The Franchise Tax Board, California’s taxing authority, has consistently taken an aggressive stance in claiming out-of-state businesses have income tax reporting requirements for “doing business in California.” The FTB reached a limit in Swart Enterprises, Inc. v. Franchise Tax Board, Cal. Ct. App. (5th App. Dist.), 7 Cal. App. 5th 497 (2017). In that case, a California appeals court ruled against the FTB’s claim that a foreign corporation with a passive .02% ownership in a California LLC was doing business in California. As a result, the FTB was forced to modify its ruling on doing business in California by members of multi-member limited liability companies.
FTB Walks Back Prior Ruling
Specifically, the FTB has modified California FTB Legal Ruling No. 2014-01, 07/22/2014, which sets forth the FTB’s analysis on a number of “doing business” scenarios involving members of multiple-member LLCs that are classified as partnerships for tax purposes. The ruling had asserted that the distinction between “manager-managed” and “member-managed” LLCs, made no difference in determining whether a member of the LLC was doing business in California. The reasoning in Swart Enterprises made that assertion untenable. As a result, the FTB has removed the language and replaced it with the innocuous phrase: “a narrow exception may apply in limited circumstances.”
The “Narrow Exception” Isn’t That Narrow
The “narrow exception” refers to Swart Enterprises and it is not that narrow. The reasoning in Swart Enterprises specifically points out that the operating agreement governing the LLC provided for a manager-managed LLC, in which the manager “had full exclusive and complete authority in the management and control of the business . . . .” This, according to the court, established that the out-of-state corporation was a passive investor, and not actively engaged in business in California.
The key is using a California entity that is manager-managed, in accordance with the language blessed in Swart Enterprises, such that the investment is “passive”
The reasoning in Swart Enterprises, and the fact that the FTB has had to back down from its prior maximal position, means that taxpayers who move their business out of state, but have continuing operations in-state, have a broader opportunity to restructure their entities to minimize California taxes. The key is using a California entity that is manager-managed, in accordance with the language blessed in Swart Enterprises, such that the investment is “passive.” This may involve relinquishing management authority to a California member (who will be taxed by California in any case) to insulate the out-of-state entity from actively participating in California.
Why It Matters
Presumably an operating agreement with language similar to Swart Enterprises will result in the same conclusion for foreign entities with ownership interests in a California LLC. Although the entity at issue only had a .02% interest, it is not clear what the limits of ownership might be to preserve “passive” ownership status. Anything under 50% might qualify. However, more likely the legal analysis would be fact specific, with passive status determined by all the facts and circumstances.
For instance, if the FTB considered the owner as part of a control group, even a smaller ownership percentage by each owner might result in a court deeming the investment as nonpassive. The FTB alludes to this issue in its modified ruling by mentioning that in its example a 15% interest is assumed, much higher than the .02% interest of Swart Enterprises. But that hardly counts as an argument. The real issue is what are the limits of LLC ownership interest that can qualify as passive under the Swart Enterprises reasoning. The modified ruling may tell us the FTB’s position, but not how a court would look at it.
The modified language can be found in California FTB Legal Ruling No. 2018-01, 10/19/2018.
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