Swart's Athwart California's Taxation of Out-of-State Corporations
The California Franchise Tax Board (FTB) started 2017 with a setback as the Court of Appeal for the Fifth Appellate District held in Swart Enterprises, Inc. v. Franchise Tax Board that the FTB could not impose California’s annual $800 minimum franchise tax on an out-of-state corporation solely on the basis of that corporation’s passive investment in an LLC doing business in California. Swart goes a long way toward resolving years of contention in this area and opens California to millions in refund claims. The Court’s decision focused on the particular facts of that case, however, and an out-of-state corporation should therefore be careful in relying on Swart in taking a position that it need not pay the minimum tax or file a California return. Nonetheless, an out-of-state corporation that has paid the tax may want to consider filing a protective claim for refund.
California has two parallel taxes – franchise, and income – for corporations. California imposes the franchise tax on corporations formed or doing business in California, and the income tax on other corporations to the extent they have income from California sources. Thus, any corporation that has income from California (for example, rents from California property, or income from a business operating in California) must pay California tax on and file a California return reporting that income. The difference between the two regimes is that a corporation subject to the franchise tax must always pay a minimum $800 annual tax and file a California tax return regardless of income, whereas a corporation subject to the income tax has no such automatic requirement.
The central issue in Swart was what constitutes doing business in California for purposes of the franchise tax. The California State Board of Equalization (a taxpayer’s appellate body of first resort from an adverse FTB decision) held in 1996 (Appeal of Amman & Schmid Finanz AG) that a non-California corporation was not doing business in California (and, therefore, did not owe the minimum franchise tax) solely as a result of that corporation’s being a limited partner in a limited partnership doing business in California. The Board concluded that, under California’s limited partnership statute, a limited partner’s ability to participate in a limited partnership’s management was so restricted that such partner could not be deemed doing business in California solely as a result of the partnership’s underlying activities.
Notwithstanding Amman & Schmid, the FTB consistently imposed the minimum franchise tax and return filing requirement on non-California corporations investing in California LLCs, and issued deficiency notices to non-complying corporations, even though the FTB’s grounds for distinguishing Amman & Schmid were unclear. The FTB eventually laid out its grounds in Legal Ruling 2014-01, arguing that an investor in a California LLC – unlike a limited partner in a California limited partnership – did not automatically have a passive role in management as a matter of statute. Instead, the investor’s management role depended on whether the LLC was managed by managers or by its members, and it was this element of choice that distinguished an LLC from a limited partnership. Although out-of-state corporations did not agree with this approach, most simply paid the $800 franchise tax and filed returns because fighting the matter was not worth the attorney fees (not to mention the escalating back taxes, penalties and interest for non-compliance).
The Swart decision
This state of affairs lasted until 2013 when Swart Enterprises, Inc. (Swart) decided to challenge the FTB. Swart, an Iowa corporation, invested $50,000 in California-based Cypress Equipment Fund XII, LLC (Cypress) for a 0.2% interest. Cypress was a California LLC which invested in capital equipment in California and other states, and was managed by a California corporate manager which had full, exclusive and complete authority in the management and control of the business of the Fund under Cypress’ articles of organization and management agreement. Swart has no connection to California other than its passive interest in Cypress, and although Cypress filed California tax returns Swart did not because it had no California-source income through the fund. The FTB nonetheless demanded that Swart file a return and pay the $800 minimum tax plus penalties and interest. Swart complied but sued for a refund in the Superior Court for Fresno County (where Cypress operated). The trial court sided with Swart on cross-motions for summary judgment, holding that Swart was not doing business in California, relying on Amman & Schmid while rejecting the FTB’s approach in Legal Ruling 2014-01.
Though the trial court decision was a taxpayer victory, its use was limited because it was unpublished and the FTB could appeal it (which the FTB did). The significance of the Court of Appeal’s decision this month is that it affirmed the trial court and upheld the taxpayer’s position in a published decision on which taxpayers may rely. The Court of Appeal. relying on Amman & Schmid and rejecting the FTB’s approach in Legal Ruling 2014-01 (in fact stating that it was perplexed by the FTB’s position), continued that:
[t]he relationship between Cypress LLC and Swart supports the conclusion Swart was a quintessential passive investor. Swart had no authority to participate in the management and control of the Fund, it was not liable for the debts and obligations of the Fund, it did not own an interest in specific property of the Fund, nor could it act on behalf of the Fund. Under these circumstances, Swart’s interest in Cypress LLC was akin to that of a limited partner, and it cannot be deemed to be ‘doing business’ in California by virtue of the fact Cypress LLC was ‘doing business’ in California.
The Court of Appeal filed its decision on January 12 and the FTB may file a petition with the California Supreme Court for review within 40 days of that date. Whether the FTB does so – or, if it does, whether the Supreme Court grants the petition and agrees to hear the case – is difficult to predict.
Even if the Court of Appeal’s decision stands, out-of-state corporations should be careful before taking the position based on Swart that they are not required to file returns or pay the minimum tax. Swart clearly does not apply if the corporation does in fact have California-source income, whether through the LLC or other sources. Further, even if an out-of-state corporation’s only contact with California is as an investor in an LLC with California operations, the Court of Appeal’s decision was narrow and focused on the particular facts of the case – i.e., where the out-of-state corporation had only a minor stake in the LLC, the LLC was managed by managers (and not by its members) under California law, and the LLC’s articles and operating agreement gave exclusive authority over the LLC’s management to the managers. As the FTB’s Legal Ruling 2014-01 correctly notes, California’s and other states’ LLC statutes are much more flexible than limited partnership statutes and can give significant managerial authority to members based on the formation documents and operating agreement. Thus Swart might not apply where an LLC is managed by its members as set forth in the articles of organization under California law or, even if the LLC is managed by one or more managers under the articles, the members retain significant rights to participate in management under the operating agreement. Further, many states (like Delaware) do not require that an LLC set forth in its articles of organization (or state equivalent) whether it is manager- or member-managed, and so one must determine a putative passive investor’s role in management based on a careful reading of the operating agreement and other factors. In short, whether an out-of-state corporation must file California tax returns and pay the minimum tax must be determined on a case-by-case basis, with due regard to the statutes of the state where the LLC is formed as well as to the specific provisions of the operating agreement. We can anticipate further litigation in this area as out-of-state corporations and the FTB sort out exactly when and where the Swart decision applies.
Finally, out-of-state corporations may want to file protective claims for refund while these issues get sorted out. Generally, the deadline for filing a refund claim is 4 years after the underlying tax is paid, and there is no California statutory provision for extending this deadline. A protective claim is a relatively straightforward document (no more than 2 pages), and the attorney fees for preparing one are well worth preserving one’s ability to recover any back taxes, penalties and interest later on.
How can Nossaman help?
Nossaman attorneys have extensive experience in advising non-California corporations that invest in California entities or begin direct business operations in California, including tax return and payment requirements and including corporate registration requirements of the Secretary of State (which requirements are not necessarily similar to tax requirements). Please contact us if you have questions on how your potential investment in a California entity might affect your California filing obligations, as well as your ability to file for a refund of California taxes based on the Swart decision.