Doing Business in California - Swart Enterprises v. FTB

Out-of-State LLC Operating Agreement Modifications to Avoid California’s $800 Minimum Tax

The California Franchise Tax Board (“FTB”) assesses the minimum $800 tax on

• an out-of-state LLC with in-state natural person members and
• an out-of-state LLC that is a member of an in-state LLC

unless those LLCs have adopted an operating agreement and business management rules that avoid the tax. This FTB tax liability is assessed even when the members do not participate in management of the LLC and the sole connection to California is ownership of an LLC interest. This article explores the FTB’s position and an LLC’s options to avoid the California tax.

Difference Between “Transacting Business” and “Doing Business”

Under California law an LLC may be liable for a tax even though it is not required to register with the California Secretary of State. The FTB requires LLCs “doing business[1]” to pay a tax, whereas the California Secretary of State requires an LLC be “transacting business[2]” before they are required to register. An LLC that has a bank account in California is doing business for tax purposes,[3] but is not transacting business requiring an entity registration.[4]

The duty to register with the California Secretary of State arises after “’ . . . enter[ing] into repeated and successive transactions of business in this state, other than in interstate or foreign commerce.[5]”

“Doing Business” in California – Tax Obligations

Any LLC operation in California subjects it to tax because “’Doing business’ means actively engaging in any transaction for the purpose of financial or pecuniary gain or profit.” The FTB and courts have interpreted “doing business” to be any single transaction in California where the intent is to make a profit or decrease a loss.[6]

In July 2014,[7] , the FTB determined that an out-of-state LLC with a member residing in California was doing business in California and was required to file a California tax return and pay the minimum tax. Similarly, the FTB determined that every out-of-state LLC member of a California LLC was doing business and was required to file a California tax return and pay the minimum tax. If that out-of-state LLC had any members that were LLCs, those LLCs were also required to file a return and pay California taxes.
FTB Legal Ruling 2014-01 evaluated several scenarios with manager- and member- managed LLCs that elected to be taxed as partnerships. The FTB’s reasoning hinged on its position that “[t]he default rules in California's LLC Act[8] provide that members of LLCs have the right to manage and conduct the LLC's business. Therefore, . . . if an LLC is classified as a partnership for tax purposes, the members, who are considered general partners for tax purposes, are ‘doing business’ where the LLC . . . is ‘doing business,’ even though the members have limited liability protection.”[9]

The FTB applied this reasoning to assess the minimum tax against Swart Enterprises, LLC (“Swart”) , an Iowa LLC that owned 0.2% of a California manager-managed LLC. The decision presented an obvious problem for the Iowa LLC, since if the LLC were found liable for the tax, then each of its LLC members would also be liable to pay the California tax. Swart challenged the FTB’s determination and appealed the case to the Superior Court of California for Fresno County. On appeal, the trial court agreed with the LLC members and held that “[p]assively holding an investment does not appear to constitute ‘doing business’ or [being] actively engaged in a transaction for gain or profit.” The FTB then appealed that decision and the Swart case is now pending in the California Court of Appeal. The FTB did not file its opening brief until October 27, 2015, so it will be some time before the California courts resolve the issue.

California Revised Uniform Limited Liability Company Act

An LLC offers features of a corporation (i.e., limited personal liability) and some features of a partnership (i.e., management flexibility and pass-through taxation).[10] The California Revised Uniform Limited Liability Company Act[11] defined an LLC as an entity that is separate from its members.[12] Without an agreement to the contrary, in a member managed LLC, “. . . every member is an agent of the limited liability company for the purpose of its business or affairs. . . .”[13] Each LLC has broad contract authority to enter into operating agreements that can alter the obligations and responsibilities of members.[14]

The FTB in its Legal Ruling 2014-01 and its appeal in Swart refers to LLC operating agreement without restrictions on members’ rights. In the California Board of Equalization’s (“BoE”) 2006 decision in In re Mockingbird Partners, LLC, the Board observed: “In a member-managed LLC, every member of an LLC is an agent of the LLC for conducting the usual business of the LLC, unless the articles of organization or operating agreement restrict the scope of the agent's authority (emphasis added).”[15] That case involved a Montana LLC as the owner of Montana real property managed by a third-party Montana management company. The LLC’s connection to California included the following:
·         a loan to a San Francisco trust secured by the Montana real property,
·         a California bank account,
·         a tax return prepared in California, and
·         the California residence of the two LLC members.

​The LLC did not register with the Secretary of State, but listed a California address on the LLC’s tax return. The BoE concluded that “. . . with appellant's members being California residents, some activity related to the purchase of the Montana property occurred in this state.”

In a 2011 case, the BoE held: “Appellant has not alleged, and has provided no evidence to indicate, that its sole member and manager left California whenever conducting appellant's business. (emphasis added)”[16] In both cases, the BoE found that the LLCs were doing business in California at least in part because the governing documents did not expressly restrict the members from transacting business from within California, and the taxpayers lacked evidence to contradict the FTB’s assertion that the members had done so.

