California lost again in its effort to collect franchise taxes from passive investors in limited liability companies doing business in the state.
The state may have to pay millions of dollars in refunds.
California collects a minimum tax of $800 from members in LLCs doing business in the state. The Franchise Tax Board has been sending overdue tax notices to LLC members. The notices ask for as much as $2,000 to $3,000 once penalties and interest are added.
State franchise taxes must be paid by every corporation that is formed in California, qualified to do business there, or actually doing business in California.
“Doing business” is defined as “actively engaged in any transaction for the purpose of financial or pecuniary gain or profit.” Anyone holding an interest in an LLC that is a partnership for tax purposes is considered by the Franchise Tax Board to be doing business in California if the LLC is doing business in California. Partners are normally considered to do directly what the partnership does.
A state superior court judge in Fresno County ruled in November 2014 that holding a passive interest in an LLC is not doing business in the state.
A state court of appeals upheld the decision in January. The case is called Swart Enterprises, Inc. v. California Franchise Tax Board.
Swart, a corporation formed in Iowa, operates a 60-acre farm in Kansas that feeds cattle for beef sales. Swart invested $50,000 in 2007 for a 0.2% interest in a fund, called Cypress Equipment Fund VII LLC, that leases equipment to lessees in California. Swart has no other ties to California.
The appeals court said that business activities undertaken by a partnership cannot be attributed to limited partners. Swart was equivalent to a limited partner. It had no ability to participate in the management and control of the fund. Because the business activities of the fund cannot be attributed to it, it was not doing business in California.
Another state tax agency, the State Board of Equalization, takes the position that a limited partner in a limited partnership is not doing business in California solely by reason of holding the partnership interest. The Franchise Tax Board used to follow the same approach, but changed its position in a ruling while the Swart case was pending in the superior court. Its current position is that each partner in a partnership — including an LLC treated as partnership — is considered to engage in whatever business the partnership does. The ruling is Legal Ruling 2014-01.
The appeals court said the Franchise Tax Board’s position “defies a commonsense understanding of what it means to be ‘doing business’.”