LEGAL RULING 2018-01: THE CALIFORNIA FTB ISSUES ADDITONAL GUIDANCE ON ITS NARROW INTERPRETATION OF TAXPAYER RELIEF UNDER SWART ENTERPRISES
In Legal Ruling 2018-01 (2018-01), the Franchise Tax Board (FTB) has modified its previous Legal Ruling 2014-01 (July 22, 2014) (Original Ruling), which addresses the FTB’s opinion of the determination of taxable nexus of LLCs and LLC members where the LLC (entity level) is doing business in California. The Original 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. For taxable nexus purposes (i.e. “doing business”), the FTB interpreted these “general partnership principles” (not defined) to mean that the administration or day-to-day business activity (i.e. member-managed v. manager-managed) is irrelevant to the question of whether an outstate LLC member is doing business in California for California tax purposes.
The Swart Case
The Original Ruling was issued prior to the taxpayer victory at the California Appellate Court in Swart Enterprises, Inc. v. FTB case (Cal. Ct. App., 5th Dist., No. F070922). In the Swart case, the California Appellate Court ruled in favor of the taxpayer, and in its opinion explained that:
- The administration or business activities of a flowthrough entity is directly relevant to the determination of whether outstate members of an LLC with ties to California are actually “doing business” in California.
- Where the interest of an outstate member of a LLC doing business in California participates in that LLC for primarily investment purposes (i.e. passive) and is not involved in the actual management of the LLC, not enough connection (i.e. nexus) exists with California for purposes of “doing business” and paying California’s minimum fee of $800.
- The Swart court’s treatment of outstate members of an LLC is consistent with existing authority as articulated in the State Board of Equalization case, Amman & Schmid Finance (No. 96-SBE-008), dealing with S Corps.
- The Swart court recognized the small percentage of ownership in the LLC by Swart (.02%) as a factor in its decision, but did not set forth any specific ownership percentage as a threshold test for “doing business.”
FTB Legal Notice 2017
Subsequent to the Swart ruling, several taxpayers initiated refund claims based on the Appellate Court’s opinion. In response, the FTB issued guidance on its interpretation of the Swart result in FTB Notice 2017-01. Under 2017-01, the FTB informed taxpayers that for purposes of filing refund claims based on the Swart ruling, taxpayers were required to articulate how their own facts match those of Swart. Subsequent informal guidance issued from the FTB (FTB Tax News, March 2018, and the FTB’s website) took this requirement further. According to FTB informal guidance, outstate LLC members filing a refund claim or claiming immunity under Swart must not exceed a 0.2% ownership percentage in an LLC doing business in California, even though this was not articulated as a requirement by the Appellate Court.
FTB Legal Ruling 2018-01
Subsequent to its issuance of Legal Notice 2017-01, and additional informal guidance published in its FTB Tax News (March, 2018), the FTB has modified the Original Ruling to incorporate its interpretation of the Swart result, specifically relating to the relevance of the distinction between “manager-managed” LLCs and “member-managed” LLCs.
The FTB’s first modification addresses a paragraph that explains its position in the Original Ruling that the distinction between member-managed and manager-managed LLCs was irrelevant to the determination of taxable nexus. As the California Appellate Court in Swart corrected this interpretation, such references have been removed. In its place, 2018-01 states:
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. Thus, if an LLC classified as a partnership for tax purposes is “doing business” in California under Section 23101, the members of the LLC are themselves generally considered to be “doing business” in California.
The FTB’s second modification also eliminates references to its original member-managed / manager-managed analysis, and references the Swart decision only to the extent that it provides a narrow exception in “limited circumstances.” In modifying the Original Ruling this way, the FTB appears to be continuing in its attempt to minimize the effect of the Swart decision as (1) it applies a very broad concept of “general partnership principles” to assess outstate members with California tax (notably the “general partnership principles” phrase is not defined); and (2) it takes the position that the taxability outstate LLC members of an LLC doing business are by (the FTB’s) definition, almost per se taxable, and that the Swart result can only provide relief in very “limited circumstances.” This is another way of articulating the FTB’s position, not supported by the Swart case, that only outstate LLC members whose facts exactly match those of Swart can find relief under Swart.
Next Steps: It is unclear whether the FTB’s modification of the Original Ruling dates to its original issuance in 2014. In spite of the FTB’s informal guidance, neither the Swart case or Letter Ruling 2018-01 addresses how much above the 0.2% interest in the LLC remains protected from “doing business” in California. The FTB currently takes the position that LLC members filing qualifying refund claims under Swart must be at or under the 0.2% ownership threshold. Consistent with this approach, in 2018-01, the FTB comments on the applicable example from the Original Ruling (finding an outstate member to be “doing business” in California) by saying: “Please note that Member J’s 15 percent membership in LLC greatly exceeds the taxpayer’s 0.2 membership interest in the Swart Court of Appeal decision.” While taxpayers and their advisors will likely continue to argue that even a 15% membership interest on its own is not sufficient for “doing business” under the binding Swart decision, taxpayers must assess their client’s factual situation carefully in relation to the Swart facts to greater understand a potential response by the FTB during refund claim processing, audits, or the voluntary disclosure (VDA) process.