A Washington state limited liability company with a minority interest in another LLC doing business in California doesn’t owe the state’s $800 annual “doing business” tax.
Jali LLC was a Washington limited liability company. For the years in issue, it was not registered to do business with the California Secretary of State. In December 2012, Jali acquired an ownership interest in Bullseye Capital Real Property Opportunity Fund LLC (no connection to the federal opportunity zone program). Bullseye was a Delaware limited liability company. Bullseye is classified as a partnership for income tax purposes, was registered with the California Secretary of State, and conducted business in California for all disputed years.
Jali owned a direct, capital interest in Bullseye of 4.75% and 3.19% for the 2012 and 2013 tax years, respectively, and 1.12% for the 2014, 2015, and 2016 tax years. Jali’s membership interest in Bullseye was its sole connection with California. Jali did not initially file a California LLC return for any tax year. The California Franchise Tax Board (FTB) determined that Jali had a filing obligation. The FTB, therefore, issued a Demand for Tax Return(s). Jali filed returns for 2012-2016. After paying taxes, penalties, and interest, Jali filed refund claims for all amounts paid on the basis that it was not doing business in California. The FTB denied the claims, asserting, improbably, that Jali did not meet the facts of Swart Enterprises Inc. v. Franchise Tax Bd.
Jali appealed to the California Office of Tax Appeals (OTA), which disagreed with the FTB’s reasoning and found for Jali. Jali LLC, 2019-OTA-204P (Calif. Off. Tax App. 7/8/19, corrected 9/3/19)
Bright-Line Test Rejected
California Revenue and Taxation Code (R&TC) Section 17491(a) provides that an LLC “doing business” in California shall pay the annual $800 LLC tax. R&TC Section 23101(a) provides that a taxpayer is doing business in California if it is “actively engaging in any transaction for the purpose of financial or pecuniary gain or profit.”
In Swart, the issue was whether the franchise tax applied to an out-of-state corporation whose sole connection with the state was a passive 0.2% ownership interest in a manager-managed (as opposed to a member-managed) California LLC. The court held that “passively holding a 0.2% ownership interest, with no right of control over the business affairs…did not constitute doing business in California within the meaning” of R&TC Section 23101(a).
The FTB sought to distinguish Swart. It placed heavy, if not exclusive, reliance on one statement made by the court: “We conclude Swart was not doing business in California based solely on its minority ownership interest in Cypress LLC.” The FTB seized upon this language and argued that “because ’solely’ means ’exclusively,’ that means actively doing business is exclusively dependent on the size of a taxpayer’s membership interest, i.e., the size of a business entity’s membership interest is not only suggestive of doing business,” but is determinative. The FTB then concludes that ”because the membership interest in Swart was only 0.2%, 0.2% is deemed to be the threshold, i.e., the line of demarcation, between actively and passively doing business moving forward.“ The FTB concluded that Jali was ”actively“ doing business in California, because its membership interest in Bullseye ”was well beyond the 0.2% Swart limit.“ The OTA disagreed with the FTB’s reasoning.
When the entire opinion is considered, the OTA noted, “it becomes abundantly clear the court’s holding was squarely grounded on the relationship between the out-of-state member and the in-state LLC.” The appeals court pointed to the fact that “Swart had no interest in the specific property of Cypress LLC, it was not personally liable for the obligations of Cypress LLC, it had no right to act on behalf of or to bind Cypress LLC and, most importantly, it had no ability to participate in the management and control of Cypress LLC.” Swart’s interest, the court noted, ”closely resembled that of a limited, rather than a general, partner.” The court concluded that “because 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 Cypress LLC.” Swart, the OTC concluded, did not establish a bright-line 0.2% ownership threshold for purposes of making nexus determinations for out-of-state members holding interests in in-state LLC’s classified as partnerships.
The OTA agreed with Jali that it was not subject to California tax. After all, Bullseye was a manager-managed LLC, and was managed by elected directors, not by Jali. Jali was not personally liable for any debt, obligation, or liability of Bullseye, and Jali had no power to participate in Bullseye’s management, or bind or act on behalf of Bullseye in any way. Jali had no interest in any specific property of Bullseye. Even though Jali’s percentage interest in Bullseye was substantially greater than that in Swart, “both are indisputably minority interests.” Therefore, like Swart’s interest in Cypress LLC, Jali’s interest in Bullseye closely resembled that of a limited, rather than a general, partner, “and there is no evidence that Jali had any ability or authority, directly or indirectly, to influence or participate in the management or operation of Bullseye,” the OTA said.
The OTA rejected the FTB’s 0.2% ownership threshold as the new bright-line legal standard for distinguishing between an active and passive ownership interest in an LLC classified as a partnership. A holistic approach must be adopted. “While ownership percentages may be a factor in nexus determinations,” it is not necessarily determinative, “as one must still conduct a fact-intensive inquiry into the relationship between the out-of-state member and the indigenous LLC.” This may include, the OTA pointed out, whether the LLC is member or 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, the OTC concluded, that such an interpretation, focusing, ultimately, on whether the out-of-state member’s interest more closely resembles that of a limited, rather than a general, partner, “properly reflects the rationale of Swart and faithfully adheres to its legal principles.”
Jali, therefore, met its burden of showing that it was not doing business in California under R&TC Section 23101(a) and, therefore, was not subject to the contested annual $800 LLC tax. The FTB’s action in denying Jali’s refund claim was reversed in full.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Robert Willens is president of the tax and consulting firm Robert Willens LLC in New York and an adjunct professor of finance at Columbia University Graduate School of Business.