What Constitutes “Doing Business” in California Under the Tax Code?
For years, the California Franchise Tax Board has imposed tax liability on any out-of-state corporation or LLC that was “doing business” in California. See Cal. Rev. & Tax Code, § 23151. Section 23151 allows the taxation of foreign LLCs (even if they have not qualified or registered to do business here) if they
- Engage in any transaction in California for the purpose of financial gain or profit OR
- Are “doing business” in California
Under section 23101 of the Tax Code, the phrase “doing business” is defined as “actively engaging in any transaction for the purpose of financial or pecuniary gain or profit.” Cal. Rev. & Tax Code, § 23101, subd. (a). If a foreign LLC is subject to taxation, the minimum tax is $800 per year but could be much higher based on sales and revenue. Being subject to the franchise tax also creates the administrative obligation to file California tax returns.
The members of many out-of-state LLC complain about the tax and about having to file tax returns. This is particularly true where an out-of-state LLC is used as an investment vehicle. Last year, the California Court of Appeals provided some relief. See Swart Enterprises, Inc. v. Franchise Tax Board, 7 Cal. App. 5th 497 (Cal. App. 5th Dist. 2017). The court held that an Iowa corporation passively holding a 0.2% ownership interest, with no right of control over the business affairs of an LLC here in California, is not “doing business” in California within the meaning of section 23101.
The quick facts of the case are these: The Iowa corporation was called Swart Enterprises, Inc. (“Swart”). Swart was a family-held corporation that operates a 60-acre farm in Kansas. Swart had no physical presence in California, such as real or personal property, or employees. Swart did not — and does not — sell or market products or services to California. The only connection Swart had with California was its $50,000 investment in Cypress Equipment Fund XII, LLC (“Cypress”). Swart’s investment amounted to a 0.2% ownership interest in Cypress.
Cypress is/was an LLC organized under California law in 2005 for purposes of acquiring, holding, leasing, and disposing of capital equipment. Cypress was manager-managed and non-manager members like Swart had no authority to manage or control or make decisions on behalf of Cypress. The Cypress articles of organization gave to the managers “full, exclusive and complete authority in the management and control of the business of the Fund….”
After making its investment in Cypress in 2007, the Franchise Tax Board issued a notice to Swart asserting that it must file tax returns and pay its assessed franchise tax. Swart disagreed and took the case to court. Swart argued that a mere passive investment like the one described was not “doing business” in California. The trial court agreed, and the court of appeals affirmed. The court went so far as to say that Franchise Tax Board’s argument “… defies a commonsense understanding of what it means to be ‘doing business.'”
The Swart decision is likely good news for investors that use corporations and LLCs as investment vehicles since passive investments may not trigger franchise tax liability. There is still potential tax liability based on other provisions in the Tax Code, so caution is still in order.
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For more information, call corporate attorney Michael Leonard, Esq., of San Diego Corporate Law. Mr. Leonard’s law practice is focused on business, transactional, and corporate matters and we proudly provide legal services to business owners in San Diego and the surrounding communities. Call Mr. Leonard at (858) 483-9200 or contact him via email. Like us on Facebook.