United States

Franchise tax did not apply to ownership interest in California LLC

Non-resident had small investment in manager-managed LLC


UPDATE (2/24/2017): Recently, it has been reported that the California Franchise Tax Board (FTB) will not appeal the Swart Enterprises, Inc. v. Franchise Tax Board appellate court decision to the California Supreme Court. 

In Swart, the taxpayer was an Iowa-based S corporation whose only connection to California was a 0.2 percent investment in a multi-member manager-managed limited liability company (LLC) filing in California. Both the California Court of Appeal and the California Superior Court ruled that taxpayer was not ‘doing business’ in California, relying on the precedent set in Appeals of Amman & Schmid Finanz AG (California SBE 96-SBE-008, April 11, 1996). 

In Amman & Schmid, foreign corporations had interests in limited partnerships that acquired, managed, rented and sold California real property. Those foreign limited partners only connections to California were the receipt of their distributive shares of the limited partnership’s California-source income. Since the foreign limited partners were not entitled to possess specific partnership property and were prohibited from participating in the management of the limited partnership, the foreign limited partners were inactive participants and were not doing business in California for purposes of the minimum franchise tax.

For taxpayers that are similarly situated to the taxpayers in Swart, the minimum $800 is not required to be paid with the upcoming 2016 California returns and/or extension requests. Taxpayers impacted by the Swart decision include:

  • Foreign limited partners with investments in limited partnerships with California filing requirements
  • Foreign members in manager-managed LLCs where the foreign member’s investment is substantially similar to a limited partner’s interest
    • The following situations continue to rise to the level of doing business for a foreign member who:
      • Is a member of a member-managed LLC (per FTB LR 2014-01) and/or
      • Exceeds the factor threshold standards, for the 2016 tax year, (per CR&TC section 23101(b)-(d)) of:
        • The lesser of $547,711, or 25 percent of the total sales
        • The lesser of $54,771, or 25 percent of the total real and tangible personal property; or
        • The lesser of $54,771, or 25 percent of the total compensation paid

The FTB has indicated it will issue guidance in the near future and will also likely revise/withdraw FTB Legal Ruling 2014-01, which addressed California return filing requirements for business entities that are members of multiple-member LLCs treated as partnerships.

UPDATE (1/20/2017): Considerations for upcoming 2016 returns

At this time, it is unknown if the Franchise Tax Board (FTB) will accept this decision or appeal to the California Supreme Court, and if appealed, whether or not California’s highest court will grant certiorari and hear the case. Since a final decision in Swart has not yet been rendered, what should impacted taxpayers do? The two alternatives for upcoming 2016 California entity returns are:

  • An aggressive position would be to file the original California return and not pay the $800 minimum tax. Disclosure should be made on the return that the taxpayer is not subject to the annual $800 minimum tax imposed under CR&TC section 23153 pursuant to the California Appellate Court decision Swart Enterprises, Inc., v. Franchise Tax Board, CA Court of Appeal, Fifth Appellate District, F070922, Jan. 12, 2017. Taxpayers taking this position should be aware that the FTB can be expected to issue notices assessing tax, interest and possible penalties.
  • A conservative position would be to file the original California return and pay the $800 minimum tax. The original return could include a protective refund claim, requesting a refund of the $800 minimum tax and citing the same Swart decision above. The protective refund claim should ideally be an actual amended return. Alternatively, a statement attached to the return or separate letter mailed to the FTB, containing the required elements of a valid refund claim, should also be acceptable. Per CR&TC section 19322, the required elements of a timely-filed claim for refund include:

o   Shall be in writing
o   Shall be signed by the taxpayer or taxpayer’s authorized representative
o   Shall state the specific grounds upon which it is founded

ORIGINAL (1/18/2017): On Jan. 12, 2017, the California Court of Appeal filed its determination in Swart Enterprises, Inc. v. Franchise Tax Board, affirming the California Superior Court, holding a passive 0.2 percent ownership interest, with no right of control over the business affairs of the limited liability company (LLC), does not constitute ‘doing business’ in California.

In recent years, California has taken the position, and assessed tax accordingly, on non-resident entity members (i.e., corporations, S corporations, partnerships and LLCs that are organized outside of California) of LLCs that are doing business in California. However, a recent California Court of Appeal decision could limit California’s ability to assess the minimum tax on non-resident, non-managing members in manager-managed LLCs.


On July 22, 2014, the California Franchise Tax Board (FTB) issued Legal Ruling 2014-01. In the ruling, the FTB discusses the tax treatment of LLCs and their members when the LLC is doing business in California. The ruling states that “if an LLC is treated as a partnership for tax purposes, both the LLC and its members, are subject to the same legal principles applicable to any partnership.”

The ruling also explains that members are subject to the same legal principles as partners. Accordingly, if an LLC was doing business in California, all of its members were also doing business in California, and therefore, were subject to the California filing requirement and $800 minimum tax. This, as stated, was true regardless of whether the LLC was ‘member-managed’ or ‘manager-managed.’

Relying on the case Amman & Schmid Finanz AG, et al., the FTB drew a narrow distinction between general and limited partners of limited partnerships, noting that corporate non-resident limited partners were not doing business in California even if the limited partnership itself was doing business. However, the FTB refused to apply this principle to non-resident members of manager-managed LLCs, even though their rights are virtually identical to those of limited partners in limited partnerships. The FTB stated, “if an LLC is classified as a partnership for tax purposes, the members, who are considered general partners for tax purposes, are “doing business” where the LLC is “doing business.”

