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California Court Rules in Favor of Taxpayer in “Doing Business” Decision


2/2/2017
 
Synopsis 
 
On January 12, 2017, the California appellate court (the “Court”) reaffirmed the judgment of Swart Enterprises, Inc. v. California Franchise Tax Board. In Swart, the Court held that an out-of-state corporation was not “doing business” in California and was, therefore, not subject to California’s franchise tax. Swart’s only connection with California was its passive ownership interest in a manager-managed California LLC with no right of control over the business affairs of the LLC. 
 
Background
 
Swart Enterprises, Inc. headquartered and incorporated in Iowa, operates a 60 acre farm in Kansas and has no property or employees in California. In 2007, Swart invested in Cypress Equipment Fund XII, LLC which was formed in 2005 as a manager-managed LLC under California law.  As a manager-managed LLC, members in Cypress are not authorized to take part in the control, conduct, or operation of the Fund or act on the Fund’s behalf.  Swart’s sole connection with the state of California was its 0.2 percent ownership interest in the California-based Fund. 
 
Argument and Decision
 
The California Franchise Tax Board (“FTB”) argued that, pursuant to California Revenue and Tax Code Section (“Section”) 23101, a foreign business entity is considered to be “doing business” in California if it is a member of an LLC that is operating in California. The California Attorney General also argued that the term “doing business” should be interpreted broadly to include Swart’s passive investment.  The Court disagreed, citing Section 23101 which defined “doing business” as “actively engaging in any transaction for the purpose of financial or pecuniary gain or profit.”
 
The Court explained that the term “actively” is the opposite of “passively or “inactively” and means “active transaction for pecuniary gain or profit.” The mere 0.2 percent interest Swart passively held was not sufficient to conclude that Swart was doing business in California. The Court, therefore, rejected the FTB’s position that a taxpayer can be deemed to be doing business in California solely by virtue of holding a passive membership interest in an LLC doing business in California.
 
The FTB also argued that, when an LLC elects to be treated as a partnership for federal income tax purposes, all members of the LLC must be treated as general partners in the partnership.  Accordingly, the FTB argued, Swart was “doing business” in California because Cypress was doing business in California, as the activities of a partnership can be attributed to a general partner. 
 
The Court disagreed, holding that there is no authority under either California or Federal Law to support the claim that members of an LLC treated as a partnership for federal income tax purposes should be treated as general partners. The Court further stated that “this interest closely resembles that of a limited, rather than a general, partnership” for the following reasons:
 
  1. No interest in the specific property of Cypress
  2. Not personally liable for the obligation of Cypress
  3. No right to act on behalf of or to bind Cypress
  4. No ability to participate in the management or control of Cypress
 
What Does CohnReznick Think?
 
While the FTB has the option to appeal this decision to the California Supreme Court, it is unclear whether such appeal will be filed.  With the affirmation of the lower court’s ruling, we suggest that LLC members owning a non-managing interest in an LLC doing business in California file a protective refund claim based on the above decision.
 
Contact
 
For more information, please contact Eddie Delgado, Principal, State and Local Tax Services, at eddie.delgado@cohnreznick.com or 310-843-8246, or Krista Schipp, Director, State and Local Tax Services, at krista.schipp@cohnreznick.com or 818-205-2616, or John On, Senior, State and Local Tax Services, at john.on@cohnreznick.com or 310-622-4338.
 
 
Any advice contained in this communication, including attachments and enclosures, is not intended as a thorough, in-depth analysis of specific issues. Nor is it sufficient to avoid tax-related penalties. This has been prepared for information purposes and general guidance only and does not constitute professional advice. You should not act upon the information contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is made as to the accuracy or completeness of the information contained in this publication, and CohnReznick LLP, its members, employees and agents accept no liability, and disclaim all responsibility, for the consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it. 
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