In what is likely to be ultimately released as a precedential decision, the Office of Tax Appeals in a 3-to-0 decision, issued its opinion in In the Matter of the Appeal of Jali, LLC, Case No. 18073414(July 8, 2019). This decision clarifies and overrules the FTB’s current administrative interpretation of Swart Enterprises, Inc. v. Franchise Tax Bd. (2017) 7 Cal.App.5th 497.
In Swart, the California Court of Appeal ruled that an Iowa corporation should not be deemed to do business in California (or become subject to the California $800 corporate minimum tax) where it held a nominal interest (0.2%) in an LLC investment fund that was manager-managed, and that was qualified to do business in California. Swart had no physical presence and sold no products into California.
The court indicated that Swart could only be required to pay the minimum tax to the Franchise Tax Board if had been incorporated in California, registered to do business or was actively doing business in California. The court identified that income from passive investments cannot be considered doing business in California. Furthermore, any limited partner-type interest does not rise to the level of being treated as being engaged in doing business in California. Amman & Schmid, 96 SBE 008 (1996.) The Court further identified a number of facts indicating no business activities or control arising from investment, and concluded that Swart could not be considered to be doing business solely by reason of its nominal 0.2 percent interest.
Subsequently, the FTB published in early 2017, Notice 2017-01, which stated that the FTB would not further appeal the Swart decision. The FTB also stated as guidance that it would follow this decision with respect to both return filing obligations and/or claims for refund, where the taxpayer could show that the facts were the same as those in the Swart case. While not providing greater guidance, the FTB administratively limited its interpretation to investment interest so nominal to closely match the 2/10ths of one percent interest, virtually eliminating and rejecting most requests that the FTB should follow the Swart decision.
The Jali Decision
In Jali, the FTB charged an out-of-state LLC the $800 LLC tax for each and every year from 2012 through 2016. LLC to Eversheds Sutherland (US) LLP, a Washington State Company (Eversheds) held an interest in Bullseye Capital Real Estate Opportunity Fund (Bullseye) another out-of-state LLC that generated investment income. While Bullseye reported no California source income, it was registered to do business in California, and was considered doing business in California, although it reported no California source income.
In the Jali case, Eversheds had zero connections to California itself. It wasn’t incorporated or registered to do business in California; it held less than a five percent (5%) interest in Bullseye, a real estate limited liability company, organized in Delaware. Bullseye, was manager-managed, and acquired, managed and sold real property. Taxpayer held varying interests from the 2012 through 2016-years, initially owning 4.75%, but its interest declined to 1.12% the last three years.
The FTB claimed that the investment income was derived from business activities due to holding more than a 0.2% interest in Bullseye, because Bullseye had registered to do business in California. The FTB concluded that Eversheds must be deemed to be doing business in California. The FTB further claimed that the Swart decision solely protected holders of less than a 0.2% investment interest. The further FTB argued that the Swart decision, provided a clear division between actively doing business and passively doing business in California.
In reviewing the facts and the Swart case, the Office of Tax Appeals flatly rejected the FTB’s arguments. Office of Tax Appeals identified that “doing business” and the nature of a passive investment under the Swart decision must be based on the actual facts, and would not be subject to an arbitrary distinction as suggested by the FTB. The court found close analogy to Swart, stating
Swart had no interest in the specific property of Cypress LLC, it was not personally liable for the obligations of Cypress LLC, it had no right to act on behalf of or to bind Cypress LLC and, most importantly, it had no ability to participate in the management and control of Cypress LLC.” (Swart, supra, 7 Cal.App.5th at pp. 503, 508, 510-511.) In the court’s view, these facts demonstrated that Swart’s interest closely resembled that of a limited, rather than a general, partner. (Id. at p. 503.) Indeed, in rejecting the same argument FTB advanced there as it does here, the court concluded that “[b]ecause the business activities of a partnership cannot be attributed to limited partners, Swart cannot be deemed to be ‘doing business’ in California solely by virtue of its ownership interest in Cypress LLC.” (Ibid., emphasis added and internal citation omitted.)5 Accordingly, Swart did not establish a bright- line 0.2 percent ownership threshold for purposes of making nexus determinations for out-of- state members holding interests in in-state LLCs classified as partnerships.
In its analysis, the Office of Tax Appeals found that Eversheds has no effective management influence. Given all of the facts, that Bullseye was a manager-managed LLC and was not managed by Eversheds, and that Ebersheds had no power to participate in Bullseye’s management, or bind or act on behalf of it in any way, the investment was passive. Eversheds was not considered to be doing business in California. While ownership percentages may be a factor in nexus determinations, it is not determinative in and of itself.
This decision will likely qualify additional out-of-state business entities to not be required be considered to do business in California (and pay minimum tax) solely by reason of having a minority interest in a pass-through investment entity that is registered in California. Any entities, which have not registered in California to do business (and are not otherwise required to do so) should apply and seek a refund of any minimum tax that the FTB may have assessed. On the other hand, this decision does not abate potential taxation from any California source income involving passive investments.
This decision also does not change general principals with respect to whether an out-of-state entities is considered to do business in California either due to actual physical presence in California (aka physical nexus) or due to having sufficient sales or other activities to be deemed to do business (under economic nexus statutes.)
Because the issue of “doing business” in California involves evaluating a number of facts and situations vary, where there is any question, one should check with a tax professional who is familiar with California’s laws involving “doing business” in California.