Swart Broadens

California’s Franchise Tax Board believes that any business with even a remote tie to California should pay California tax. Let’s say you own a 0.21% interest in Acme LLC. Acme invests in something in California. You have no authority to manage (or administer) Acme. In the decision in Swart Enterprises, a 0.2% holding for such an LLC was ruled not to be conducting business in California. The FTB noted that similar businesses could file a refund:

Explain why the taxpayer has the same facts as in the Swart Court of Appeal decision (i.e., sole connection to California is a 0.2 percent membership interest, or less; in a manager-managed LLC; and the original members of the LLC delegated to a sole manager full, exclusive, and complete authority to manage and control the LLC). [emphasis added]

And, yes, the FTB has been continuing to challenge businesses with more than a 0.2% interest. But that may stop soon.

Appeals of FTB decisions now go to the Department of Taxation and Fee Administration. Satview Broadband, Ltd. fell astray in filing California tax returns. Satview is a Nevada LLC that owned a 25% interest in Escape Broadband, LLC. Satview was a limited partner (member) of Escape, and like in Swart, was a passive investor.

Satview paid back taxes and then filed a claim for refund. The FTB denied the claim. One of the issues was the doing business question: Was Satview doing business in California solely by owning a 25% stake in another LLC as a nonmanaging member of that other LLC? After the FTB denied the claim for refund, Satview appealed to the Department of Taxation Fee Administration.

The only conceivable basis in the record before us upon which it could be contended that appellant was actively engaging in transactions for profit in California is the fact that appellant held a non-managing minority member interest in Escape, an LLC that admittedly was doing business in California. However, the doing-business status of a pass-through entity – here an LLC taxable as a partnership – is not automatically attributed to its non-managing minority members where, as here, there is no indication that the non-managing minority member had any power or authority, directly or indirectly, to participate in the LLC’s management or operations.

In Swart, the taxpayer had a 0.2% interest; here, it’s a 25% interest. The FTB is holding that if you exceed 0.2% you need to file in California.

The court in Swart rejected FTB’s position that Swart’s passive holding a minority non-managing interest in Cypress established that Swart was “actively engaging in any transaction for financial or pecuniary gain or profit” during the year at issue. It found that the leading authority, Golden State Theatre & Realty Corp. v. Johnson (1943) 21 Cal.2d 493, could not be interpreted so broadly as to warrant characterizing Swart’s investment activity as “doing business” in the state. (Swart, supra, 7 Cal.App.5th, at pp. 503-505.) We draw the same conclusion under the instant facts. To hold otherwise would ignore the important distinction between actively and passively (or inactively) engaging in business transactions. (Ibid.)…

FTB makes no argument that the operative facts of this appeal are materially different from those at issue in Swart. Although appellant’s percentage interest in the in-state pass- through entity at issue here is significantly greater than the percentage interest in Swart (25 percent as opposed to 0.2 percent), both are minority interests. Without any allegation – much less any showing – that appellant had any ability or authority, directly or indirectly, to influence or participate in the management or operation of Escape’s business, we cannot uphold FTB’s position that Escape’s doing-business status may be attributable to (i.e., flow through to) appellant. Merely pointing to the fact that appellant held a non-managing minority interest in an LLC that was doing business in this state does not, standing alone, satisfy the requirement that FTB show a rational basis for its determination. Consequently, we conclude that appellant is not liable for the 2011 and 2012 NQSF penalties.

It will be interesting to see if the FTB will continue to state that businesses with solely passive interests in other entities that invest in California are doing business in the state. Unfortunately, this opinion is not precedential so my suspicion is that the FTB will continue to force companies to fight it. I also doubt that the FTB will appeal this decision to the court system. Doing so would turn this non-precedential decision into a precedential decision.

Still, this is overall good news. The administrative judges at the Department of Taxation and Fee Administration appear to have a grounding in reality. Sooner or later there will be a precedential decision on this issue, and the FTB will be forced to realize that not everyone is doing business in California.

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