Corporation Not “Doing Business” in California for Owning Only A 25% Passive Non-Managing Member Interest in an LLC Doing Business in California
The California Office of Tax Appeals recently issued a decision that might spur corporate investments by non-California corporate entities. See In the Matter of the Appeal of Satview Broadband, Ltd., OTA Case No. 18010756 (September 25, 2018). In that case, the Office of Tax Appeals ruled in favor of a Nevada corporation, holding that it was not “doing business” in California for tax purposes by merely owning a 25% passive, non-managing interest in an LLC. This follows the logic of a California Court of Appeals case called Swart Enterprises, Inc. v. Franchise Tax Board, 7 Cal.App.5th 497 (Cal. App. 5th Dist. 2017). The Swart decision held that an Iowa corporation owning a mere 0.2% of an LLC doing business here in California was not itself “doing business” and, thus, was not required to file tax returns and pay franchise taxes.
The issue of “doing business” is important for non-California investors and the combination of Swart and now Satview Broadband decisions should remove disincentives for investments by corporate entities in small businesses. For many years, the California Franchise Tax Board has defined “doing business” as owning any percentage of membership units in an LLC doing business in California. Based on that standard, any corporation or other corporate entity was required by the FTB to file an annual tax return and pay annual franchise taxes (the minimum being $800 per year). As expected, this has impeded corporate investments in LLCs doing business here in California. The FTB’s argument has been that LLCs are treated like general partnerships; in general, what one partner does is considered done by all partners. This is the logic used by the FTB (with the “positive” effect of gaining tax revenue for the FTB).
However, that logic has been successfully challenged. The statutory basis for the “doing business” standard is Cal. Rev. & Tax. Code, § 23101(a) which defines “doing business” as “actively engaging in any transaction for financial or pecuniary gain or profit…” The FTB has taken a very broad approach to defining “doing business.” The courts are now taking a much more narrow and common sense approach.
Briefly, here are the facts of Satview Broadband. The entity at issue was Satview Broadband, Ltd., a Nevada limited liability company (“Satview”). Satview failed to file corporate tax returns with the FTB in 2009, 2011, 2012, 2013, or 2014 on the grounds that it was not actively engaged in business in California during those years. However, at all times, Satview Broadband was a 25% owner of interests in Escape Broadband, LLC (“Escape”). Satview was a passive investor in Escape, was not part of management, and did not have the power or rights to appoint anyone to be managers. Satview was a passive investor. Despite these facts, the FTB assessed various taxes, late penalties, and fees against Satview, and Satview sought review. As noted, the Office of Tax Appeals agreed with the taxpayer, holding that “[w]ithout any allegation –much less any showing – that appellant [Satview] had any ability or authority, directly or indirectly, to influence or participate in the management or operation of Escape’s business, we cannot uphold FTB’s position that Escape’s doing-business status may be attributable to (i.e., flow through to) appellant.”
For those considering an investment in an LLC, this ruling highlights another reason to pay careful attention to the operating agreement.
Interestingly enough, the FTB is continuing to fight this issue. Following the Satview Broadband ruling, the FTB issued Legal Ruling 2018-01 (October 19, 2018) asserting that Swart is a “narrow exception” applicable in only limited circumstances.
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