In California, there are an array of state tax agencies and state taxes. Among those taxes are two parallel tax obligations: franchise tax and income taxes. From these two parallel obligations, businesses will owe one or the other, but not both. Generally, businesses located in or doing business in California are subject to the franchise tax. Businesses with income from sources located in California but not necessarily actively engaged in business in the state are typically subject to the income tax. Businesses subject to the franchise tax are always liable for, at least, the $800 minimum, annual tax. Businesses that pay state income tax are not subject to a minimum tax amount. Our Sacramento tax return lawyers explain more below.
This dual track taxation system generates a fair amount of litigation including Swart Enterprises, Inc. v. California Franchise Tax Board. Many out-of-state companies question why they should have to pay California state tax when their business has little to no active involvement in the state. Swart opens the door to the possibility that companies may be able to seek a refund for income taxes paid.
Swart Arose out of a Passive Investment into a California Company
Swart Enterprises is a family-owned business incorporated and operated in Iowa which also runs a farm in Kansas for sales of beef products in Nebraska. Swart has few links to California since it does not have any physical premises in the state, does not own property, has no employees in the state, and does not sell or market its products or services in California.
The sole link between California and Swart Enterprises is a $50,000 investment into Cypress Equipment Fund XII, LLC which resulted in Swart becoming a member of the LLC. Swart’s membership interest in the LLC was 0.2 percent. Swart does not direct or otherwise interfere with Cypress’s daily business operations. In fact, the membership agreement contained language expressly prohibiting “Members other than the Manager [taking] part in the control, conduct or operation of the Fund…”
In 2010, the California FTB demanded that Swart file a California corporate franchise tax return on the basis that Swart was actively engaged in business in California through its investment in Cypress. Essentially the FTB asserted that under section 23101, “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 under section 23151, corporations doing business in the State of California must file a tax return and pay the annual minimum franchise tax of $800.
Swart paid the tax plus interest and penalties under protest.
A Passive Investment in an LLC Does Not Constitute Doing Business in California
At trial, the trial court found that a passive investment into a manager-run LLC did not constitute active business activities in California. At appeal, the Fifth Appellate district affirmed the trial verdict under substantially similar reasoning. The essential part of the courts ruling holds that the term “doing business,” for the purposes of franchise tax obligations, is “actively engaging in any transaction for the purpose of financial or pecuniary gain or profit.” (§ 23101, subd. (a); see Cal. Code Regs., tit. 18, § 23101 (Regulation 23101).) However, merely holding a passive investment of 0.2 percent when the investor has no authority or control over the management of the LLC is not “active engagement” and thus cannot constitute “doing business” in California. As such, Swart was not subject to the franchise tax or the minimum tax.
The impact of this ruling is likely that out-of-state corporations will be able to petition the California Franchise Tax Board for the return of franchise tax paid under similar circumstances. That is, your company may qualify for a tax refund if it has made passive investments into California and has few or no active business activities in the state. While the matter is still subject to appeal to California’s Supreme Court, businesses can be to file refund applications immediately.
Work with Strategic Sacramento Tax Attorneys
If your business is concerned about unjustified taxation by California’s Franchise Tax Board, a Sacramento tax attorney of NewPoint Law Group, LLP may be able to assist. We can assess whether the tax imposed by the FTB or other state tax agency is justified by your business activities and the law. To schedule a confidential legal consultation at our Folsom or Roseville law offices, call 800-358-0305 or contact us online.