In Swart Enterprises,¹ a California Court of Appeal (Court) upholding a lower court ruling found that a corporation was not "doing business" in California within the meaning of the state's "doing business" statute² and was not subject to the state's annual $800 minimum franchise tax. In reaching this conclusion, the Court noted that the corporation's sole connection with California was passively holding a 0.2% membership interest in a limited liability company (LLC) treated as a partnership for federal and California income tax purposes and having a mailing address and doing business in California. The Court also rejected the assertion by the California Franchise Tax Board (FTB) that the LLC's election to be taxed as a partnership required each member to be treated as a general partner (thereby imputing the business activities of the LLC to each member for purposes of the doing business statute). On February 22, the FTB announced that it will not appeal this ruling.

Swart Enterprises, Inc. (Swart) is an Iowa-based company engaged in farming activities in Kansas and Nebraska. Swart did not have a physical presence (e.g., employees, real or personal property) in California, but held various passive business investments, including a 0.2% membership interest in a manager-managed California LLC³ that acquired, leased and disposed of capital equipment located in various states, including California and throughout the world. At issue in this case was whether Swart was doing business in California — i.e., was it "actively engaging in any transaction for the purpose of financial or pecuniary gain or profit."⁴

The trial court held in favor of Swart. On appeal, the California Attorney General (AG) argued that Swart was doing business in California and subject to the minimum tax because the LLC elected to be treated as a partnership for federal income tax purposes. Since the LLC was doing business in California, the AG argued Swart was doing business in California. The Court disagreed, finding Swart's passive ownership of the minimal interest in the manager-managed LLC to "closely resemble that of a limited, rather than general, partnership" and reasoning that Swart did not have the right to act on behalf of or bind, or participate in the management and control of, the LLC. The Court found the California State Board of Equalization's (SBE) ruling in Appeals of Amman & Schmid Finanz AG,⁵ "strongly supports the conclusion Swart was not doing business in California," holding that, "[b]ecause the business activities of a partnership cannot be attributed to limited partners … Swart cannot be deemed to be 'doing business' in California solely by virtue of its ownership interest in [the] LLC."

The Court also rejected the AG's argument that Swart itself, as a member of the LLC, was doing business in the state by virtue of its ownership interest in the LLC. The AG's contention was based on Legal Ruling 2014-01 (issued during the pendency of the Swart litigation) in which the FTB formalized its position that LLC members are 'doing business' in California if the LLC is doing business in the state, regardless of whether they are members of a member-managed LLC or a manager-managed LLC (see Tax Alert 2014-1551). In the legal ruling, the FTB took the position that even a member of a "manager-managed" LLC is "doing business" in California "because the distinction between manager-managed LLCs and member-managed LLCs is not relevant for purposes of determining whether members of an LLC, which is 'doing business' in California and is classified as a partnership for tax purposes, are 'doing business' [in California] within the meaning of Section 23101." (Emphasis added.) The FTB (and the AG) asserted that members of a manager-managed LLC have the right to exercise some control over the LLC because they relinquish control over the LLC to the manager and the members have the right to remove the manager. The Court disagreed, holding that Swart could not have exercised any right of control by relinquishing control of the LLC to a manager, because "[Swart] never had this right to begin with." The LLC was established as manager-managed two years before Swart invested in it. Moreover, given Swart's 0.2% investment interest, it reasonably can be inferred that Swart would not have been able to exercise influence over the decision to designate the LLC as manager-managed; Swart could not remove the manager on its own, as such action required a majority vote of the members.

Implications

The FTB recently announced it will not request reconsideration or petition the California Supreme Court for review. Nevertheless, the Court's decision highlights a clear challenge to the FTB's present position with respect to the "doing business" standard as applied to corporate members of either member-managed or manager-managed LLCs and the viability of the SBE's ruling in Appeals of Amman & Schmid as it relates to this issue.

In Tax Alert 2014-1551, we stated the FTB's arguments relative to passive LLC members represent an arguably aggressive posture. In holding for the taxpayer and dismissing the FTB's arguments, the Swart court validated this view. As a result, observations made in Tax Alert 2014-1551 remain relevant. In particular, taxpayers (and the FTB) should consider the LLC formation laws of California and other states, which may govern the proper determination of whether a corporate member of an LLC doing business in the state is, by extension, also "doing business" within California.

A "doing business" analysis is equally relevant to multi-tiered pass-through organizations; a review at each level requires a similar assessment. If an LLC member is also a pass-through entity, a conclusion that the LLC member was not doing business in California could affect whether the pass-through entity's owners were doing business in California.

Taxpayers should consider whether they have been paying California minimum tax merely because they owned an interest in an LLC doing business in California, with no other factors or business operations in the state. To the extent their facts are similar to those presented in Swart, taxpayers should consider filing refund claims but fully consider whether the costs of filing such claims would offset the potential refund. Also, each taxpayer should consider the applicable statute of limitations for the various tax years and coordinate discussions with EY professionals with those dates in mind. In considering whether to file a refund claim, remember that, even if the taxpayer is not subject to the $800 minimum franchise tax, it would be subject to California income tax on any California-source income that flows from the LLC.⁶ We expect the FTB to issue guidance regarding Swart-related refund claims soon. Taxpayers should consider their procedural options and be aware of any statute of limitations issues when deciding to file a refund claim. EY is monitoring this development, and will issue additional Tax Alerts as necessary.

Until the FTB releases information regarding its position on the Swart decision, we expect the FTB staff to challenge taxpayers' refund claims in other fact patterns, including:

— The LLC in question is "member-managed" as opposed to "manager-managed"
— The taxpayer (or the unitary group in which it is a member) owns a controlling interest in the LLC (perhaps measured solely by its economic interest)
— The taxpayer became a member of a manager-managed LLC at its formation
— The state law governing the LLC's formation confers to the taxpayer any rights to the LLC's property or decision-making powers that are not found in California law
— The tax years at issue begin after 2010⁷

It is also worth noting that there is pending litigation in Bunzl Distribution v. Franchise Tax Board, which involves the treatment of a single member LLC in a combined group and could be affected by the Swart decision.

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ENDNOTES

¹ Swart Enterprises, Inc. v. California Franchise Tax Board, No. F070922 (Cal. Ct. App., 5th Dist., Jan. 12, 2017).

² Cal. Rev. & Tax. Code Section 23101. This section was amended for years beginning on or after January 1, 2011. The years in question in this case were years prior to that date.

³ The investment LLC (Cypress Equipment Fund XII, LLC) was organized in California and had its mailing address in San Francisco.

⁴ Cal. Code Regs. tit. 18, Section 23101. Note, effective for tax years begininning on or after January 1, 2011, the "doing business" statute was amended to expand the scope of "doing business in California" by adopting a bright-line factor presence nexus standard, under which nexus is created if the applicable sales, payroll or property threshold is exceeded. The Court disregarded the amended statute as inapplicable to the Swart case.

⁵ Appeals of Amman & Schmid Finanz AG, et. al. (1996) 96-SBE-008, 1996 Cal. Tax LEXIS 62.

⁶ Swart Enterprises, supra, at 5. The amount of any potential refund decreases as the taxpayer's California-source income approaches $9,050 after which any potential refund would be entirely negated (e.g., the 8.84% tax would apply) (for example, the FTB could still strongly argue that the LLC itself (which is assumed to have its own, separate nexus in California) would have a withholding obligation on the share of California-source income attributed to the corporate owner).

⁷ Id, at 2.