Industry Insights

Passive California LLC Members May Not Be Subject to Franchise Tax

January 2015

In recent years, the California Franchise Tax Board (FTB) has aggressively pursued and issued tax notices to limited liability company (LLC) members whose only connection with California is through investment in a California LLC. The state often assesses an estimated liability in an amount two or three times the $800 minimum tax after penalties and interest are applied.

The FTB recently released guidance on its position in Legal Ruling 2014-01, which states the business of a partnership is the business of each partner and that partners do business where the partnership is doing business. In other words, the active and passive members of a partnership are doing business in California when the LLC is doing business in California, regardless of whether the member participates in the management of the LLC.

The recent Fresno County Superior Court of California holding in Swart Enterprises, Inc. v. California Franchise Tax Board overturns the FTB guidance for passive corporate members of a California LLC. The court found the taxpayer’s mere ownership of a passive interest in a California-managed investment fund did not rise to the level of doing business in the state. A major contention of the case was that the taxpayer did not have the authority to either manage or delegate managers because the LLC operating agreement gave sole operating authority to the LLC managers and not the investors. In addition, the taxpayer did not have enough ownership to exercise any management control. The FTB is likely to appeal the decision due to the large number of potential refund claims.

There may be a narrow refund opportunity, as the ruling applies only to taxpayers with no connection to California other than passive LLC interests. Taxpayers with these particular facts who have been assessed or are filing California franchise tax should consider filing protective refund claims. The California statute of limitation is four years.

If you have any questions regarding your ownership in a California partnership, contact your BKD advisor.

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