Investors Fight California Tax Bills Tied to Tiny Stakes in LLCs

Feb. 26, 2020, 5:30 PM

Passive investors in thousands of limited liability companies want California to spare them from a state business tax after the U.S. Supreme Court declined to take up the issue.

With the court’s rejection of Arizona’s challenge to an $800 minimum franchise tax on out-of-state investors, the investors who see the tax as an overreach are shifting back to ongoing litigation on two fronts in California: administrative appeals to the Office of Tax Appeals and lawsuits in state court.

The Arizona investor who pushed Attorney General Mark Brnovich (R) to take the cause to the high court also isn’t giving up.

“I’m ready to pound the drums as best I can,” said Steve Snyder, who questions California’s authority to tax him as an out-of-state minority owner in an LLC. Snyder is chief executive officer of dietary supplement manufacturing company 21st Century Healthcare Inc.

The fights could end if the California Franchise Tax Board broadens its view of when investors owe tax based on whether they are active or passive, practitioners say. Without that guidance, investors may be discouraged from doing business in California.

“The FTB has to realize its aggressive approach needs to be revised,” said Carl Joseph of Ernst & Young LLP’s indirect and state and local tax practice.

The tax board won’t say how many investors nationally are facing tax bills, or whether it is considering a change in its guidance. A spokesman declined to comment, citing ongoing litigation. But Arizona estimated in its complaint to the Supreme Court that California has been assessing about 100,000 investors a year for 10 years, with 13,000 of those going to Arizonans who end up paying $10.6 million a year to California.

The investors are mostly individuals who elect to be treated as partners in the LLCs, but they can also be investment arms of corporations.

The FTB’s aggressive stance has kept some corporate clients from investing in California energy or real estate projects, said Carley Roberts, an attorney with Pillsbury Winthrop Shaw Pittman LLP in Sacramento.

Who is Doing Business?

At issue is whether the investors are doing business in California, or more specifically whether they are “actively engaging in any transaction for the purpose of financial or pecuniary gain or profit.”

The FTB is hinging its determinations that the investors owe California tax on an element of a 2017 appellate court ruling, Swart Enterprises v. FTB.

In that case, the court said an Iowa investor with a 0.2% interest in a California LLC wasn’t doing business in the state and didn’t owe the $800 tax. Swart’s small, passive holding wasn’t enough, the court said.

In court and administrative appeal filings since then, as well as in guidance to taxpayers, the FTB says Swart’s 0.2% ownership threshold is a bright line, and any LLC with a larger interest is doing business in the state. The tax board also argues taxpayers have options if they disagree: They can protest their assessments at the tax agency, appeal to the state tax appeals office, or go to court.

Deeper Analysis

But taxpayers argue the tax board is skipping deeper analysis into whether the investors are active or passive, as was the case in the Swart opinion. Several of them are exercising their options to fight the assessments.

Their argument got a boost in a recent, precedent-setting ruling from the appeals office in favor of Jali LLC. The company was managed by a Washington resident who held passive interests between 1.12% and 4.75% over five years in another LLC that was registered to do business in California.

A three-judge OTA panel rejected the tax board’s argument that a 0.2% ownership threshold is a new bright-line legal standard for distinguishing between an active and passive ownership interest in an LLC. Ownership percentages are a factor, but examination of the relationship between the out-of-state member and the in-state LLC is also necessary, the panel said.

The appeals office issued the ruling in July 2019 and it became precedential this month, meaning it can apply to similar cases.

Jali’s manager who brought the appeal didn’t respond to a request for comment.

The appeals office has also started setting an upper bound for doing business in the state, saying in another precedent-setting ruling in 2019 that a Georgia LLC holding a 50% interest in another LLC doing business in California failed to show it wasn’t managing the business and therefore owes state tax.

Further complicating the cases is a 2011 law that sets other thresholds for doing business in California, EY’s Joseph said. A company is automatically doing business in the state once its sales, property, or payroll exceed 25% of its totals, or total California sales exceed $601,967, a number indexed for inflation each year. This could also apply to passive investors with larger stakes in California LLCs.

“The FTB will attempt to apply both,” Joseph said, referring to its Swart rule or the 2011 law. “They’ll be happy to win on either one.”

Two Class Actions

It isn’t easy to resolve the tax assessments individually, especially from another state, Joseph said. The time and expense to protest, appeal, or sue may far outstrip the $800 tax bill, even when interest and penalties tally up to several thousand dollars.

That’s why investors are also seeking class status for two lawsuits being combined into one in state trial court in San Francisco. If they win class status they can sue collectively, putting more pressure on the tax board to change its approach, Amy Silverstein, an attorney with Silverstein & Pomerantz LP in San Francisco, said. She is representing the plaintiffs in both class actions and represented Swart.

The two class actions are led by a Texas LLC that owns part of an LLC that owns part of a third LLC that does business in California, and a New Jersey LLC that is a member of a manager-managed LLC based in San Francisco, according to court documents.

The tax board has so far declined to say how many investors could qualify as class members, Silverstein said. Most investors face an average tax bill of $2,000-$3,000 for each year at issue, and many are being assessed for multiple years. It could be at least six months before the court decides if they can proceed as a class.

Meanwhile, the administrative tax appeal rulings are chipping away at the FTB’s arguments, and the tax board should reconsider its position, Silverstein said.

“Maybe FTB could think about resolving the Swart class actions without everyone having to invest a decade and the corresponding amount of money,” Silverstein said.

—With assistance from Brenna Goth in Phoenix.

To contact the reporter on this story: Laura Mahoney in Sacramento, Calif. at lmahoney@bloomberglaw.com

To contact the editors responsible for this story: Jeff Harrington at jharrington@bloombergtax.com; Colleen Murphy at cmurphy@bloombergtax.com

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