|August 4, 2014|
Previously published on July 31, 2014
On July 22, 2014, the California Franchise Tax Board (FTB) provided guidance in Legal Ruling 2014-01 (Ruling) regarding when a corporation - including a limited liability company taxed as a corporation - is required to file a California return and pay any applicable taxes and fees because of its membership in a multi-member limited liability company (LLC) taxed as a partnership.
“Doing business” in California for franchise tax purposes
For purposes of California’s corporate franchise tax, part (a) of Section 23101 of the Revenue and Taxation Code (“Section 23101”) defines “doing business” as “...actively engaging in any transaction for the purpose of financial or pecuniary gain or profit.” Under part (b) of Section 21301, for taxable years beginning on or after Jan. 1, 2011, a taxpayer is also “doing business” in California if any of the following conditions are met:
The taxpayer is organized or commercially domiciled in California; or
The taxpayer’s California sales, property, or payroll exceed certain thresholds (which amounts include a taxpayer’s pro rata or distributive share from pass-through entities).
Attribution of “doing business” in California to members of LLC
For federal tax purposes, LLCs (with multiple members) are taxed as a partnership unless an election has been made for the LLC to be taxed as a corporation. California follows this federal rule. Most tax law consequences flow from the decision of the LLC to be taxed as either a partnership or a corporation. The Ruling notes that in this context, the term “partnership” refers to a general partnership as opposed to a limited partnership. In a general partnership, all of the partners are general partners and have the right to manage and conduct partnership business.
Under federal tax law, partnerships are treated as flow-through entities, which means that “[t]he character of any item of income, gain, loss, deduction, or credit included in a partner’s distributive share ... shall be determined as if such item were realized directly from the source from which realized by the partnership, or incurred in the same manner as incurred by the partnership.” (Section 702(b) of the Internal Revenue Code) California conforms to this federal provision. Therefore, the Ruling explains that the business of the partnership is the business of each partner. Consequently, according to the Ruling, the activities of the partnership are attributed to each partner and the partners will be considered to be “doing business” in the same geographic locations in which the partnership is “doing business.”
The Ruling explains that the same rules discussed above apply to a LLC and its members when the LLC is taxed as a partnership. Therefore, if a LLC classified as a partnership is “doing business” in California, then its members are also “doing business” in California. The Ruling clarifies that this is the case even if the LLC is manager-managed because members of a LLC generally have the right to participate in its management which includes the right to delegate such management power to a manager. Therefore, whether a LLC is manager-managed or member-managed is not relevant for purposes of determining whether a member of a LLC that is classified as a partnership is “doing business” in California within the meaning of Section 23101.
California franchise tax consequences for corporate members of a LLC
The Ruling provides several examples regarding when a corporate member of a LLC taxed as a partnership will have a return filing requirement and be subject to the payment of franchise taxes. In each example, the LLC is taxed as a partnership, has a California return filing requirement, is subject to the LLC taxes and fees, and has a corporate member holding a 15 percent membership interest in the LLC. Generally in each example, such corporate member is not incorporated, organized, or registered to do business in California, and has no activities or factor presence in California other than through its membership in LLC.
In the Ruling’s first two examples, the LLC is (a) either registered to do business in California or organized in California; and (b) does not have sufficient activities to constitute “doing business” within the meaning of Section 23101(a) or (b). In these examples, the corporate member of such LLC is not incorporated, organized, or registered to do business in California, has no activities or factor presence in California sufficient to constitute “doing business” within the meaning of Section 23101, and has no California source income. In those scenarios, the Ruling provides that the corporate member of such LLC is not required to file California returns and is not subject to franchise taxes because the LLC’s acts of registering to do business or being organized in California are not attributable to its members.
In the Ruling’s other examples (“Other Examples”), the LLC is either:
1. Commercially domiciled (which is the principal place from which the trade or business of the taxpayer is directed or managed) in California;
2. Is “doing business” in California within the meaning of Section 23101;
3. Is “doing business” in California within the meaning of Section 23101 and is manager-managed; or
4. The sales of the LLC in California exceed the applicable thresholds of Section 23101, so that the LLC is “doing business” in California within the meaning of Section 23101.
In each of these Other Examples, the LLC qualifies as “doing business” in California, and has a California return filing requirement and is subject to LLC taxes and fees. In these Other Examples, such corporate member is not incorporated, organized, or registered to do business in California and has no activities or factor presence in California other than through its membership in LLC.
In these Other Examples, the Ruling provides that such “doing business” activities are attributable to the members of the LLC. Consequently, in these Other Examples, the corporate member of such LLC has a California return filing obligation and is subject to franchise taxes. In addition, the Ruling notes that the corporate member is also “doing business” in California if its distributive share of the sales of the LLC in California also exceeds the applicable thresholds of Section 23101.