Taxpayer Victory in California Franchise Tax Case
In a case that could hold significant taxpayer benefits, the California Court of Appeals recently ruled that a member of a California limited liability company who held a 0.2 percent passive ownership interest in the company and was not doing business in California was not liable for the state's $800 minimum franchise tax.
The case (Swart Enterprises, Inc. vs. Franchise Tax Board) evolved from the position taken by the California Franchise Tax Board that by electing to be treated as a partnership for tax purposes, the limited liability company imputes general partner tax status on each member of the company. That meant all members of the limited liability company were defined as "doing business" in California, which then subjected each member to California franchise tax.
A lower court found that the position being taken by the franchise tax board related to taxing non-California members, where those members have no authority or responsibility to manage the limited liability company or to be responsible for the activities or obligations of the company, was in error. According to the lower court, these members should not be subject to the California franchise tax based solely on limited liability company ownership.
The franchise tax board appealed, but the decision of the lower court was upheld by the California Court of Appeals. The franchise tax board has decided not to appeal the decision to the California Supreme Court. Therefore, taxpayers with similar fact situations should take this decision into consideration.
It should be noted that the lower court and state appeals court decisions are based on very fact-specific information. Any reliance on these decisions should be reviewed carefully in relation to another taxpayer's facts.
In this case, Swart Enterprise, Inc. is a family-owned corporation incorporated in Iowa. Swart Enterprise 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. Furthermore, Swart Enterprise 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 do so
- Could not act as an agent for the LLC or bind it in any way
Steps for Affected Taxpayers
If an affected taxpayer decides to file and pay the franchise tax, it is recommended that a statement or protective refund claim be included with the return referencing this case (Swart Enterprises, Inc., v. Franchise Tax Board, CA Court of Appeal, Fifth Appellate District, F070922, Jan. 12, 2017). Such protective claim should cover all required elements of a timely-filed refund claim, which includes having it in writing, outlining the specific grounds on which the claim is made, and be signed by the taxpayer or an authorized representative. Note that affected taxpayers may want to consider filing protective refund claims for all open years if their facts warrant it.
If, however, an affected taxpayer is confident that their facts are in agreement with the facts present in the Swart Enterprises case and are completely comfortable with the appeals court decision, the taxpayer could file the California franchise return, not pay the franchise tax, but disclose in the return that they believe they are not subject to the franchise tax based on the Swart Enterprises decision by the appeals court.
The franchise tax board has indicated that they will be providing additional guidance on potential refunds in the near future.
If you would like more information about the implications of this case, or would like to discuss options to move forward, contact your Eide Bailly professional or a member of our SALT team for more information.
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