In Swart Enterprises Inc. v. Franchise Tax Board, a California Appellate Court held that an out-of-state corporation holding a passive investment in a manager-managed California limited liability company (LLC) was not "doing business" in the state for franchise tax purposes. Taxpayers who hold similar passive investments and have criteria similar to this case should review their California filing positions to determine whether California tax returns and California minimum taxes continue to apply.

Facts and Procedural History

Swart Enterprises, Inc. (Swart) is a small family-owned corporation incorporated in Iowa. The LLC that Swart held as a passive investment is taxed as a partnership for federal tax purposes. Swart's sole connection to California was its 0.2 percent interest in the LLC investment fund.

Swart was not involved in any way with the LLC's operations or management; in fact, the LLC's operating agreement prohibited members other than the manager from taking part in the control, conduct or operation of the fund, and members had no right or authority to act for or bind the fund. Nevertheless, the California Franchise Tax Board (FTB) asserted that Swart was doing business in the state based on its ownership interest in the LLC, and assessed Swart the $800 minimum franchise tax fee.

Swart challenged the assessment in the Fresno County Superior Court, which held that Swart's passive ownership interest in the LLC did not amount to doing business in the state.

Court of Appeal's Decision

On appeal, the court agreed with the trial court's reasoning that Swart's interest closely resembled that of a limited partner. The appellate court reached this conclusion based on a number of factors, such as the fact that Swart had no interest in the specific property of LLC, was not personally liable for the debts of LLC, had no right to act on behalf of or bind LLC and, most importantly, had no ability to participate in the management and control of LLC.

For purposes of determining whether a foreign company is "doing business" in California, the State Board of Equalization concluded previously in Appeals of Amman & Schmid Finanz AG that the business activities of a partnership cannot be attributed to its limited partners. As Swart's activities were determined to resemble those of a limited partner, Swart could not be deemed to be "doing business" in California solely by virtue of its passive ownership in the LLC.

The court found no authority to support the FTB's contention that Swart was a general partner of the LLC based on the LLC's election to be treated as a partnership for federal income tax purposes. The FTB has publically stated that it will not challenge the appellate court's decision.

CBIZ Observations

With the FTB's decision not to challenge the decision, taxpayers outside of California who hold passive investments in the state should assess the availability of potential refund claims, as well as their ongoing requirements to file California tax returns. The FTB is working to issue guidance with respect to this ruling in advance of the March 15 filing deadline for LLCs. It will not be surprising if the FTB attempts to limit the scope of the Swart decision to the very specific facts of the case.

The years at issue in the Swart decision were prior to California's adoption of its factor presence "doing business" standards. As a result, it is still unclear whether a passive member's share of an LLC's receipts would trigger a "doing business" determination if such share of receipts exceeded the statutory threshold.  However, such a determination may be rebutted in factual situations similar to Swart. It is important to note that Swart clearly does not apply if a foreign entity has a physical presence in the state, is registered to do business in the state, or is actively engaged in any transaction for the purpose of financial or pecuniary gain in California.

Lastly, an out-of-state corporation's requirement to file California tax returns and pay the minimum tax must be determined on a case-by-case basis, with due regard to the statutes of the state where the LLC is formed as well as the specific provisions of the LLC's operating agreement.

If you have any questions regarding the California tax law, please contact your CBIZ tax advisor.

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