Corporate Close-Up: Did the California Franchise Tax Board Paint with Too Broad a Brush in Legal Ruling 2014-01?

A recent California Franchise Tax Board legal ruling clarifies when an out-of-state corporate member of an LLC is doing business in California on the basis of the LLC's activity in the state.  Because all LLC members generally have the right to manage and conduct the business of an LLC, the FTB takes the position that members are doing business in California when the LLC has business activities in the state.  As a consequence, the members are subject to the state's franchise tax and must file tax returns.  When the LLC's activity in the state consists only of registering to do business or being organized in the state, without actually conducting any business activities, corporate members have no franchise tax liability.

The FTB's ruling is consistent with the long-established principle that partners of a partnership are doing business in California if the partnership is doing business in the state.  In its decision in Amman & Schmid Finanz AG , however, the State Board of Equalization carved out an exception for out-of-state corporations whose only California contacts were as limited partners in limited partnerships with business activities in the state. The Board distinguished limited partners because they lack the power to manage and conduct partnership business.

Although the FTB's legal ruling describes a number of situations in which an out-of-state corporate member of an LLC has a tax filing obligation in California, the FTB does not consider whether an exception would apply to an LLC member with no management authority.

Effective January 1, 2014, California adopted its version of the Revised Uniform Limited Liability Company Act (RULLCA).  The Act generally applies to all LLCs existing on or after January 1, 2014, without a transition period for companies formed before the effective date.

In a discussion of why states should adopt RULLCA, the Uniform Law Commission cites the advantage of a flexible management structure. LLC members may have any type of management structure they want, including a corporate-style board of directors and officers.  The operating agreement determines the type of management structure.

Under RULLCA, the authority of members and managers to bind an LLC is determined by agency law, and not by their status as members or managers.  Certificates of authority may be filed with the Secretary of State to provide notice that only certain members or managers have authority to conduct business on behalf of the LLC.

As provided in Cal. Corp. Code § 17703.01(a), every member in a member-managed company is an agent of the company for the purpose of its business or affairs, and any act of the member binds the company, unless the member has, in fact, no authority to act and the person with whom the member is dealing has actual knowledge of that fact.  Relations among members and how an LLC's activities are conducted are governed by the operating agreement. Under § 17701.10, the operating agreement may relieve a member of responsibility and otherwise vary the role a member plays in the company.  As a result, a member may have no managerial authority and the member's interest in the LLC could become the equivalent of a limited partner's interest in a limited partnership.

If the corporate limited partners in Amman & Schmid were not doing business in California because they had no say in the management of the partnership, shouldn't a corporate member of an LLC receive similar treatment if its right to participate in management is curtailed by the LLC's operating agreement?

by Mike Dazé

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