California Goes After Flow-Throughs with Passive Investments in California

Let’s say you’re the manager of a business in Florida. Your business has some excess capital, so you decide to invest in the RussFox Fund, LLC. Your investment makes up a whopping 0.02% of the fund. (Put another way, you own 2/10000 of the LLC.) The RussFox Fund invests and trades capital equipment, including some in California. You take no part in the management of the fund–you’re clearly a passive investor.

One day you open the mail and see a notice from California’s Franchise Tax Board, California’s state income tax agency. It says you’re Florida business is liable for the $800 California minimum franchise tax (plus penalties and interest, of course) because your business has California-source income.

Now, would California do that? The answer is they have already done so. The facts that I gave mirror the facts of a case written up by Tax Analysts on a Kansas-based company called Swart Enterprises, Inc. Swart paid the FTB and then filed a claim for refund. That claim was denied; Swart has now filed a lawsuit in Fresno County Superior Court. It will likely be some time before this case is decided, but it will be interesting to follow.

Of course, the conclusion that Tax Analysts writes is exactly what I thought: “While states are always on the lookout for each and every dollar of tax revenue, taxing investments in California serves as a big disincentive for out-of-state companies to invest in the state.”


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