Manager-Managed LLCs Subject to Tax

The FTB has determined that manager-managed LLCs are subject to the tax. "If an LLC is treated as a partnership for tax purposes, both the LLC and its members, are subject to the same legal principles applicable to any partnership. Thus, if an LLC classified as a partnership for tax purposes is ‘doing business’ in California under Section 23101, the members of the LLC are themselves ‘doing business’ in California. This is true even in the case of ‘manager-managed’ LLCs. Members of LLCs generally have the right to participate in the management of the business. Part of that power necessarily includes the right to delegate the power to manage the business in favor of a manager, and the power to revoke that delegation at any time. (emphasis added)[17]"

Operating Agreement Restrictions to
Prevent Unintended and Unwarranted FTB Tax Liability

If an LLC, through its members is in fact doing business in the State of California, that LLC should file and pay taxes in California. But where this is not the case, the LLC operating agreement should clearly limit the LLC members’ authority and obligations to avoid unintended and unwarranted tax consequences. The Court’s decision in Swart, will clarify the issue of tax liability for a subset of cases that involve a passive LLC member, owning 0.2% of a manager-managed LLC. Members of LLCs in other scenarios would also benefit from thoughtfully drafted LLC agreements.

The FTB has consistently recognized that LLC members have the right to modify their operating agreements to exclude the LLC’s liability from California tax. The FTB imposes a tax on LLCs that choose not to amend their operating agreement to identify members as limited partners or to enact other restrictions that avoid the FTB’s “doing business” tests. There are many ways to change an LLC’s operating agreement to avoid the tax. An LLC owner should evaluate the needs of the business and members as it modifies the agreement to avoid tax liability. A few possible changes include:

1. The LLC can define that it is a partnership for tax filing purposes. For business operation purposes, including “doing business,” it is a corporation, and its members have the same restricted rights that shareholders do.
2. ​The LLC can define that it is a limited partnership for tax filing purposes, and name limited partners. Alternatively, the LLC could classify members as limited partners by geography, those outside jurisdictions where the LLC is authorized to operate are limited partners and barred from management participation.
3. An out-of-state LLC can limit the rights of members to act solely when they are within the LLC’s jurisdiction, specifically voiding any action taken while a member is in California.[18]
4. An LLC can create separate classes of interest.[19] The LLC may separate the management, voting and economic rights.
5. The LLC may limit the location of its bank accounts and tax preparers to those jurisdictions where the LLC has filed to transact business.

These suggestions would of course require refinement to match the needs of each particular business. The point is that careful advance planning should be used to help clients avoid unintended and unwarranted LLC taxation in California.





[1] California Revenue and Taxation Code § 23101

[2] California Corporations Code § 17708.03

[3] In re Mockingbird Partners, LLC, No. 306061, 2006 Cal. Tax LEXIS 166 (Cal. Bd. of Equalization May. 17, 2006).

[4] California Corporations Code § 17708.03 (b) (3)

[5] Cal. Franchise Tax Bd., Legal Ruling No. 2014-01 (Jul. 22, 2014).

[6] “It is not necessary, to constitute “’Doing business,’” that there be a regular course of business or transactions. (Hise v. McColgan (1944) 24 Cal.2d 147.) A transaction does not need to result in actual profit for purposes of R&TC section 23101, and the relevant inquiry is whether the activity or transaction was motivated by financial or pecuniary gain. (Id.) In Carson Estate Co. v. McColgan (1943) 21 Cal.2d 516 (Carson), a corporation was held to be doing business when it made a purchase of bonds in one year, a sale of bonds in the following year, 12 purchases and sales of stock in the year thereafter and 2 such transactions in the last year which was considered. Thus, in Carson, a single purchase of bonds in one year constituted “doing business.” In re Mockingbird Partners, LLC, No. 306061, 2006 Cal. Tax LEXIS 166 (Cal. Bd. of Equalization May 17, 2006).

[7] Cal. Franchise Tax Bd., Legal Ruling No. 2014-01 (Jul. 22, 2014).

[8] California Revised Uniform Limited Liability Company Act, Corp. Code §§ 17701.01 et. seq.

[9] Cal. Franchise Tax Bd., Legal Ruling No. 2014-01 (Jul. 22, 2014).

[10] McNamee v. Dep't of the Treasury, 488 F.3d 100, 107 (2d Cir. 2007)

[11] California Corporations Code § 17701 et. seq.

[12] California Corporations Code § 17701.04 (a)

[13] California Corporations Code § 17703.01 (a)

[14] California Corporations Code §§ 17701.07, 17701.10 (b)

[15] In re Mockingbird Partners, LLC, No. 306061, 2006 Cal. Tax LEXIS 166 (Cal. Bd. of Equalization May. 17, 2006).

[16] In re Legend Plus Enterprise, LLC, No. 486026, (Cal. Bd. of Equalization February 22, 2011).

[17] Cal. Franchise Tax Bd., Legal Ruling No. 2014-01 (Jul. 22, 2014).

[18] Ibid.

[19] California Corporations Code § 17712.01