the information was collected.

    How to contact Mondaq

    You can contact us with comments or queries at enquiries@mondaq.com.

    If for some reason you believe Mondaq Ltd. has not adhered to these principles, please notify us by e-mail at problems@mondaq.com and we will use commercially reasonable efforts to determine and correct the problem promptly.

    By clicking Register you state you have read and agree to our Terms and Conditions