In a rare move in the favor of taxpayers, the California Court of Appeal recently issued a decision determining that passive business owners actually do not need to pay taxes to the California Franchise Board if the business is located out of state.
Everyone knows about the California Franchise Tax Board’s dreaded $800 minimum annual fee if you or your business is “doing business” in the State of California. (Cal. Rev. & Tax Code § 23151). This tax is required whether or not the company is incorporated in California or not. All that is required is that the business “does business” in California (whatever that means), and with that, the company must pay taxes to the State of California.
The best example of the absurd outcome that has on occasions resulted from the broadness of these requirements involves the case of Swart Enterprises, Inc., which was tax-slapped several years ago by the California FTB for not paying taxes on California income. Swart was incorporated in Iowa, operated a farm in Kansas, with no property, employees, or other business relationship to California. Swart’s only relationship to California was its status as an investor in a limited liability company located in California (a 2% ownership). Swart was not a manager of the California LLC, but in the FTB nonetheless took the position that Swart “did business” in California and was obligated to pay taxes to the State of California. Head-slap.
However, the passage of time has allowed justice to finally work its way into the picture. A decision by the California Court of Appeal reversed the ruling in favor of the FTB, and held that passively owning an interest in a California company does not constitute “doing business” in California.
Here’s what the judges had to say:
We are not persuaded Swart may be deemed to be doing business in California because it owns a 0.2 percent interest in a manager-managed LLC doing business in California. Swart’s only connection to California was a mere 0.2 percent ownership interest it passively held during the tax year the franchise tax was imposed. This interest closely resembled that of a limited, rather than general, partnership as evinced by the fact Swart had no interest in the specific property of Cypress LLC, it was not personally liable for the obligations of Cypress LLC, it had no right to act on behalf of or to bind Cypress LLC and, most importantly, it had no ability to participate in the management and control of Cypress LLC. Because the business activities of a partnership cannot be attributed to limited partners (Appeals of Amman & Schmid Finanz AG (1996) 96 SBE 008 (Amman & Schmid)), Swart cannot be deemed to be “doing business” in California solely by virtue of its ownership interest in Cypress LLC.
Hooray! A taxpayer-favorable decision comes so rarely out of any legal jurisdiction that the Court of Appeal’s decision is no doubt causing rejoice among investors across the nation. At the very least, it will save many investors the dreaded $800/year annual fees, especially for startups and businesses that might not always be making enough to pay distributions.
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If you are seeking a business lawyer, or for information on retaining AXIS Legal Counsel to represent your business in connection with any legal matter, contact firstname.lastname@example.org or call (213) 403-0130 for a confidential consultation.
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