Corporate Close-Up: Taxpayer Prevails in Challenging Nexus Based on Minority LLC Interest

Robert Merten III Author

An out-of-state corporation is not liable for California franchise tax based solely on its minority interest in a manager-managed LLC, the California Court of Appeal recently affirmed in Swart Enterprises, Inc. v. Cal. Franch. Tax Bd. Taxpayers who have previously filed California corporate franchise tax returns based on minority interests in LLCs doing business in California might consider filing refund claims based on the ruling.

Out-of-state taxpayers with similar facts should determine whether their situation contains material distinctions from Swart, Robert Merten III, an attorney with Sutherland’s Sacramento office and coauthor of the Bloomberg BNA California Corporate Income Tax Navigator (subscription required), told Bloomberg BNA. If not, taxpayers are well advised to file refund claims with California. Merten said that questions to consider in making that determination include:

  • Does the LLC have any California-source income?

  • Is the LLC member-managed?

  • Does the taxpayer have a larger stake in the LLC?

  • Does the LLC have less favorable operating agreement terms?” 

The FTB argued both at the trial level and on appeal that, under Cal. Rev. & Tax. Code § 23101, Swart was doing business in California by virtue of it being a member of an LLC doing business in California.

Prior to 2007, Swart Enterprises had no contact with California. It was an Iowa corporation that operated a farm in Kansas. In 2007, it purchased a 0.2 percent member interest in an investment fund, Cypress Equipment Fund XII, LLC (Cypress). Cypress was a California LLC organized by a third-party management corporation that had complete and exclusive authority in the management and control of Cypress. 

In 2009, Cypress elected to be taxed as a partnership. Though Swart had no other contacts with California, the FTB required it to file a 2010 California corporate franchise tax return based on its 0.2 percent interest in the Cypress partnership and pay the minimum franchise tax of $800. Swart paid the tax, and then filed for a refund challenging the FTB’s authority to impose the franchise tax.

In the 1996 case In re Amman & Schmid Finanz, the California State Board of Equalization (SBE) had previously held that out-of-state corporations were not doing business in California solely because they owned a limited interest in a partnership that was doing business in California. In Swart, the Court of Appeal effectively extended that logic to taxpayers that are minority members of a manager-managed LLC, stating that Swart “had no interest in the specific property of [Cypress], it was not personally liable for the obligations of [Cypress], it had no right to act on behalf of or bind [Cypress] and Swart was prohibited from participating in the management and control of [Cypress].”

“[The] key consideration is the absence of a right of control by the would-be-taxpayer over the business affairs of the two types of pass-through entities,” Merten told Bloomberg BNA. “Specifically, the taxpayer in Amman & Schmid had no control over the limited partnership’s actions as a limited partner, and similarly here Swart had no control over the manager-managed LLC investment fund as a 0.2 percent limited member.”

The FTB also contended that because Cypress had elected to be taxed as a partnership for federal income tax purposes, it apparently qualified as a general partner under I.R.C. § 702, which the FTB urged requires that the activities of the partnership be imputed to all partners.

The Court of Appeal found the FTB’s argument flawed, stating that it “draws no distinction between general and limited partnership interests.” The court also noted that the argument simply ignored the SBE’s conclusion in Amman & Schmid that a limited partner is not doing business solely based on its ownership interest in a limited partnership. 

As for where the FTB goes from here, Merten said that it’s not clear. He told Bloomberg BNA that he doesn’t believe that the FTB “would want to bring the issue to the highest state court on facts so strongly stacked against it, but the same logic holds for the FTB deciding to take the case to the Court of Appeal and obviously it decided to do so anyway.”

Continue the discussion on BNA’s State Tax Group on LinkedIn: Will the FTB be likely to appeal Swart to the California Supreme Court? What are its chances of success if it does so?

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