The California Franchise Tax Board (FTB) informed taxpayers in FTB Notice 2017-01 that it will not appeal the ruling of the California Court of Appeal (Court) in Swart Enterprises,¹ and that it will follow the Court's decision "in situations with the same facts." The corporate taxpayer's sole connection with California was passively holding a 0.2% membership interest in a manager-managed limited liability company (LLC). The LLC was treated as a partnership for federal and California income tax purposes, and was itself doing business in California. The corporate taxpayer acquired a membership interest in the LLC after the original members decided the LLC should be manager-managed. The manager was given complete authority to manage the LLC, such that the corporate taxpayer was found not to be involved in the LLC's management. The Court held that the taxpayer 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. For more on the decision, see Tax Alert 2017-385.

The FTB has stated that taxpayers believing they have the "same facts" as Swart should consider whether they are required to file a return and/or whether a refund claim is appropriate. Taxpayers filing a refund claim should cite the holding in Swart and explain how their facts are the same as those in Swart.

Implications

Corporations with no activities in California, other than that of being a member of a manager-managed LLC that is doing business in California, should determine whether they have an opportunity to file claims for refund and/or whether they no longer have a filing obligation in California. The FTB will likely argue, however, that Swart only applies to those corporations with the following facts:

(1) The corporations has a small ownership interest in the LLC (Swart only had a 0.2% interest in the LLC in question).

(2) The corporation is a member of a manager-managed LLC.

(3) The corporation has no ability to manage the LLC under the LLC operating agreement. In Swart, the taxpayer lacked any ability to manage the LLC, as the operating agreement gave the manager exclusive and complete control to manage it. The taxpayer also became a member of the manager-managed LLC after the original members voted to make the LLC manager-managed, such that it never exercised control in choosing how the LLC was managed. In addition, the manager of the LLC could only be removed by a majority-vote of the members; the taxpayer had no ability to do so unilaterally.

For tax years beginning on or after January 1, 2011, a corporation must also ensure that its pro-rata distributive share of payroll, property and sales from the activities of the LLC do not cause it to be considered doing business in California under the new bright-line nexus provisions under Cal. Rev. & Tax. Code Section 23101(b). Furthermore, even if a corporation is not doing business in California, if it receives California-sourced income from the LLC, it must also file a California tax return and pay the California Corporate Income Tax upon that income.

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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, as applicable to the year at issue, considers an entity to be doing business if it is "actively engaging in any transaction for the purpose of financial or pecuniary gain or profit." This section was amended for tax years beginning on or after January 1, 2011, to provide additional ways an entity may be found to be doing business. One of the additional means to be found doing business, is upon an entity's property, payroll, and/or sales exceeding certain thresholds. The years in question in this case were preceded January 1, 2011, so this case does not speak to the amended provisions under Cal. Rev. & Tax. Code Section 23101 applicable to tax years beginning on or after January 1, 2011.