In applying this rule, California was able to assess an $800 minimum tax on non-residents, even if their only connection to California was by virtue of their status as a passive investor in an LLC doing business in California. This was the practice challenged in Swart Enterprises.

Swart Enterprises litigation

On Nov. 14, 2014, the Superior Court in Fresno County issued an unpublished decision in Swart Enterprises. The taxpayer in this case, Swart Enterprises, Inc. (Swart) was a family-owned corporation incorporated in Iowa. Swart had no physical presence or employees in California, it did not sell or market products or services to California, and it was not registered with the California Secretary of State to transact business in the state.

In 2007, Swart invested $50,000 in Cypress Equipment Fund XII, LLC (Cypress or the Fund) and became a member of the LLC. Cypress was formed in 2005 as an LLC under California law for purposes of acquiring, holding, leasing and disposing of capital equipment. The Fund was manager-managed. Pursuant to Cypress’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. Swart’s investment in Cypress amounted to a 0.2 percent ownership interest. This was Swart’s sole connection to California.

California law provides that franchise tax is imposed on the net income of every corporation doing business within the state. Doing business is defined as “actively engaging in any transaction for the purpose of financial or pecuniary gain or profit.” Based upon its ownership interest in Cypress, the FTB argued that Swart’s interest in Cypress constituted doing business in the state and assessed the $800 minimum corporate franchise tax on Swart for the tax year ending June 30, 2010. Swart paid the tax, which amounted to $1,106 with penalties and interest, but contested the payment and requested a refund.

The Superior Court first addressed whether Swart was doing business in California under Cal. Code Regs. section 23101. According to the court’s interpretation of section 23101, which addresses doing business in California, the term ‘actively’ is the opposite of ‘passively’ or ‘inactively’ and means ‘active transaction for pecuniary gain or profit.’ For example, the court pointed out, the purchase or sale of stocks or bonds may constitute doing business, but the mere receipt of dividends and interest by a corporation and the distribution of such income to its shareholders does not. According to the court, Swart’s 0.2 percent interest in Cypress was passive, and therefore, Swart was not doing business in California. Similar to a shareholder’s receipt of dividends and interest, the court noted, Swart merely passively held onto its investment in the tax year the franchise tax was imposed.

The court then addressed the FTB’s assertion that the distinction between active and passive LLC members does not apply because LLCs are treated as general partners and all partners are general partners that have the right to manage and conduct partnership business. The court was not persuaded by this argument, stating that the “FTB cites to no authority for any of these assertions.”

Instead, the court was highly persuaded by the reasoning in the Amman case. The court found that similar to the limited partner in Amman, Swart had (1) no interest in specific property of the LLC; (2) was not personally liable for the LLC’s obligations; (3) played no role in the LLC’s management and had no right to do so; and (4) could not act as an agent for the LLC or bind it in any way. Following this reasoning, the court held that Swart was not subject to the $800 minimum tax. The FTB subsequently appealed this decision and continued to assess the $800 minimum tax to all members of LLCs that were doing business in California.

On appeal to the California Court of Appeal, the court affirmed Superior Court’s decision, noting that Swart’s interest closely resembled that of a limited, rather than general, partnership. The court of appeal noted that 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 bind Cypress LLC and, most importantly, it had no ability to participate in the management and control of Cypress LLC. Additionally, the court noted there was no legal authority to support the state’s argument that an LLC member was rendered a general partner of the LLC as a result of the LLC’s election to be treated as a partnership for federal purposes. Therefore, based solely on its minority ownership interest, the court held Swart was not doing business in California and thus not subject to the $800 minimum franchise tax liability.


Under the standard developed in Swart, California cannot automatically impose the minimum tax on members of LLCs that do business in California through the attribution theory. The court established a four-part test, that if met, will relieve members of the $800 minimum tax. The test is as follows:

  1. The member has no interest in the specific assets of the LLC
  2. The member has no liability for the obligations of the LLC
  3. The member has no ability to act on behalf of or bind the LLC
  4. The member has no right to participate in the management or control of the LLC

It is currently not known whether the state will  appeal the decision to the California Supreme Court. Regardless, impacted taxpayers and tax professionals should be aware of the decision. Affected non-resident taxpayers should discuss the Swart Enterprises decision with their tax advisors and consider whether to continue to pay the franchise tax liability during the pendency of the litigation and/or consider simultaneous protective refund claims of the tax.

Also note that Swart Enterprises specifically addresses whether Swart was doing business prior to Jan. 1, 2011. For tax years beginning on or after Jan. 1, 2011, Cal. Rev. & Tax Code section 23101(b) was added to include in the definition of doing business, any of the following conditions:

  • Organized or commercially domiciled in California
  • California sales in excess of $500,000 or 25 percent of the taxpayer’s total sales (adjusted for inflation), including the taxpayer’s pro rata or distributive share of pass-through entity sales
  • California payroll or property in excess of $50,000 or 25 percent of the taxpayer’s total payroll or property (adjusted for inflation), including the taxpayer’s pro rata or distributive share of pass-through entity payroll and property

For tax years beginning on or after Jan. 1, 2011, LLC members should also review section 23101(b) notwithstanding Swart Enterprises to determine whether to pay the franchise tax for the taxable year.


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