California Gets Slapped Down on Overly Aggressive $800 Franchise Taxes

In a new California Court of Appeals decision, Swart Enterprises, Inc. v. Franchise Tax Board, judges are placing limits on how far California can go in collecting fees.

The Facts of the Swart Case

In Swart Enterprises, Inc., (7 Cal.App.5th 497, 212 Cal.Rptr.3d 670 (2017)), the material facts were not in dispute. Swart Enterprises, Inc. (Swart), was a small family-owned corporation, incorporated in Iowa. Swart operated a 60-acre farm in Kansas, where it occasionally fed cattle for beef sales in Nebraska. Its place of business and headquarters were located in Iowa. Swart had no physical presence in California, such as real or personal property, or employees. Swart did not sell or market products or services to California, and Swart was not registered with the California Secretary of State to transact interstate business.

Swart invested $50,000 in Cypress Equipment Fund XII, LLC (Cypress LLC) and became a member of this California LLC. Swart’s investment amounted to a 0.2 percent ownership interest in Cypress LLC. This was Swart’s sole connection with California.

Cypress LLC was formed as an LLC under California law for purposes of acquiring, holding, leasing, and disposing of capital equipment. The LLC was manager-managed, as opposed to member-managed. Under Cypress LLC’s articles of organization and operating agreement, the sole manager of the fund, Cypress Equipment Management Corporation III, was given “full, exclusive and complete authority in the management and control of the business of the Fund….” Cypress LLC elected to be taxed as a partnership under federal and state law, and it was not required to pay taxes because it had insufficient income.

Swart was not involved in any way in Cypress LLC’s operations or management. In fact, “Members other than the Manager [were prohibited from taking] part in the control, conduct or operation of the Fund and [had] no right or authority to act for or bind the Fund.” Thus, members had no authority to act as an agent, bind, execute an instrument on behalf of Cypress LLC, or to otherwise act in any way on its behalf.

Swart passively held its 0.2 percent investment. However, based on its 0.2 percent ownership interest in Cypress LLC, the California Franchise Tax Board (CFTB) demanded that Swart file a California corporate franchise tax return and pay the $800 minimum franchise tax due on that return. Swart paid the tax, which amounted to $1,106 with penalties and interest, but contested it and requested a refund. Swart claimed it was not subject to the franchise tax because it held no other investments in California, it did not otherwise do business in California, and it was only a passive member in Cypress LLC. Swart further claimed imposition of the franchise tax violated the due process clause and commerce clause of the United States Constitution. The CFTB denied Swart’s request for refund. Swart timely filed a complaint seeking a tax refund and declaratory relief. After briefing and argument on the parties’ cross-motions for summary judgment, the trial court entered an order granting Swart’s motion for summary judgment and denying the CFTB’s motion for summary judgment. Swart was awarded a refund in the amount of $1,106.71, and the CFTB appealed.

The Decision in Swart

In Swart, the California Court of Appeal was not persuaded that Swart could be deemed to be doing business in California simply because it owned a 0.2 percent interest in a manager-managed LLC doing business in California. The Court emphasized that 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. The Court noted that 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; Swart was not personally liable for the obligations of Cypress LLC; Swart had no right to act on behalf of or to bind Cypress LLC; and, most importantly, Swart had no ability to participate in the management and control of Cypress LLC. The Court stated that, without more, such an investment was insufficient to conclude that Swat was “doing business” in California. The Court pointed out that, just as the business activities of a partnership could not be attributed to limited partners, Swart could not be deemed to be “doing business” in California solely by virtue of its 0.2 percent ownership interest in Cypress LLC. The Court reasoned that, like a shareholder’s receipt of dividends and interest, Swart merely passively held onto its investment in the tax year the franchise tax was imposed. Based upon this rationale, the California Court of Appeal concluded that Swart was not “doing business” in California as required for imposition of the California franchise tax.

In reaching this conclusion, the California Court of Appeal also concluded that there was no authority to support the conclusion that Cypress LLC’s election to be taxed as a partnership under federal and state law automatically rendered Swart a general partner of Cypress LLC. The Court opined that Swart’s interest in Cypress LLC was not automatically transmuted into a general partnership interest for purposes of the California franchise tax; to the contrary, the relationship between Cypress LLC and Swart supported the conclusion that Swart was a quintessential passive investor. The Court stressed that Swart had no authority to participate in the management and control of Cypress LLC; Swart was not liable for the debts and obligations of Cypress LLC; Swart did not own an interest in specific property of Cypress LLC; and Swart could not act on behalf of Cypress LLC. Under these circumstances, the Court concluded that Swart’s interest in Cypress LLC was more akin to that of a limited partner, and that Swart could not be deemed to be “doing business” in California by virtue of the fact that Cypress LLC was “doing business” in California.

Brief Discussion

The recent decision by the California Court of Appeal in Swart is a victory for passive, out-of-state members of California LLCs. Indeed, in Swart, there were hundreds of other out-of-state investors in Cypress, LLC.

In its never-ending quest to generate even more California revenue, the California Franchise Tax Board (CFTB) has become increasingly aggressive in taxing out-of-state members of LLCs, even though these out-of-state members have no real nexus to California.

Apparently, the California courts now are taking a dim view of the CFTB’s revenue-raising measures. Witness that, in Swart, the California Court of Appeal even awarded costs on appeal to Swart.

In addition, there are other similar cases wending their way through the California court system.

Unfortunately, the CFTB most likely will appeal the decision in Swart to the California Supreme Court.

Conclusion

For now, at least, the recent decision by the California Court of Appeal in Swart means that out-of-state members of California LLCs, who invest passively in manager-managed California LLCs, are not required to pay California’s mandatory $800 annual franchise tax.

It should be remembered, however, that the Swart decision is limited to manager-managed California LLCs, and it does not address member-managed California LLCs.

California requires extra planning for corporations and LLCs. Call us at 800-600-1760 or request a free 15-minute consultation for more information.

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