Originally published on Forbes.com.
Swart Enterpirses is an Iowa Corporation that had no business activity or physical presence in California. California still dinged the company $800 in minimum tax, $1,106.71 including interest and penalties. The reason was that Swart had invested $50,000 in Cypress Equipment Fund XII, LLC. Swart’s investment in Cypress gave them a 0.2% interest and no management rights.
The California Franchise Tax Board thought that was enough to require Swart to file and pay the minimum tax. Swart paid, but did not agree. The company sued for refund. It argued that either the California statute did not require them to pay the minimum tax or it was unconstitutional if it did. Sorry to spoil the suspense, but the Superior Court of California for the County of Fresno ruled in favor of Swart Enterprises.
FTB’s position was that being a member of an LLC is considered the same as being a general partner in a partnership for federal income tax purposes and being a general partner is doing business in California. The Court did not see it that way.
FTB asserts that in this context, the term “partnership” refers to a traditional general partnership; in a general partnership all of the partners are “general partners” who have the right to manage and conduct partnership business; and the distinction between “active” and “passive” LLC members does not apply to general partnerships. But FTB cites to no authority for any of these assertions. It only cites to Corp. Code § 16202(a) for the proposition that a general partner is presumed to be a co-owner of the business. That is not what the statute states. It reads, “the association of two or more persons to carry on as coowners a business for profit forms a partnership, whether or not the persons intend to form a partnership.”
Since the Court found that the statute did not require that Swart pay the minimum tax it did not reach its constitutionality.
You have to wonder how it was that Cypress, which seems like a pretty sophisticated outfit sold the units to an Iowa corporation without giving them a heads up that California would be wanting a minimum tax. The K-1 instructions they have on-line, seem to assume that their partners are individuals. It seems that there may be even more serious issues with the way Cyrpress was marketed, so failure to note a California tax trap may be the least of their problems.
Paul Hastings covered the decision and wrote.
Why should taxpayers care about an $800 victory for Swart?
The LLC in which Swart invested had hundreds of other investors, most of whom were outside of California. The FTB’s position would have turned all of these investors into California taxpayers. Investments such as this are frequently made through special purpose vehicles and multi-tier pass-through structures. Under the FTB’s aggressive interpretation, it is possible that one entity deemed to be “doing business” within California could trigger annual filing requirements for many parties, resulting in both tax costs and disclosure costs.
Despite the favorable outcome in Swart, out-of-state taxpayers should proceed with caution. The order is unpublished and therefore cannot be relied upon as precedent in a legal action, although it is instructive and could be persuasive in dealings with the FTB. The FTB generally has a 60-day window in which to appeal.
Keith Paul Bishop also gives a nice summary noting that FTB may still appeal. Marty DaKessian along with several coauthors noted
The Swart decision is significant because it curbs the FTB’s efforts in Legal Ruling 2014-01 to limit the application of Amman to investors in limited partnerships. While it is the FTB’s position is that Amman does not apply in the LLC context because LLC members generally have the right to participate in the management of the business, the Swart decision instructs that if a member lacks the ability to participate in the management of an LLC doing business in California, it cannot be deemed to be “doing business” in California merely by virtue of holding a membership interest in the LLC.
When the case first came Paul Neiffer wrote a piece title “California is Out of Control”, which more or less sums up my sentiments.
This case is winding its way through the Court System and I hope that the taxpayers win. $800 may not be a lot of money, however, lets assume that Cypress, LLC generated income of $1,000,000 and based on the ownership held by Swart, this would generate $200 of income. Therefore, California is requiring them to pay $800 on $200 of income which is an effective tax rate of 400%.
If California is successful in winning this suit, they have another 383 out-of-state members that they can go after at $800 each per year or about $306,400 of additional filing fees plus interest plus penalties just for Cypress and I can guarantee that they will review every LLC filed in their state and start sending out notices even if you own .02% or less of the LLC.
Therefore, if you are farming operation in the Midwest, but you own some small passive LLC investment that is located in California, you may want to consider selling it before you get a notice from the Franchise Tax Board.
Joe Kristan commented on the case back in August, with his usual wisdom commenting on a post by Cara Griffith
So if your business sneezes in the general direction of California, make sure you stick an old-fashioned limited partnership in the ownership chain somewhere, or California will shake you down for $800, or maybe a lot more.
This should especially make businesses wary about buying interests in publicly-traded or broker marketed LLCs. Most of these have at least a little bit of California income, and they might just make a California filer out of your LLC or corporation. And it’s not just California — wherever the LLC might be, so might you be also. It can mean increased state taxes, not to mention increased tax return prep fees.
Generally not much consideration is given to state tax implications when alternative investments are purchased. It is not unusual for flow through investments to produce surprising state tax results. The surprises are inevitably unpleasant. Swart Enterprises won, but that leasing partnership will have to do really well to make up for the aggravation it has created for them.