On January 12, 2017, the California Court of Appeal held in a published opinion that a taxpayer passively holding a 0.2 percent interest in a California-based limited liability company (CA LLC) was not “doing business” in the state for purposes of being subject to California’s franchise tax. Swart Enters., Inc. v. Cal. Franchise Tax Bd., Case No. F070922 (Cal. Ct. App. Jan. 12, 2017). The court based its decision on the plain language of the applicable California income tax statutory and regulatory provisions, and expressly declined to consider any constitutional issues. 

Background

The taxpayer, Swart Enterprises, Inc. (Swart), operated a small farm in Kansas, had no physical presence in California, and did not sell or market products or services to the state. Swart’s only connection to California was a 0.2 percent ownership interest in the CA LLC that was formed for the purpose of acquiring, holding, leasing and disposing of capital equipment. Swart was not involved in the CA LLC’s operations or management and was not granted management rights by the CA LLC’s operating agreement. 

The Franchise Tax Board (FTB) argued Swart was required to file a California corporate franchise tax return and pay the minimum $800 franchise tax because the 0.2 percent interest in the CA LLC meant Swart was “doing business” in California. 

Court of Appeal’s Decision

The court soundly rejected the FTB’s position, noting that it “defies a commonsense understanding of what it means to be ‘doing business.’” The court explained under California Revenue Code Section 23101, “doing business” means “actively engaging in any transaction for the purpose of financial or pecuniary gain or profit” (emphasis added). Contrasting the statutory term “actively” with the opposite terms “passively” and “inactively,” the court found Swart did not “actively” engage in any transaction because it had held its investment in the CA LLC for several years prior to the tax year in issue and had no role in its operations. 

The court also rejected the FTB’s assertion that the CA LLC’s election to be treated as a partnership for federal income tax purposes meant that Swart should be treated as a general partner, which would cause Swart to, likewise be doing business in California. The FTB cited no legal authority to support its position. Noting such, the court explained that a tax election for one purpose (federal income tax pass-through treatment) does not necessarily control for all taxation purposes in all circumstances (California franchise tax “doing business” standard).

The FTB’s position also failed to distinguish between general and limited partnership interests. A limited partner is not doing business in California by virtue of the fact it has an ownership interest in a limited partnership and, as reasoned by the court, Swart’s interest in the CA LLC was more akin to a limited rather than a general partnership interest. Specifically, Swart “had no authority to participate in the management and control of the [CA LLC], it was not liable for the debts and obligations of the [CA LLC], it did not own an interest in specific property of the [CA LLC], nor could it act on behalf of the [CA LLC].”