Investment Companies Advisor: State of California Franchise Tax Board Loses Appeal as California Courts Affirms Passive LLC Interest Position

March 27, 2017 by Vic DeMaise

Complexities involving individual states and the corresponding tax filing requirements pertinent to each has resulted in an increased focus for tax planning and compliance. A recent case has the potential to affect certain Investment Funds (particularly Fund of Hedge Funds) and the filing requirements in the State of California – Swart Enterprises, Inc. v. California Franchise Tax Board (“Swart”)[1]. This January 12, 2017 court decision made it clear that having a passive interest alone does not mean you are “doing business” in California.

In order to best understand the reasoning in Swart it is necessary to briefly mention the 1996 appeals of Amman & Schmid Finanz AG as the Swart[2] case expounds and extrapolates the appellate court’s decision in Amman. In Amman, the appellants (corporations organized under the laws of countries other than the United States) asserted that they were not “doing business” in the State of California for purposes of the California Franchise Tax and contrary to the claims of the California Franchise Tax Board (“FTB”). The foreign corporations, as limited partners, acquired partnership interests in descending tiers of limited partnerships – resulting in the appellants holding less than one percent of the distributive partnership interest containing California sourced income. The “bottom” tier partners in these limited partnerships acquired, managed, rented and sold rental properties in California. In finding the appellants were not “doing business” in California, the Court of Appeals held, a partner in a limited partnership has no interest in specific partnership property, is not bound by the obligations of the partnership, has no right to manage and/or conduct partnership business, and cannot bind the partnership.  In other words, their role is exclusively passive in nature.

More recently in Swart, the court of appeals upheld the trial court’s finding (and the ruling in Amman) that an out-of-state corporation is not considered “doing business” in the state when the corporation’s only nexus with the state is passive ownership in a manager-managed limited liability company. Swart was an out-of-state corporation with no physical presence in California.  Akin to the appellants in Amman, Swart’s only ties to the state were passive in nature. Specifically, Swart owned a 0.2 percent membership interest in a Californian LLC. Further, this LLC was exclusively manager-managed – Swart was never directly involved in operation and/or management of the LLC[3].

The underlying genesis of the Swart case is as follows: in tax year 2010, the FTB determined that Swart was “doing business” in California thereby requiring Swart to file a corporate franchise tax return and pay the $800 minimum franchise tax. The FTB’s decision was based solely on the fact that Swart owned a 0.2 percent membership interest in the California LLC and the LLC had elected to be taxed as a partnership.  Swart filed suit claiming it was not “doing business” in California and was likewise not responsible to file a franchise tax return and pay the minimum tax. The trial court agreed with Swart and the FTB appealed.  The appellate court upheld this decision.

In its well-reasoned decision, the Court of Appeals defined “doing business” as active participation in any transaction undertaken for the purpose of financial or pecuniary gain or profit. Since Swart was not “actively” engaged, and was “merely passively holding onto its investment in the year the franchise tax was imposed” it was not “doing business” for purposes of franchise tax. As for the LLC members’ election to be taxed as a partnership for federal income tax purpose, the Court of Appeals stated that the rights and obligations Swart had as a result of its 0.2 percent interest in a manager-managed LLC were similar to those of a limited, not general, partner. Pursuant to the LLC formation agreements, Swart had no interest in any of the LLC’s property, was not liable for any of the LLC’s obligations, had no right to act on behalf of or bind the LLC, and no ability to participate in the management and/or control of the LLC. The Court concluded, because the business activities of a partnership cannot be attributed to limited partners, Swart cannot be deemed to be “doing business” solely on the basis of its passive ownership interest in the LLC.

Based on the statutory investment company exemption rules and the above discussion and case law, a review of the requirements to file California Tax Returns should be given careful consideration (depending, of course, on the facts and circumstances).  It is important to note, the Swart decision does not extend to general partners and managing members of the LLC.  Other state specific provisions must also be examined, such as those regarding distributive shares of in-state source income.

The Elliott Davis Decosimo Investment Companies Team can help you evaluate the appropriate tax treatment and elections for your unique situation. We have resources throughout the firm that can help provide additional guidance related to complex state tax filing requirements. We can also assist investment entities that are required to provide state tax information to their U.S. investors. If you have any questions regarding your investment entity’s state tax filings, please check with your Elliott Davis Decosimo advisor.

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[1] Swart Enterprises, Inc. V California Franchise Tax Board, No. 13CECG02171, 2014 BL369879, Cal. Superior Ct, Fresno County 2014 Case No. F070922.  The FTB’s statute of limitations for further appeal of the Swart decision expired on or about February 12, 2017.  Therefore, the holding in Swart is now final.

[2] Appeals of Amman & Schmid Finanz AG, Cal SBE 96-SBE-008, 1996

[3] In fact, Swart was precluded by the LLC’s operating agreement from engaging in the management and/or operations of the LLC.