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Foreign LLCs with California Managing Members Risk Taxation in California
California resident-owned businesses that operate as foreign (non-California) LLC may need to reconsider their choice of entity or take steps to carefully structure their business model and operations. The California Board of Equalization (“BOE”) has ruled in a pair of recent agency decisions that foreign LLCs with managing members who are California residents are subject to the $800 annual California LLC tax pursuant to California Revenue and Taxation Code (“Rev. & Tax. Code”) section 17941.
The decisions are based on the interpretation and application of the statutory language “actively engaging in any transaction for the purpose of financial or pecuniary gain or profit,” which defines “doing business” for purposes of the tax. Both decisions reasoned that when California residents are managing an LLC's operations and engage in some activity supporting or advancing the LLC's business these activities satisfy “doing business” and trigger the minimum LLC tax.
The Statutory Framework
California Rev. & Tax. Code Section 17941 imposes an $800 annual tax on every LLC that is “doing business” in the state of California . This fee is in addition to the graduated LLC fee based on gross income. The Franchise Tax Board (“FTB”) has also asserted that foreign LLCs doing business in California must also pay the graduated LLC fee based on the LLC's gross income from all sources. Though recent constitutional challenges have held that the graduated fee is actually an unconstitutional and unapportioned “tax” on foreign LLCs, no similar challenge has been advanced in the state courts relating to the minimum LLC tax.
The Agency Decisions
The BOE handles appeals from determinations by the FTB relating to taxation. Most of the BOE's decisions are “unpublished” and therefore do not carry the full precedential effect of court cases. However, these decisions offer valuable insights as to how the FTB approaches taxation issues as well as to whether the BOE is willing to support and enforce those approaches.
In Re: Mockingbird Partners, LLC : Mockingbird Partners, LLC (“Mockingbird”) was formed in 2000 in Montana for the purpose of engaging in real estate development, related activities, and “any other lawful business purpose.” Mockingbird was a member-managed LLC and its principal asset was a Montana rental property it acquired in 2001 that was managed by a Montana property management company. In 2002, one California resident member had lent Mockingbird money evidenced by a note. Mockingbird self-assessed the annual $800 fee for both 2001 and 2002, but then filed amended returns seeking a refund for each year. After the FTB denied the refund claims, Mockingbird filed its appeal.
The BOE denied Mockingbird's appeal, noting that under California law every member of a member-managed LLC is an agent of the LLC. Relying on this relationship, the BOE next inferred that the members of the LLC who lived in California “must have” engaged in activities related to the original acquisition of the Montana rental property while in California. Though perhaps not central to the decision, the fact that the LLC was authorized to open a bank account in California and that the California members had signing privileges was also referenced by the BOE.
In Re: International Health Institute, LLC : International Health Institute, LLC (“IHI”) formed in Nevada in 1999. IHI did not qualify to do business in California and claimed to be organized solely for the purpose of holding "passive investments," including owning interests in other LLCs and partnerships, some of which engaged in the business of investing in California rental and resale real estate. A 1999 California tax return was filed, listing a California address with the $800 minimum LLC tax being paid. In 2002, IHI sought a refund, arguing that it did no business in California.
The BOE denied IHI's appeal. Noting that the “only conceivable purpose for purchasing [interests in California LLCs or partnerships] is financial gain,” the BOE found those investment purchases sufficient to support a finding of doing business. However, the BOE went further and again applied the same “inferred in-state conduct” reasoning of the Mockingbird decision. The BOE concluded that the LLC had to be doing business in California because the sole member/manager was a California resident, and IHI failed to either allege or establish that “its sole member and manager left California whenever conducting the LLCs business.”
Important Issues to Consider
In the FTB's view not only will “doing business” be interpreted broadly to attach to any “active” conduct on the part of a California resident managing member, but residency may also be used to infer such activities, and apparently the LLC bears the burden of proving that these residents did not engage in any such conduct in California.
Whether the FTB's current approach will survive challenge beyond the BOE remains to be seen. As such, foreign LLCs with California resident members and managers are exposed to an uncertain risk of taxation under this tax regime. To be safe, foreign LLCs with California resident members and managers should be certain to document that they do not engage in any activity to further the business of the LLC from within California. Businesses that cannot do so may need to re-evaluate the risk/reward analysis for their business model and choice of entity or acknowledge a risk of taxation in California.
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