ASK THE CALIFORNIA EMPLOYMENT TAX AND PAYROLL TAX ATTORNEY – FOR AN LLC, WHAT DOES “DOING BUSINESS IN CALIFORNIA” MEAN?
By Robert S. Schriebman
When is an out-of-state limited liability company (LLC) doing business in California for the purpose of filing income tax returns and paying any taxes? On July 7, 2020, the Office of Tax Appeals (OTA) issued its decision in the Aroya Investment I, LLC case (2020-OTA-255P).
Aroya was a Delaware formed LLC based in New York. It was classified as a partnership for both IRS and FTB income tax purposes. It conducted business in California within the meaning of the R&TC during 2016. It was not registered to do business with the California Secretary of State until 2016.
In December 2014, Aroya acquired a minority non-managing membership interest in a San Diego office building. Its ownership was very small, 0.78%. Outside of owning this small interest Aroya conducted no business transactions of any kind in California.
On January 12, 2017, the California Court of Appeals issued a decision stating that an out-of-state corporation’s passive holdings of a 0.2% ownership interest in a manager-managed LLC that was doing business in California, with no right of control over the business affairs of that LLC, was not itself doing business in California. (Swart Enterprises, Inc. v. Franchise Tax Bd. (Swart, supra, 7 Cal.App.5th at p. 500).
Aroya timely filed a 2016 California LLC return (Form 565) and paid the $800 LLC tax. It then filed an amended return, seeking a refund of the $800 on the basis that it was a limited partner of the San Diego business and not doing business in California. The claim for refund was based upon the Swart decision.
Let’s see how the OTA decided this one.
The OTA’s Aroya Decision
The OTA began its discussion by making reference to R&TC § 23101(b). This section says in substance that if an out-of-state entity owns tangible property that exceeds $50,000, adjusted annually for inflation, that entity is deemed to do business in California and must file income tax returns and pay a minimum $800 per year tax. The law is effective for any ownership acquired on or after January 1, 2011. After a lengthy discussion, the OTA concluded that the 0.87% interest was worth approximately $481,000 as the property itself was worth $61.5 million. Aroya conceded the valuation.
Aroya argued that the valuation test no longer applied because of the Swart case. It argued that the Swart case clearly established the rule that a non-management minority interest does not constitute doing business in California. The OTA shot down the argument and held that R&TC § 23101 contains two alternative tests for doing business, and the satisfaction of either test leads to the conclusion that Aroya was doing business in California. The first test is the valuation test above. If that test is met, end of story. The OTA stated that Swart dealt with a tax year prior to 2011 and for tax years beginning on or after January 1, 2011, the valuation rule applies, per R&TC § 23101(b). Since Aroya owned an interest in real property worth more than $50,000, it was doing busines in California in 2016 and thereafter.
In law school students are taught a maxim: “Hard cases make bad law.” The word “hard” does not mean difficult. Judges get paid to decide difficult cases everyday – that’s why we have judges. Cases that are “hard” mean cases that are difficult to the understanding or not easy to the intellect; oppressive; harsh or abusive. The logic of the decision of the Swart case made common sense. If your ownership is so small that you have no managerial power or control over the decisions of the majority, you have a passive investment. Passive investments, in my opinion, do not constitute doing business in California. Where is King Solomon when you need him, now?
Robert Schriebman has a successful practice in the Rolling Hills Estates area of Los Angeles County serving clients throughout California and the United States. He has successfully dedicated more than 40 years to helping individual taxpayers, business owners, CPAs, Enrolled Agents, and tax attorneys navigate the complicated tax systems of the federal and state governments. Mr. Schriebman is in private practice. He is not affiliated in any way with the EDD and he is not employed by the EDD or any other agency of the State of California.
Robert Schriebman has written the only 2 books ever published dealing with how California Employment Development Department (EDD) operates. See “California Tax Collection Practice and Procedures” and “California Taxation Practice and Procedure,” both published by Commerce Clearing House.
Robert Schriebman has written over 20 books including the major manual used nationally by practitioners and the IRS, “IRS Tax Collection Procedures – A Manual for Practitioners” published by Commerce Clearing House.
Robert Schriebman has written over 20 books including the major manual used nationally by practitioners and the IRS, “IRS Tax Collection Procedures – A Manual for Practitioners” published by Commerce Clearing House in addition to the only 2 books ever published dealing with how California Employment Development Department (EDD) operates. See “California Tax Collection Practice and Procedures” and “California Taxation Practice and Procedure,” both published by Commerce Clearing House.
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