Office of Tax Appeals Clarifies Definition of ‘Doing Business’ in California
On July 8, 2019, the California Office of Tax Appeals (OTA) held that a foreign out-of-state limited liability company, Jali, LLC (Jali), which retained a 4.75 percent ownership interest in an LLC conducting business in the state, wasn’t doing business in California under California Revenue and Taxation Code Section 23101(a).
Jali, formed in Washington state, acquired an ownership interest in Bullseye Capital Real Property Opportunity Fund, LLC (Bullseye). Jali held between a 1.12 percent and 4.75 percent direct capital interest for the 2012 to 2016 tax periods. Bullseye, formed in Delaware, conducted business in California and disclosed Jali’s capital interest on its Schedule K-1. The Franchise Tax Board (FTB) determined Jali must file a corporate franchise return based solely on Jali’s ownership interest in Bullseye. After filing returns for the 2012 to 2016 tax periods and paying taxes, penalties and interest, Jali filed a refund claim. The FTB denied the claim, which Jali subsequently appealed.
Under California’s Revenue and Taxation Code §23101(a), “doing business” includes “actively engaging in any transaction for the purpose of financial or pecuniary gain or profit.” California imposes a franchise tax on companies actively “doing business” within the state. The FTB determined that Jali was actively doing business in California solely based on Jali’s membership interest in Bullseye. The FTB argued that in light of the Swart Enterprises, Inc. v. Franchise Tax Board (Swart) opinion, “doing business” is dependent on the size of the taxpayer’s membership interest. The FTB contended that 0.2 percent was the threshold between actively and passively doing business.
On appeal, both Jali and the FTB relied on the facts of Swart to support their respective positions. In Swart, the appeals court held that passively holding a 0.2 percent ownership interest with no right of control didn’t constitute doing business in California within the meaning of California Revenue and Taxation Code §23101(a).
The FTB distinguished the facts of the present case from Swart, stating that because Jali’s 4.75 percent ownership interest in Bullseye exceeded the 0.2 percent threshold, Jali was considered to be actively doing business in California. The FTB’s argument relied exclusively on one line from the Swart opinion: “We conclude Swart was not doing business in California based solely on its minority ownership interest.” The FTB interpreted this statement to mean that actively doing business in California is entirely based on the size of the taxpayer’s membership interest.
Jali also relied on Swart to support its argument by comparing facts that mirrored those from Swart. Jali indicated that Bullseye was a manager-managed LLC, and Jali wasn’t one of the elected directors, didn’t have any management authority and wasn’t personally liable for Bullseye’s debts or liabilities. Similar to the argument in Swart, Jali established they were more like a limited partner or a passive investor than a general partner.
The OTA rejected the FTB’s argument and ruled in Jali’s favor. The OTA disagreed that Swart created a bright-line rule that a specific amount of membership interest was the sole factor in distinguishing between passive and active ownership in an LLC. Instead, the OTA took a holistic approach to consider all relevant factors regarding the relationship between the member and the LLC, including factual inquiries into the management type of the LLC, whether the member holds a nonmanaging member interest and whether the member is actively involved with the business decisions. The OTA stated that while Jali’s ownership interest is greater than the ownership interest in Swart, both are still minority interests and there was no evidence Jali was actively engaged in Bullseye’s business activities. The OTA’s reasoning parallels that found in “In the Matter of the Appeal of Satview Broadband, Ltd.,” issued September 25, 2018. There, under similar facts but with a 25 percent interest, the OTA held in favor of the taxpayer.
For more information, please contact your BKD trusted advisor or use the Contact Us form below.