• California Court of Appeal Holds Passive LLC Interest Does Not Create Nexus
  • April 13, 2017 | Authors: William H. Gorrod; Bradley R. Marsh
  • Law Firm: Greenberg Traurig, LLP - San Francisco Office
  • A non-California corporation’s only connection with California was its passive minority interest in a limited liability company (LLC) that was doing business in California. The California Court of Appeal held that this limited connection was not sufficient to subject the out of state corporation to California’s Corporation Franchise Tax. All taxpayers that have filed and paid California corporation franchise tax based solely on the ownership of a passive membership interest in an LLC that is doing business in California should consider whether they may be able to submit a refund claim.

    Background

    On January 12, 2017, in Swart Enterprises, Inc. v. Franchise Tax Board, Case No. F070922 (Cal. App. Ct. 2017), the California Court of Appeal, Fifth Appellate District, ruled on the California corporation franchise tax filing requirement for Swart Enterprises, Inc. (Swart), an out of state corporation that operated a farm. Swart’s only connection with California was a 0.2% passive ownership interest in a California LLC that was engaged in the acquisition, holding, leasing, and disposition of capital equipment. Under the LLC agreement, the LLC manager had exclusive and complete authority for the management and control of the LLC, and other members, including Swart, were prohibited from participating in the control or operation of the LLC. Swart was not liable for LLC’s debts and obligations under the terms of the LLC agreement.

    The California Franchise Tax Board (FTB) took the position that Swart was required to file a California corporation franchise tax return on the basis that it was “doing business” in California as a result of its ownership of the membership interest in the LLC.

    California Court of Appeal’s Analysis of the California Nexus Standard

    Section 23101 of the California Revenue and Taxation Code, in pertinent part, provides that a corporation is “doing business” in California if it is actively engaging in any transaction for the purposes of financial or pecuniary gain or profit. The court determined that Swart’s passive ownership interest in the LLC was comparable to a limited partnership interest, and as such, the activities of the LLC within California could not be attributed to Swart in order to require Swart to file a California return.

    The FTB had until February 22 to request review by the California Supreme Court, but did not file an appeal. As such, the Court of Appeal’s decision is final.

    Potential Refund Opportunity

    While the California Court of Appeal’s decision was based on the specific facts regarding the taxpayer’s ownership interest, participation in the LLC’s activities, and the terms of the LLC agreement, an out of state taxpayer with a passive ownership interest in an LLC that is doing business in California should consider whether it should be required to file a California tax return or pay taxes in California based on the court’s decision in Swart. In addition, taxpayers that have filed and paid California corporation franchise tax based solely on the FTB’s position that ownership of a passive membership interest in an LLC that is doing business in California creates a filing requirement should consider whether they may be entitled to a refund.