On January 12, 2017, California’s Court of Appeal, Fifth Appellate District, determined that Swart Enterprises, Inc., a passive minority member of a manager-managed LLC, wasn’t doing business in California for purposes of the state’s franchise tax.
Swart was a small, family-owned C corporation domiciled in Iowa. In 2007, Swart acquired a 0.2 percent interest in a California manager-managed LLC, Cypress Equipment Fund XII, LLC. For Swart’s June 30, 2010, tax year-end, the California Franchise Tax Board (FTB) asserted the corporation was doing business in California by virtue of its membership in the LLC doing business in California. As such, the FTB assessed the $800 minimum franchise tax on the corporation as well as $306 in additional penalties and interest.
Swart contested the assessment and ultimately received a favorable judgment from Fresno County Superior Court in November 2014. However, the FTB appealed the decision to the Court of Appeal, arguing that an LLC member wasn’t a limited partner and inherently had the right to manage the LLC. It proposed that an LLC’s election to be taxed as a partnership for federal tax purposes converted the LLC’s members into general partners such that they should be attributed to the partnership’s activities. In addition, despite limitations in the operating agreement that prevented Swart from managing the LLC, the FTB contended the right to relinquish management and control of the LLC and the right to vote on a manager’s removal constituted rights to manage the LLC in themselves.
The Court of Appeal wasn't persuaded. Rather, it faulted the FTB’s inability to provide any legal authority that an election to be treated as a partnership for federal tax purposes converts LLC members into general partners. It pointed to the 0.2 percent minority interest of Swart and the management limitations dictated in the LLC’s operating agreement as evidence that Swart lacked the ability to manage, control or act on the LLC’s behalf. Even removal of a manager required a majority vote of the members. Furthermore, the court referenced the State Board of Equalization’s decision in Amman & Schmid as substantiation that passive limited partners could not be deemed doing business as a result of their ownership interests in partnerships doing business in California. The court analogized Swart’s rights and activities to that of a passive, limited partner even though it was an LLC member. As such, it couldn’t conclude that Swart was actively doing business in California for purposes of the franchise tax.
Given the broad implications, the FTB likely will appeal the decision in Swart Enterprises, Inc. v. Franchise Tax Board to the California Supreme Court. Therefore, the Court of Appeal’s decision in this matter isn’t likely the final resolution. Taxpayers with circumstances similar to Swart’s may have an opportunity to challenge or claim a refund of franchise taxes.
Contact your BKD advisor if you have questions on how Swart Enterprises, Inc. v. Franchise Tax Board affects your organization.