Corporate Close-Up: The Long Arm of the California Franchise Tax Is Evident in Another $800 Pass-Through Entity Nexus Case

The California State Board of Equalization upheld a determination by the Franchise Tax Board that an Arizona limited partnership is liable for the $800 annual tax for the privilege of doing business in California as a result of its ownership interest in a second partnership organized and managed in California. [In re CFL, LP, No. 764609 (Cal. State Bd. Equal. Oct. 14, 2014, released July 7, 2015)]

The taxpayer, CFL, was deemed to be doing business in California because it is a general partner in Catalina Foothills Center, a California partnership also deemed to be doing business in California where it is registered and managed, even though Foothills Center's sole asset is real property located in Arizona.

CFL is an Arizona limited partnership and holds a 12.5 percent general partner interest in Foothills Center, a California partnership. Foothills Center's other general partner, Catalina Oracle Partners, a California limited partnership, holds the remaining 87.5 percent interest. As stated in the decision, Foothills and Oracle were organized in California in November 1985 to conduct a real estate investment business, with an asset of real property in Arizona. Oracle manages Foothills Center's activities from a shared business address in California and the two entities used the same tax return preparer. Thus, the SBOE had no trouble concluding, under Cal. Rev. & Tax. Code § 23101, that Foothills and Oracle were doing business in California where they were organized and commercially domiciled. 

Following previous decisions in Ahmanson & Co., No. 65-SBE-013 (Cal. State Bd. Equal. April 5, 1965) and Amman & Schmid Finanz AG, No. 96-SBE-008 (Cal. State Bd. Equal. April 11, 1996), the SBOE held that the activities of the Foothills partnership are attributable to its general partners, and each general partner has the right to manage and conduct the activities of the partnership. CFL argued that it had ceded all management decisions to Oracle under the partnership agreement and that it should be considered a limited partner because its minority interest could not overturn any management decisions made by Oracle. The SBOE agreed with the FTB, however, that CFL simply exercised its right as a general partner by delegating management duties to Oracle. As a general partner, therefore, CFL is deemed to be doing business in California because Foothills is doing business in California, and CFL must file a return and pay the annual $800 tax for that privilege.

Recently, practitioners gathered at Bloomberg BNA's State Tax Advisory Roundtable discussed another $800 California tax case involving pass-through entity nexus. In Swart Enterprises, Inc. v. California Franch. Tax Bd., No. 13CECG02171, 2014 BL 369879 (Cal. Super. Ct. Nov. 14, 2014), the Franchise Tax Board levied tax on Swart for doing business in the state, although Swart's only connection with California was a 0.2 percent interest in a California limited liability company.  

The court sided with the taxpayer in this case, emphasizing in its decision that Swart had no power to influence management decisions. The court did not buy the FTB's argument that Swart exercised its right to control the LLC by relinquishing that right to the LLC's managers "because it never had any such right to begin with. It was not a founding member, and never had a large enough interest to influence such a decision even if it was." Thus, Swart was not deemed to be doing business in California nor liable for the $800 annual tax.

As Steven Wlodychak, Principal, Ernst & Young, summarized at the Roundtable discussion, Swart is about "reading the doing business rules under California's own law and concluding that, in fact, doing business does not include just investing passively in an LLC."

Continue the discussion on Bloomberg BNA’s State Tax Group on LinkedIn: to establish nexus, where should states draw the line between passive investment and active participation in the business of a pass-through entity?

A complete report of the Roundtable discussion can be found in the Multistate Tax Report, Vol. 22, No. 6 (June 26, 2015). Additional discussion of jurisdiction to tax owners of interests in pass-through entities can be found in 1500-2nd T.M., State Taxation of Pass-Through Entities: General Principles.

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