California Court of Appeals Confirms Passive LLC Members Aren’t Liable for Minimum Franchise Tax
February 27, 2017
A California court determines that passive investors are not “actively engaged” and thus are not doing business in California for franchise tax purposes.
For years, California has taken the position that all members of an LLC (electing for federal tax purposes to be taxed as a partnership) doing business in the state have a California franchise tax filing requirement. This has proven frustrating for businesses that have only a small ownership interest. When these members do not file in California, they almost assuredly receive a bill for the $800 minimum tax with penalties and interest months or even years later.
The California Court of Appeals recently issued an opinion affirming the Superior Court’s ruling against the California Franchise Tax Board on this issue.  In their ruling, the Appeals Court concluded that a non-managing member of an LLC who, apart from its minority ownership interest in the LLC, had no other connection to California was not considered to be doing business for California franchise tax purposes and thus did not have a minimum franchise tax requirement.
California’s business taxing regime is broken out between two parts: a franchise tax for entities who are deemed to be “doing business” in California and an income tax for entities not “doing business” but still receiving California-source income. The franchise tax is much like the income tax in that it is measured by net income but it also imposes an $800 minimum tax. Entities are considered to be “doing business” and thus subject to the franchise tax in California if they are “actively engaging in any transaction for the purpose of financial or pecuniary gain or profit.” 
The issue in the case focuses on interpretation of what active engagement in the state for financial gain entails. The Franchise Tax Board’s longstanding position has been that members of LLCs that are taxed as partnerships are akin to general partners of a partnership and thus are actively engaging (or have/had the ability to activity engage) in the management of an LLC with California operations. The court sided with the taxpayer by rejecting this assertion. The court reasoned that the taxpayer/member was merely a passive investor when such taxpayer: (i) was a non-managing member with a 0.2 percent interest in a manager-managed LLC, (ii) did not have the power to exercise control or participate in the management of the LLC, (iii) could not single-handedly designate the LLC as a member-managed LLC or remove managers, and (iv) could not act on behalf of the LLC.  Accordingly, where such an entity is not organized or commercially domiciled in the state and does not meet the state’s factor presence thresholds for property, payroll and sales, it is not actively engaged in California for the purpose of financial gain and will not owe California franchise tax. 
The Franchise Tax Board decided not to appeal this case to the California Supreme Court, meaning that the issue is now finally resolved in the taxpayer’s favor. This case clearly limits the scope of the “actively engaged” standard for doing business. Taxpayers that have paid the $800 franchise tax under similar circumstances should consider whether or not they want to file refund claims. However, it is important to note that the reasoning in this opinion is based on the taxpayer’s specific facts, and therefore, certain factual differences to your particular situation may not result in the same outcome. For example, what if a member has a larger ownership percentage, say 40 percent, or the LLC is member-managed, or the member was an initial member that voted to make the LLC a manager-managed LLC?
Aprio’s SALT group has experience with the California franchise tax and can help you assess your particular tax situation. We constantly monitor these and other important state tax issues and will include any significant developments in future issues of the Aprio SALT Newsletter.
This article was featured in the February 2017 SALT Newsletter. To view the entire newsletter, click here.
 Swart Enterprises, Inc. v Franchise Tax Board, F070922 (Cal. Ct. App. 5th Dist., 1/12/17).
 See CA Rev. & Tax Cd. §23101(a).
 The court notes that the decision to be a manager-managed LLC was made two years before the taxpayer’s investment.
 See CA Rev. & Tax Cd. §23101(b). Businesses that have at least $54,711 in CA property, $54, 711 in payroll, $547,711 in receipts, or if their CA property, payroll or receipts are at least 25 percent of their total for that factor, are deemed to be doing business in CA regardless of the extent of their other activities. These thresholds are adjusted annually for inflation. It’s important to note that an entity not “doing business” in California is only relieved from the California franchise tax. If that entity receives a distributive share of California-source income, then it still has an income tax return filing requirement; it will just not owe the $800 minimum franchise tax.
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