Posts Tagged ‘Swart.Enterprises’

Jolly Good News on the Swart Front

Tuesday, September 10th, 2019

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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Arizona vs. California Franchise Tax Board

Monday, June 10th, 2019

Legal authorities in the Grand Canyon State are not amused by California’s view that indirect interests in California LLCs mean that the entities are doing business in California. And they’re mad enough to take action, asking leave to sue California in the United States Supreme Court.

The issue involved is not new. California’s Franchise Tax Board believes that indirect ownership of an entity doing business in California, or even indirect ownership of an entity that indirectly owns another entity that does business in California, is enough to make all such entities be considered to do business in California. Arizona calls this an “illegal scheme” and wants it to end. The only way is to ask the Supreme Court for permission to take the case; Arizona filed the request in February. California objects to the characterization and states that impacted business owners have ways of fighting the $800 charge.

The problem is that the charge is $800, and the cost to fight is in the thousands of dollars, so few do. There are cases (such as Swart) where business owners fight back, but they take years, are expensive, and require extraordinary deep pockets. Arizona estimates the damage to Arizona business at $10.6 million a year.

Disputes between the states are subject to judicial review by the Supreme Court; however, the Supreme Court must agree to take the case. The Supreme Court is scheduled to decide whether or not to review this in the coming weeks. If the Supreme Court takes the case, it would likely be heard next winter.

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Swart Broadens

Thursday, November 29th, 2018

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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FTB Not Appealing Swart Decision

Wednesday, February 22nd, 2017

Last month a California appellate court ruled that California’s Franchise Tax Board was wrong in trying to assess an Iowa corporation with a 0.2% ownership in an LLC that invested in California the California minimum Franchise Tax. It was announced today that the FTB will not appeal the decision. The court’s conclusion was,

We conclude Swart was not doing business in California based solely on its minority ownership interest in Cypress LLC. The Attorney General’s conclusion that a taxation election could transmute Swart into a general partner for purposes of the franchise tax, and that the business activities of Cypress can therefore be imputed to Swart, is not supported by citation to appropriate legal authority and, in our view, defies a commonsense understanding of what it means to be “doing business.”

This is good news for passive business entity investors who happen to be investing in California. It’s likely that other cases that are winding way through the courts will now be settled and that the FTB will adopt a common-sense approach on this issue. Chris Smith, the FTB’s Trade Media Liaison, sent an email noting that, “[The] FTB is working on providing information to taxpayers in light of the decision which it expects to release soon.” I will link to that information when it becomes available.

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Swart Wins Appeal; Not Liable for California Minimum Tax

Thursday, January 12th, 2017

Good news for non-California businesses that are passive investors in an investment that invests in a California entity. The Franchise Tax Board (California’s income tax agency) has been ruling that business entities that have no active business in California but make an investment in another entity that invests in California must pay California’s mandatory $800 annual franchise tax. Today, a California Court of Appeal upheld the lower court judgment that Swart Enterprises, Inc., one such entity, is not doing business in California.

The facts of the case were not disputed. Swart is a small family-owned Iowa corporation, with a farm in Kansas; occasionally they make sales to Nebraska. Swart has no physical presence in California, no property of any kind (or employees) in California. It does not sell to California. Yet the FTB said it owed the California minimum franchise tax. Why? As the Court noted,

In 2007, Swart invested $50,000 in Cypress Equipment Fund XII, LLC (Cypress LLC or the Fund) and became a member of the LLC. Swart’s investment amounted to a 0.2 percent ownership interest. This is Swart’s sole connection with California.

Cypress was simply an investment fund. But the FTB said, “A foreign business entity (partnership, LLC, or corporation) is considered doing business in California if it is a member of an LLC that is doing business in California,” and owed the minimum $800 franchise tax. Swart paid the tax but filed a claim for refund. The FTB denied the claim. Swart filed a lawsuit which they won; the FTB appealed.

The Court of Appeals noted,

Although this matter calls for our independent judgment, our views are substantially consistent with the trial court’s ruling, which we find to be logical and well-reasoned. We are not persuaded Swart may be deemed to be doing business in California because it owns a 0.2 percent interest in a manager-managed LLC doing business in California. Swart’s only connection to California was a mere 0.2 percent ownership interest it passively held during the tax year the franchise tax was imposed. This interest closely resembled that of a limited, rather than general, partnership as evinced by the fact Swart had no interest in the specific property of Cypress LLC, it was not personally liable for the obligations of Cypress LLC, it had no right to act on behalf of or to bind Cypress LLC and, most importantly, it had no ability to participate in the management and control of Cypress LLC. Because 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. [citations omitted]

There’s more. The FTB tried to hold that because Cypress LLC is being taxed as a partnership, all partners are general partners, and Swart must pay the $800 minimum tax. The Court disagreed.

Like the limited partners in Amman & Schmid, Swart had no interest in the specific property of Cypress LLC (Corp. Code, former § 17300), it was not personally liable for the obligations of Cypress LLC (id., former § 17101, subd. (a)), it had no right to act on behalf of or bind Cypress LLC (id., former § 17157, subd. (b)(1), (2)), and Swart was prohibited from participating in the management and control of Cypress LLC…

We conclude Swart was not doing business in California based solely on its minority ownership interest in Cypress LLC. The Attorney General’s conclusion that a taxation election could transmute Swart into a general partner for purposes of the franchise tax, and that the business activities of Cypress can therefore be imputed to Swart, is not supported by citation to appropriate legal authority and, in our view, defies a commonsense understanding of what it means to be “doing business.”

There are many other similar cases working through the appeals process and the California court system. (There is a case of a corporation that invested in another entity that invested in another entity that made a California investment, and California is attempting to impose the $800 minimum tax on the corporation. That’s a passive investor in another passive investor that has made an investment in California.) It appears that California courts are taking a dim view of the idea that a passive investor with no ties to California can be made into an entity liable for California tax simply making an investment in California. Incidentally, the Court awarded legal costs to Swart.

The bad news is that I fully expect the Franchise Tax Board to appeal this decision to the California Supreme Court. Still, we appear to be reaching the point where California will likely cease this practice.

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California Goes After Flow-Throughs with Passive Investments in California

Saturday, August 17th, 2013

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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