Are Corporate Investors Doing Business in California if They Invest in California Llcs? a Look at Swart

• Publication year: 2018
• Author: By Jeffrey S. Reed

Are Corporate Investors Doing Business in California If They Invest in California LLCs? A Look at Swart

By Jeffrey S. Reed¹

Investing in the stock of a California company does not cause an investor to be taxable in California. Should the treatment be the same if, instead of purchasing stock, an investor purchases a membership interest in a California limited liability company? Or is an investment in a limited liability company a different form of investment than a stock purchase such that it warrants different California tax treatment?

These are not merely academic questions. California courts have recently been asked to address them. In particular, a California Court of Appeal recently concluded that a passive membership interest in a California LLC is not sufficient to cause a corporate investor to be considered "doing business" in California. However, the reach of the opinion is unclear and the California Franchise Tax Board ("FTB") is administratively attempting to limit the case to its facts. Therefore, it is unclear if investors in California LLCs and partnerships can necessarily expect the same results. Other cases currently working through the California administrative appeals process may shed additional light on when investments in California LLCs and partnerships give rise to a California tax-filing obligation.

Below is a summary of the leading California case, administrative guidance issued by the FTB in response to the case, and a summary of pending class action refund litigation addressing the same passive investment in an LLC fact pattern.

I. SWART WINS IN COURT (TWICE)

The leading case addressing the California tax consequences of a passive membership interest in an LLC is Swart Enterprises, Inc. v. Franchise Tax Board.² Swart Enterprises, Inc. ("Swart") is a family-owned business that operates a 60-acre farm in Kansas. It is headquartered in Iowa and has no California presence (no California employees, real property, or personal property) of its own. It has an investment in a limited liability company, Cypress Equipment Fund XII, LLC ("Cypress"), a California LLC that operates an equipment leasing business. Swart has a less than 1% interest in Cypress. Additionally, based on the LLC agreement, Swart has no ability to control the decisions of Cypress. That authority is instead vested in a manager company, which has the sole ability to make decisions for Cypress.

In the FTB's view, Swart was doing business in California on account of its limited...