By Joe Haberzetle, JD, LLM

California nonresident investors have long complained about having to pay $800 annually in minimum corporate franchise tax or California LLC tax, merely for holding a passive investment in a California business and regardless of whether the investment generates income.  As it turns out, the law may have been on the investors’ side all along.

In January 2017, the California Court of Appeals held in Swart Enterprises, Inc. v. Franchise Tax Board that an out-of-state C corporation could not be required to file a California franchise tax return and pay the $800 minimum tax merely because it held a 0.2% interest in a manager-managed LLC that operated in the state.

In its decision, the appellate court compared this passive investment to a limited partner interest in a California partnership, which California courts have previously held does not create a taxable presence for the limited partner.

On February 28, 2017, the California Franchise Tax Board announced it would not appeal the Swart decision and would issue refunds for prior years, where appropriate.  We expect a substantial number of refund claims to be filed because California has historically been aggressive in enforcing the filing requirement on out-of-state companies with ownership interests in California LLCs.

Although the taxpayer in Swart is a C corporation, it appears the court’s logic could apply equally to California’s $800 LLC tax.  Where a parent or intermediate-tier LLC is not doing business in California in its own right and merely holds a non-manager interest in a lower-tier LLC doing business in the state, we question whether the LLC tax can still be imposed.

Questions Remain

Although it is a good outcome and a well-reasoned decision, there are several questions left unanswered by the court:

1. Does the ownership percentage matter? The Swart taxpayer owned only a 0.2% interest, but once we accept the Court’s logic that a company is not “doing business” in California simply by holding a passive investment in a California LLC, shouldn’t the same conclusion result even if the out-of-state member owns a 99% interest?

2. How important is it that the LLC’s operating agreement in Swart delegated “full, exclusive and complete authority in the management and control of the business” to the third-party manager? If the investor had participated in making major decisions for the LLC (but ceded authority to the manager on day-to-day operational issues), would the investor have been “doing business” in California?

3. Could the court’s ruling be extended to nonresident, non-managing LLC members whose California tax would exceed the $800 minimum? If so, the potential refunds (and the number of affected taxpayers) would increase substantially.

While we don’t yet have answers to all the questions, it is clear that, for investors matching the Swart fact pattern, California’s reviled $800 annual tax should thankfully become a thing of the past.

Please contact Clark Nuber or your state tax professional if you would like more information about this decision or to discuss if it could affect your specific situation.

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This article contains general information only and should not be construed as accounting, business, financial, investment, legal, tax, or other professional advice or services. Before making any decision or taking any action, you should engage a qualified professional advisor.