California Rules That Minority LLC Owner is Not Required to Pay the Annual LLC Tax

Taxpayers have a potential California refund opportunity for the annual $800 LLC as the Office of Tax Appeals struck down the state’s argument that prior case law established a bright line 0.2 percent ownership test for “doing business”.

By Betsy Tuck, SALT Manager

Does your business own a minority interest in a limited liability company (“LLC”) that is doing business in California and, as a result, are you paying the annual $800 LLC tax? If so, a recent California Office of Tax Appeals Opinion may provide support for a refund claim.[1]

In California, an LLC is doing business and subject to the $800 LLC tax if it is “actively engaging in any transaction for the purpose of financial or pecuniary gain.”[2]

In 2017, the California Court of Appeal, in the Swart case, Enterprises, Inc. v. Franchise Tax Bd. (2017) 7 Cal.App.5th 497 (Swart), ruled that Swart, a foreign corporation, was not doing business in California based solely on its 0.2 percent ownership interest in Cypress LLC, an LLC that was doing business in California.[3]

The following were among the relevant facts which led to the Court’s decision in Swart:

  • Cypress LLC was a manager-managed LLC (as opposed to member-managed);
  • Swart held a passive, minority interest in in Cypress LLC; and,
  • Swart had no power to exercise control or participate in the management of Cypress.

In the current case, Jali LLC (“Jali”), an LLC formed in Washington and not registered with the CA Secretary of State, requested refunds of the annual $800 LLC tax that it paid for several years due to its ownership in Bullseye Capital Real Property Opportunity Fund, LLC (“Bullseye”).  Bullseye is a Delaware LLC that is registered with the CA Secretary of state, doing business in CA, and filing CA income tax returns as a partnership.  During the years at issue, Jali’s ownership interest in Bullseye ranged between 3.19 percent to 4.75 percent.

Very similar to the facts in Swart, Jali held a minority, passive interest in Bullseye, a manager-managed LLC. Jali held no interest in any specific property of Bullseye, had no liability for any debt or liabilities of Bullseye, and had no power to manage or act on behalf of Bullseye.

Jali believed it did not have a filing obligation in California and did not initially file returns for the years in question. Upon receiving a notice from the California Franchise Tax Board (FTB) demanding tax filings, Jali filed and paid any tax, penalty, and interest, and then filed for refunds. The FTB denied the refund claims based on its interpretation of the Swart case that the court’s opinion created a bright-line 0.2 percent ownership threshold for filing.

The Office of Tax Appeals disagreed with the FTB’s interpretation of Swart, concluding that there is not a 0.2 percent bright-line test for “doing business,” and that even though ownership percentages may be a determining factor to establishing nexus, it is not dispositive. Although Jali’s ownership was greater than 0.2 percent, it was still clearly a minority interest and no evidence existed which showed that Jali had any authority or power to make or influence management or operational decisions.

Contrast this decision with another from the Office of Tax Appeals one month later.[4]  In that case, Wright Capital Holdings LLC (“Wright”), was a foreign LLC with no activity in California outside of its 50 percent interest in Collegiate Consulting LLC (“Collegiate”), an LLC that is registered and conducting business in California. In this appeal, the Office of Tax Appeals sided with the FTB and concluded that Wright was “doing business” and owes the $800 annual fee. The opinion explained that although 50 percent is not a majority interest, Wright possessed the largest interest of any other member and could have used its interest to block Collegiate from taking action it disagreed with.

Whether you have been filing in California or are considering filing due to a minority interest in an LLC doing business in CA, consider the facts of these decisions and whether they may be applicable to you. The SALT team at Aprio has experience with these issues and can assist you in examining your particular situation to determine the most appropriate course of action, which could include a refund claim. We constantly monitor these and other important state tax topics, and we will include any significant developments in future issues of the Aprio SALT Newsletter.

Contact Betsy Tuck, SALT manager, at betsy.tuck@aprio.com or  Jeff Glickman, partner-in-charge of Aprio’s SALT practice, at jeff.glickman@aprio.com for more information.

This article was featured in the October 2019 SALT Newsletter.

[1] In the Matter of the Appeal of Jali, LLC, 2019-OTA-204P, OTA Case No. 18073414, July 9, 2019.

[2] CA Rev. & Tax Code §17941(a); CA Rev. & Tax Code §23101. Note that the LLC may also be “doing business” in CA if its property, payroll, or sales (including its pro-rata share from a partnership or S-Corporation) exceed certain thresholds.

[3] Swart Enterprises, Inc. v. Franchise Tax Bd., 7 Cal.App.5th 497 (Jan. 12, 2017).  For more information about the Swart decision, you can read our SALT newsletter article.

[4] In the Matter of the Appeal of Wright Capital Holdings LLC, 2019-OTA-219P, OTA Case No. 18010842, Aug. 21, 2019.

Any tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or under any state or local tax law or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Please do not hesitate to contact us if you have any questions regarding the matter.