California OTA Rules That Member with 50-Percent Interest in a California LLC is "Doing Business" in California
On August 21, 2019, the California Office of Tax Appeals (OTA) ruled that an out-of-state member that owned a 50-percent interest in a limited liability company (LLC) doing business in California was also considered as doing business in California. (In the Matter of Appeal of Wright Capital Holdings LLC, OTA Case No. 18010842 (8/21/19)).
This precedential opinion follows two prior decisions where the OTA ruled that LLC members owning nominal interests in California LLCs were not considered as doing business in California. It is, however, important to understand that the limits on the “doing business” inquiry presented by the recent OTA decisions do not apply if the member has independently exceeded California’s bright-line “factor presence” sales threshold (e.g., $583,867 in California-sourced sales for the 2018 tax year).
Evolution of California Law
An LLC “doing business” in California is required to file and pay the annual minimum franchise tax of $800 in addition to California’s “LLC fee.” California has two alternative tests to determine whether an entity is “doing business.” California Rev. & Tax. Code (R&TC) Section 23101(a) defines “doing business” as actively engaging in any transaction for the purpose of financial or pecuniary gain or profit. Alternatively, R&TC Section 23101(b) defines “doing business” as:
- Being organized or domiciled in California;
- Sales exceeding $500,000 or 25 percent of total sales;
- Property exceeding $50,000 or 25 percent of total property; or
- Payroll exceeding $50,000 or 25 percent of total payroll.
The factor-presence thresholds are indexed to inflation and, as noted above, the sales threshold was set at $583,867 for tax year 2018.
Before Swart, (Swart Enterprises, Inc. v. Franchise Tax Board, seven Cal. App. 5th 497 (2017)) the California Franchise Tax Board (FTB) applied the aggregate theory of partnerships to LLCs and took the position that every member of an LLC doing business in California was also deemed doing business in California. Then, in 2017 in Swart, a California court of appeals held that an out-of-state member that held a 0.2-percent, non-managing interest in a manager-managed LLC that was an investment fund in California was not “doing business” in California simply because of that member’s interest in the LLC. The court reasoned that the member was not “doing business” in California because it had no interest in specific property of the LLC, was not personally liable for the LLC’s obligations, played no role in the LLC’s management, and had no right to act as an agent for the LLC or bind the LLC in any way.
Effectively, the court found that the taxpayer in Swart was more akin to a limited partner than a general partner, and Californian law is clear that the doing business status of a limited partnership is not attributed to a partnership’s limited partners. Citing Amman & Schmid from 1996 (Appeals of Amman & Schmid Finanz AG (1996) 96 SBE 008), it appears that the reasoning from this line of cases would apply to out-of-state limited partners in the same way that it applies to out-of-state members of an LLC.
In response to Swart, the FTB issued Notice 2017-01. That guidance indicated that if an out-of-state member of a California LLC has the same exact facts as in the Swart case, then it is not considered “doing business” in California. The FTB attempted to create a bright-line test of 0.2-percent ownership.
In a 2018 non-precedential case before the OTA, an out-of-state LLC member with a 25-percent interest successfully argued that it was not “doing business” in California, using Swart as a template. (In the Matter of the Appeal of Satview Broadband Ltd., OTA Case No. 18010756 (9/25/18)). In Satview, even though the out-of-state member held a 25-percent interest in the California LLC, the OTA determined it was a non-managing member minority interest, which had no power or authority to participate in the LLC’s management or operations.
Then in Jali, (In the Matter of the Appeal of Jali LLC, OTA Case No. 18073414 (7/8/19)) an OTA opinion that became precedential in October 2019, the OTA rejected the FTB’s interpretation of Swart set forth in (FTB Notice 201701). The OTA rejected the FTB’s “0.2-percent ownership threshold as the new bright-line legal standard for distinguishing between an active and a passive ownership interest in an LLC classified as a partnership.” In Jali, the OTA indicated that “one must still generally conduct a fact-intensive inquiry into the relationship between the out-of-state member and in-state LLC,” regardless of the member’s percentage interest in the California LLC.
In Jali, the out-of-state member held between a 1.12-percent and 4.75-percent ownership interest in the LLC that was doing business in California during the tax years at issue. The OTA ruled that, while ownership percentages may be a factor in a California “doing business” determination, it is not necessarily dispositive. It is also necessary to conduct a fact-intensive inquiry into the relationship between the out-of-state member and the California LLC. The analysis includes whether the out-of-state member holds a non-managing interest and whether the out-of-state member is actively involved in the business activities of the California LLC.
Wright Capital Holdings
On August 21, 2019, the OTA issued another opinion, this time regarding whether Wright Capital Holdings, an out-of-state member, of a California LLC is “doing business” in California. Unlike the previous line of cases, however, the out-of-state member in this case had a 50-percent interest in the California LLC. The court determined that the out-of-state member was “doing business” under R&TC Section 23101(a) in California.
The OTA concluded that the facts in Swart were distinguishable from Wright Capital for several reasons. First, Wright Capital did not show that it is not a managing member of the California LLC. Second, as it holds a 50-percent ownership in the California LLC, Wright Capital has significant control over the activities of the California LLC. Even though Wright Capital’s interest was not a controlling interest, no other member had a larger interest, so Wright Capital could have presumably blocked the California LLC from taking action that it disagreed with.
As a result, the OTA held that Wright Capital was “doing business” in California by attributing its California LLC’s doing business status to Wright Capital. Wright Capital did not satisfy its burden of proving that it lacked the power or authority, directly or indirectly, to participate in the California LLC’s management or operations.
Going Forward
The California OTA has now provided a limited road map to determine when an out-of-state member with less than a 50-percent ownership interest in a California LLC is considered doing business in California. Further, Wright Capital also sets forth some of the criteria to apply when an out-of-state member with a 50-percent or more interest in a California LLC could meet its burden of proving that it is not doing business in California. Nonetheless, the OTA decisions are also clear that it is a case-by-case factual determination.
BDO Insights
- R&TC Section 23101(b) imposes California income and franchise tax jurisdiction on an out-of-state member in a California LLC if the member independently exceeds certain bright-line factor-presence standards. If the out-of-state member exceeds any of those thresholds, then the “doing business” analysis under OTA’s decisions is inapplicable.
- Determinations of whether owning an interest in an LLC “doing business” in California creates a filing requirement for the member, including an $800 minimum tax and LLC fee liability, and should be evaluated on a case-by-case basis, using the factors identified by the OTA is its recent decisions.
- The reasoning of the OTA in the decisions addressed in this alert may also be applied to out-of-state limited partners with interests in limited partnerships doing business in California.
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