The California Tax Code imposes two parallel taxes on corporations, a franchise tax and an income tax. The franchise tax is imposed on corporations that are considered to be “doing business” in California. Such corporations are subject to the $800 annual franchise tax regardless of whether they had income or not.
In 2013 Swart Enterprises, Inc. (Swart) challenged the Franchise Tax Board (FTB) of California. The Iowa based company had invested $50,000 into a California LCC investment fund with a total ownership interest of 0.2%. The fund invested in capital equipment in California and other states, and was actively managed by a California corporate manager. Swart had no other connection to California other than this passive investment and did not file a California tax return since there was no California income. Swart received a notice from the California FTB requesting the $800 minimum tax plus interest and penalties. Swart paid the requested amount due, but filed for a refund. The trial court awarded judgement to Swart based on the fact that they were not “doing business” in California.
The California FTB decided to appeal the decision to the Court of Appeals (COA). On January 12, 2017, the COA rejected the FTB’s claim that Swart should be subject to the $800 minimum tax. The FTB can now file a petition with the California Supreme Court, but must do so within 40 days of the COA ruling. Although the COA judgement is a win a for taxpayers, it should be noted that the Swart ruling does not apply if the corporation has California source income and that the court’s decision was based on very specific and narrow set of facts.
The court’s decision was based upon the facts that Swart held a limited partnership interest in the California LLC because of these specific facts.
- Swart held no interest in the LLC’s property
- Swart was not liable for the LLC’s obligations
- Swart had no right to act on behalf of the LLC
- Swart had could not participate in management or control of the LLC
The most important factor noted in the case was that Swart could not make management decisions. The fund invested into contained its own manager of the fund that made decisions versus Swart having the ability to make decisions. An LLC that is managed by a manager instead of its members and the exclusive authority is given to the LLC’s manager were key factors in the court’s decision to side with the taxpayer.
The California FTB ultimately did not appeal the decision to the California Supreme Court; setting the precedent for other organizations.
The decision on whether to file a California return must still be done on a case by case basis. Many other states do not require the articles of organization to describe whether the LLC is managed by a manager or member managed.
If you are a corporation or an LLC and have an investment in a California based partnership, please discuss the facts with your tax preparer to decide if there is a California filing requirement.