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Tax Law

You're Gonna Have to Do More Than That: Passive Investment in California Limited Liability Company Insufficient to Meet Statutory Nexus Threshold

By Evan Hamme and Timothy Gustafson

A California Superior Court held that passive membership in a limited liability company (LLC) is insufficient to meet California’s statutory “doing business” standard. In Swart Enterprises, Inc. v. California Franchise Tax Board, an Iowa corporation with no business activities or physical presence in California invested in a fund organized as a California LLC. Despite its previous Technical Advice Memorandum (TAM) finding that passive investment in an LLC did not create nexus with California, the Franchise Tax Board (FTB) asserted that Swart Enterprises, Inc. was “doing business” in the state by virtue of having previously purchased an interest in the fund two years prior to the tax year in question. Because the LLC had elected under federal and California law to be treated as a partnership for tax purposes, the FTB argued that “partnership” must be interpreted to mean a general partnership, and that each LLC member, like a general partner in a partnership, would presumptively have control over the management of the business. The court disagreed. Under California law, the fund was organized as a “manager-managed LLC” rather than a “member-managed LLC”; thus, Swart had no control over the management of the fund. Nor did Swart have a sufficient percentage interest to indirectly control its management, because Swart’s investment gave it only 0.2% ownership of the fund. Accordingly, the court held that Swart was not doing business in California. Notably, while the litigation was pending, the FTB issued a TAM effectively changing the position espoused in its earlier TAM and asserting that passive LLC members were subject to tax in California. After analyzing the California case law relating to limited partnership interests, the court stated there was “no legal authority” for the conclusions drawn by the FTB under the new the TAM. The court did not reach Swart’s contentions that subjecting Swart to California’s corporate franchise tax would violate the due process clauses of the California and United States Constitutions. Also, the court did not address the FTB’s constitutional and standing arguments. Swart Enterprises, Inc. v. California Franchise Tax Board, Case No. 13CECG02171 (Cal. Super. Ct. Nov. 13, 2014).


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