California clarifies out-of-state LLC taxation


Dana Lance
San Jose
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Josh Grossman
San Francisco
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Stuart Jeffries
San Francisco
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Matthew A. Stevens
San Francisco
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Jamie C. Yesnowitz
Washington, D.C.
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Chuck Jones
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Lori Stolly
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Patrick Skeehan
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On July 8, 2019, the California Office of Tax Appeals (OTA) released a decision holding that an out-of-state LLC whose sole connection to California was the passive ownership of a manager-managed LLC doing business in California was not “doing business” in California under Cal. Rev. & Tax. Code Sec. 23101(a).1 The OTA rejected the position of the California Franchise Tax Board (FTB) that a “bright-line” 0.2% ownership threshold applied, above which an LLC interest holder is “doing business” in California.2 Instead, the OTA held that an out-of-state minority interest holder owing between 1.12% and 4.75% of an LLC doing business in California, with nothing more, is not “doing business” in California and therefore not subject to the annual $800 LLC tax.

Background Appellant Jali, LLC (Jali) acquired an interest in Bullseye Capital Real Property Opportunity Fund, LLC (Bullseye) in 2012. Between 2012 and 2016 (the tax years on appeal), its ownership interest ranged between 1.12% and 4.75%. Bullseye was a manager-managed LLC incorporated in Delaware that was doing business in California during each of the years on appeal. Bullseye elected to be taxed as partnership for both federal and California purposes during the years on appeal. Jali’s interest in Bullseye was passive in nature, allowing Jali no power to participate in its management, bind or act on behalf of Bullseye, or retain any specific ownership interest in Bullseye’s property. Jali was also not personally liable for any of Bullseye’s debts or liabilities.

Jali did not file a California LLC return for the 2012 through 2016 tax years. Upon receiving a demand letter from the FTB for a 2012 LLC return, Jali filed returns for the 2012 through 2016 tax years paying the $800 LLC tax plus penalties and interest. After paying these amounts, Jali immediately filed refund claims for all amounts paid on the grounds that it was not “doing business in” California. The FTB denied these refund claims and Jali filed a timely appeal with the OTA.

OTA analysis regarding ‘doing business’ standard Under Cal. Rev. & Tax. Code Sec. 17941(a), every LLC “doing business” in California is subject to the annual $800 LLC tax. Cal. Rev. & Tax. Code Sec. 23101(a) provides that a taxpayer is “doing business” in California if “actively engaging in any transaction for the purposes of financial or pecuniary gain or profit.”3 In Swart Enterprises, Inc., v. Franchise Tax Board, the Court of Appeal applied this standard to an out-of-state LLC passively owing a 0.2% minority interest in an LLC that was doing business in California, and held that the 0.2% minority interest owner “was not doing business in California based solely on its minority ownership interest in the [LLC doing business in California].”4

In Appeal of Jali, the FTB argued that the 0.2% ownership level at issue in Swart must be interpreted as a ceiling, above which a minority interest holder in an LLC that is doing business in California will itself be “doing business” in California. The OTA summarized the FTB’s position as meaning that “a 0.2% membership interest in an LLC doing business in California is the new, post-Swart bright-line ownership threshold used to determine whether an out-of-state member is also doing business in the state.”

The OTA disagreed with the FTB’s interpretation of Swart, and concluded that Swart did not create any bright-line ownership rule. Rather, the “court was simply dismissing FTB’s argument that the court should base its decision on that fact alone.” Turning to the analysis in Swart, the OTA highlighted that in addition to the LLC member’s ownership percentage, “one must still generally conduct a fact-intensive inquiry into the relationship between the out-of-state member and the in-state LLC.” Concerning the relevant factual inquiries, the OTA further wrote:

This may include whether the in-state LLC is manager-managed, whether the out-of-state member holds a non-managing member interest, and whether the out-of-state member is actively involved in the business activities of the in-state LLC. We believe such an interpretation properly reflects the rationale of Swart and faithfully adheres to its legal principles.

Drawing on the factual parallels between Jali and the taxpayer in Swart, the OTA treated Jali’s minority LLC interest as more closely resembling a limited partnership interest than a general partnership interest. Accordingly, in the same manner as the taxpayer in Swart, Jali was held not to be doing business in California within the meaning of Cal. Rev. & Tax. Code Sec. 23101(a), and did not owe the $800 LLC tax described in Cal. Rev. & Tax. Code Sec. 17941(a).

Commentary This unanimous decision by the OTA follows the analysis by the California Court of Appeal in Swart, which analyzed the factual relationship between the out-of-state member and the in-state LLC to determine if the LLC interest should be treated like a limited partnership interest when applying California’s doing business standard. The OTA’s express rejection of the FTB’s argument that Swart created a 0.2% bright-line ownership threshold provides helpful guidance to out-of-state companies seeking to invest in funds organized as LLCs that may be doing business in California. When contemplating such an investment, out-of-state investors should carefully analyze the factors considered by the OTA in this matter to reach the conclusion that Jali’s minority ownership interest did not cause it to be “doing business” in California within the meaning of Cal. Rev. & Tax. Code Sec. 23101(a). In addition, refund claims may be appropriate here, particularly for out-of-state taxpayers that own numerous non-controlling, passive investments in California LLCs.

Importantly, this matter only concerns subdivision (a) of Cal. Rev. & Tax. Code Sec. Section 23101, and does not offer protection to out-of-state LLCs meeting the factor-presence “doing business” thresholds set forth in Cal. Rev. & Tax. Code Sec. 23101(b), applicable in tax years beginning on or after January 1, 2011. Last, it is worth noting that the FTB has no further right of appeal in this matter given its disposition by the OTA.

1 In the Matter of the Appeal of Jali, LLC, OTA Case No. 18073414 (July 8, 2019) (pending precedential status).
2 Swart Enterprises, Inc. v. Franchise Tax Board, 7 Cal App. 5th 497 (Cal. Ct. App. 2017).
3 CAL. REV. & TAX. CODE § 23101(a). This appeal only concerned subdivision (a) of CAL. REV. & TAX. CODE § 23101, and did not concern the bright-line factor presence nexus thresholds set forth in CAL. REV. & TAX. CODE § 23101(b), which presumably were not met during the years on appeal.
4 For a discussion on Swart, see GT SALT Alert: California Court of Appeal Holds Small Non-Managerial Interest in LLC Does Not Constitute Doing Business in State.

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