Jolly Good News on the Swart Front

Let’s say you’re the managing member of an LLC headquartered in Seattle (duly registered as an LLC in Washington State). You invest in another LLC (a Delaware LLC) that invests in property throughout the United States. You own between one and five percent of the Delaware LLC each year, and are not involved in any of the decisions of the Delaware LLC. The Delaware LLC invests in California property, and is considered doing business in California (it registers with the California Secretary of State and files a California LLC tax return). Is your Washington State LLC doing business in California?

The California Franchise Tax Board has been holding for years that if you invest in a California LLC–or a foreign LLC doing business in California–your LLC is considered doing business in California. Even an indirect investment (investing in LLC 1 that invests in LLC 2 that invests in a California LLC) is enough to be doing business in California in the view of the FTB. Then came Swart.

As previously discussed on this blog, Swart Enterprises, Inc challenged the FTB regarding its 0.2% interest in a manager-member California LLC. The courts held that such a passive investment is not doing business in California. After Swart, the FTB held that if your passive interest is 0.2% (or less), you’re not doing business in California; greater than that, you are.

Jali, LLC is a Washington State LLC that mirrors the fact pattern in the first paragraph. They invested in Bullseye Capital Real Property Opportunity Fund, LLC and California’s Franchise Tax Board asserted they were doing business in California. Jali, LLC paid the FTB for the years in question and filed a claim for refund; the claim was denied because Jali, LLC owned more than 0.2% of Bullseye. Jali, LLC appealed to the California Board of Tax Appeals.

In what will be a precedential decision, the Board of Tax Appeals noted:

FTB thus takes the position that a 0.2 percent membership interest in an LLC doing business in California is the new, post-Swart bright-line ownership threshold used to determine whether an out-of-state member is also doing business in the state. As applied to the facts of this appeal, FTB concludes that appellant is deemed to be “actively” doing business in California because its membership interest in Bullseye “was well beyond the 0.2% Swart limit.” We disagree.

FTB misconstrues the Swart court’s statement, “We conclude Swart was not doing business in California based solely on its minority ownership interest in Cypress LLC.” The court’s opinion was not “based solely” on Swart’s minority ownership interest. Rather, in making this statement, the court was simply dismissing FTB’s argument that the court should base its decision on that fact alone. When the entire opinion is considered, it becomes abundantly clear the court’s holding was squarely grounded on the relationship between the out-of-state member and the in-state LLC.

But that’s not all. The Board of Tax Appeals realizes that the key questions are, (a) Is the entity a limited or general partner, and (b) Can the limited partner control the activity of the LLC that is doing business in California?

FTB misconstrues the Swart court’s statement, “We conclude Swart was not doing business in California based solely on its minority ownership interest in Cypress LLC.” The court’s opinion was not “based solely” on Swart’s minority ownership interest. Rather, in making this statement, the court was simply dismissing FTB’s argument that the court should base its decision on that fact alone. When the entire opinion is considered, it becomes abundantly clear the court’s holding was squarely grounded on the relationship between the out-of-state member and the in-state LLC…Indeed, in rejecting the same argument FTB advanced there as it does here, the court concluded that “[b]ecause the business activities of a partnership cannot be attributed to limited partners, Swart cannot be deemed to be ‘doing business’ in California solely by virtue of its ownership interest in Cypress LLC.” (Ibid., emphasis added and internal citation omitted.) Accordingly, Swart did not establish a bright-line 0.2 percent ownership threshold for purposes of making nexus determinations for out-of-state members holding interests in in-state LLCs classified as partnerships.

Employing the foregoing legal analysis from Swart, we agree with appellant that it is not subject to California tax. Appellant points to certain relevant facts—none of which FTB contests—that are virtually identical to those in Swart. Under its operating agreement, (1) Bullseye is a manager-managed LLC, (2) it is managed by an elected director(s), not appellant, (3) appellant is not personally liable for any debt, obligation, or liability of Bullseye, (4) appellant has no power to participate in Bullseye’s management, or bind or act on behalf of it in any way, and (5) appellant has no interest in any specific property of Bullseye. And, even though appellant’s percentage interest in Bullseye is greater than that in Swart (between 1.12 to 4.75 percent versus 0.2 percent), both are undisputedly minority interests. Therefore, like Swart’s interest in Cypress, appellant’s interest in Bullseye closely resembles that of a limited, rather than a general, partner, and there is no evidence that appellant had any ability or authority, directly or indirectly, to influence or participate in the management or operation of Bullseye. [footnotes omitted]

The conclusion of the Board of Tax Appeals is clear:

[W]e reject FTB’s 0.2 percent ownership threshold as the new bright-line legal standard for distinguishing between an active and a passive ownership interest in an LLC classified as a partnership.

Unlike the earlier decision in Satview Enterprises (which was not precedential), this decision will soon be precedential. The big question is whether the FTB will appeal into the California court system. There’s a definite possibility they will (it would be consistent with the FTB’s general legal practices). No matter, this decision is excellent news for owners of minority interests in California LLCs.

(It’s also, overall, excellent news for California. You want to encourage investment in the state. The FTB’s policy of demanding the $800 for minority interest in California LLCs discourages California investment.)

If you have a non-California LLC that has been forced to pay California LLC tax for indirect interest in a California LLC (or a foreign LLC doing business in California), you should consider filing a claim for refund–or a protective claim if your statute of limitations is nearing expiration.

Case: In the Matter of the Appeal of Jali, LLC

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