Small Iowa corporation successfully challenges California’s $800 franchise tax

Editor: Anthony S. Bakale, CPA

A state’s seemingly small franchise tax can become onerous and a point of contention—particularly for groups of tiered entities that become subject to the tax at multiple levels in the ownership chain. These taxes often result in increased compliance costs due to a need to file returns for entities at multiple levels in addition to the burden of the taxes themselves. Even when the tax is nominal and simple to apply, the notion of paying an unjustly levied tax can motivate a taxpayer to take action, all the while knowing the cost to initiate change is significant.

Take, for example, California’s minimum $800 franchise tax, which is a relatively insignificant liability for many taxpayers that do business in the state. In a David versus Goliath story, one small Iowa corporation disagreed with California’s requirement to pay the state minimum franchise tax and took its case to court. Ultimately, and to the excitement of all those who hold or seek to obtain passive business interests in qualifying flowthrough entities doing business in California, the courts ruled in favor of the Iowa corporation.

Overview of the facts

The facts, as agreed to by both parties, reflect that in 2007 Swart Enterprises Inc. (Swart), a small family-owned Iowa corporation, invested $50,000 and became a member of Cypress Equipment Fund XII LLC (Cypress), a California limited liability company (LLC). The investment represented a 0.2% ownership interest in Cypress. Swart had no activities of its own in California, and this investment was its only California connection. Swart was incorporated outside of California and was not registered to do business in the state.

Cypress is a manager-managed LLC, and Swart acquired its interest after the original members delegated exclusive control and authority to the company’s managers, giving the managers exclusive and complete authority over the business operations of Cypress in the operating agreement. For the year at issue, Cypress, as an LLC, was taxed as a partnership under federal and California state law.

California’s Franchise Tax Board (FTB) required Swart to file a California corporate franchise tax return for the year ending June 30, 2010, and pay the $800 minimum tax as a result of its ownership in Cypress. Swart paid $1,106 in tax, penalties, and interest for the year in question but contested the tax and requested a refund, which the FTB denied. The trial court granted Swart’s motion for summary judgment, awarding it a full refund (Swart Enterprises, Inc. v. Franchise Tax Board,No. 13CECG02171 (Cal. Super. Ct. 11/10/14)). The FTB timely filed a notice of appeal, but the appellate court affirmed the trial court’s judgment (Swart Enterprises, Inc. v. Franchise Tax Board, 7 Cal. App. 5th 497 (Cal. Ct. App. 2017)). The FTB issued a statement in early 2017 confirming it would not appeal the appellate court’s Swart decision to the California Supreme Court.

Analysis

California franchise tax rules require that when a company is incorporated in California, qualified to transact business in California, or actively doing business in California, it must remit the minimum franchise tax (Cal. Rev. & Tax. Code §§23153(a), (b)(1)-(3)).

Whether Swart was “doing business” in California became the fundamental issue. The state’s attorney general argued that because Swart held an ownership interest in an LLC that was doing business in California, it was also considered to be doing business in California and therefore liable for the franchise tax. For the year in question, California defined “doing business” as actively engaging in any transaction for the purpose of financial or pecuniary gain (Cal. Rev. & Tax. Code §23101(a)).

The California Court of Appeal held that Swart was not doing business in California and therefore was not subject to the minimum franchise tax. The court found that holding a passive investment in an LLC was not “doing business” for purposes of the franchise tax and that the LLC’s activities could not be imputed to Swart by virtue of its ownership interest in the LLC.

Section 23101 defines doing business as “actively engaging in any transaction for the purpose of financial or pecuniary gain or profit.” Swart claimed that it had a passive investment similar to a receipt of dividends or interest and was not “actively engaging” in business within California. The attorney general claimed that doing business should be interpreted broadly to include Swart’s passive investment, citing Golden State Theatre, 21 Cal. 2d 493 (1943). However, the court found that that case did not suggest that the term “doing business” in Section 23101 or the regulations under it should be interpreted broadly to include holding a passive investment.

The attorney general argued in the alternative that Swart was doing business in California because Cypress, which was doing business in California, chose to be formed as an LLC treated as a partnership for federal tax purposes. According to the attorney general, because Cypress elected to be treated as a partnership, Swart should be treated as a general partner of Cypress, and, as such, Cypress’s activities should be imputed to Swart. The court found that the attorney general had not provided any legal authority for this argument, noting that federal Treasury regulations do not address whether an LLC that elects to be taxed as a partnership is considered a general or limited partnership or whether its members are considered general or limited partners.

Swart, in turn, argued that like a limited partner, it was a passive investor and was not doing business in California just because it held a 0.2% interest in a manager-managed LLC doing business in California. The court agreed with Swart, finding that its interest closely resembled that of a limited, rather than general, partnership because the company had no interest in the specific property of Cypress LLC, was not personally liable for the obligations of Cypress LLC, had no right to act on behalf of or to bind Cypress LLC, and, most importantly, had no ability to participate in the management and control of Cypress LLC. Following the California State Board of Equalization’s decision in In re Amman & Schmid Finanz AG,96-SBE-008 (4/11/96), in which the SBE held that the business activities of a partnership cannot be attributed to limited partners, the court concluded Swart could not be deemed to be “doing business” in California solely by virtue of its ownership interest in Cypress LLC.

Moving forward

The FTB subsequently issued Notice 2017-01 stating it would not appeal the California Court of Appeal’s decision in Swart, and, to the extent taxpayers have similar facts, they should examine the nature of their investments to determine whether they are subject to the minimum franchise tax. When a taxpayer files a refund claim for a prior year or years, it must include a citation explaining how its facts are similar to Swart. While many taxpayers may weigh the cost of preparing the return versus the $800 potential tax overpaid, taxpayers that were assessed significant late-filing or late-payment penalties and/or paid significant interest may want to reexamine whether filing a refund claim for prior periods is worthwhile.

Ultimately, it is difficult to know to what extent this decision applies to taxpayers in similar circumstances. For example, how small must the taxpayer’s ownership percentage be in the FTB’s view? What would happen if the member took part in some decisions of the LLC but not its day-to-day business and did not have authority to bind the LLC? How significant is the fact that the decision to not be member-managed was made before Swart’s admission as a member? Essentially, it appears that California is establishing a more investor-friendly taxing structure that is beneficial to the many startup and technology companies that operate there.

Swart did not specifically address whether a passive investor has no filing requirement in California or whether the LLC is still liable for passthrough income and withholding reporting to its members. Based on how California has treated limited partners in a limited partnership, holding them liable for California income tax on their state-source income even when they are not subject to the minimum franchise tax, LLC members invested in non—member-managed LLCs doing business in California should continue to file California income tax returns to report any California income received from LLC passive investments.

EditorNotes

Anthony Bakale is with Cohen & Company Ltd. in Cleveland.

For additional information about these items, contact Mr. Bakale at 216-774-1147 or tbakale@cohencpa.com.

Unless otherwise noted, contributors are members of or associated with Cohen & Company Ltd.