California Franchise Tax Board – Aggressive Business Taxation

February 4, 2020

California is known for its sunny skies, sandy beaches, and high taxes. California’s state tax agency, the Franchise Tax Board, or FTB, is infamous for its aggressive tax collection tactics. In fact, the Franchise Tax Board not only taxes persons and business entities within the state, but the Franchise Tax Board will pursue taxes from out-of-state residents and businesses who do business with Californians or hold passive interests in California businesses, even if they’ve never stepped foot in California. 

The Bindley Case

Recently, in a California Office of Tax Appeals decision, an out-of-state sole proprietor who ran his business in Arizona, but had some clients in California, was subject to California’s income tax. In that case, In the Matter of Blair S. Bindley, the state’s Office of Tax Appeals stated that this case had precedential effect and essentially declared that the Franchise Tax Board could go after non-Californians too. In Bindley, Mr. Bindley was a screenplay writer in Arizona, who wrote screenplays for a few clients who were registered businesses in California, but Mr. Bindley performed all of his services in Arizona. Mr. Bindley never filed a California tax return. The Franchise Tax Board determined that Mr. Bindley collected $40,000 of income from these California businesses, and was therefore subject to the California tax rules for apportioning income. 

The Franchise Tax Board determined that whether a nonresident is subject to apportioning income depended on:

  • Whether the taxpayer is carrying on a trade or business in California, outside of California, or a combination thereof;
  • The type of entity conducting the business; and
  • Whether the business is unitary.

California’s tax regulations give little guidance as to what a unitary business is. In fact, the regulations only describe what is nota unitary business. In Bindley, the Appeals Board derived some sort of definition as “[a] unitary business, therefore, can be defined for purposes of Regulation section 17951-4 as a business, trade, or profession conducted both within and without the state, where the part conducted within the state and the part conducted without the state are not so separate and distinct from and unconnected to each other to be separate businesses, trades, or professions.” If a business is unitary, the Franchise Tax Board will look to the place where the benefit of the service was received. If that is unclear, California law provides rules to look at the contract between the parties and make a determination there. Based on the ruling in Bindley, the Franchise Tax Board can pursue sole proprietors who merely have customers in California, regardless of whether the services are performed outside of California and the sole proprietor has no other connection to California. 

Passive Minority Interest in LLCs

The Franchise Tax Board will pursue franchise taxes from businesses that are passive investors in California businesses. According to the Franchise Tax Board’s Legal Ruling 2014-01, if an LLC that chooses to be treated as a partnership for tax purposes, then the LLC and its members will be classified as “doing business” in California. The reasoning outlined in Legal Ruling 2014-01 explains that for businesses structured as partnerships, for tax purposes, the activities of the business are attributed to each partner. These businesses will be required to file a corporate tax return and pay the minimum $800 franchise tax. 

However, some relief was found under Swart Enterprises Inc. v. Franchise Tax Board. The Court of Appeals there found that an out-of-state, passive member of a manager-managed LLC holding a 0.2 percent ownership interest did not constitute “doing business” in California, and therefore, not subject to $800 franchise tax. The Swart Court emphasized that members in a manager-managed LLC were like limited partners in a limited partnership, and, like limited partners in a limited partnership, the business activities of the LLC could not be attributed to passive members of a manager-managed LLC. The Swart Court held that the analysis came down to was how much control the members had over the management of the LLC, and that such management powers were outlined in the operating agreement and articles of incorporation. 

Even with such a precedential opinion in favor of out-of-state members of a manager-managed LLC, the FTB interpreted the Swart Court’s ruling to create a bright-line between passive and active business activities in California. The FTB only looked to the 0.2 percent threshold to decide whether a member of a manager-managed LLC was a passive member who was not doing business in California. For all intents and purposes, any membership interest above the 0.2 percent bright-line meant that a member of a manager-managed LLC was doing business in California . 

Furthermore, in a precedential, subsequent holding In the Matter of the Appeal of Jali, LLC, the Office of Tax Appeals clarified that there was no bright-line threshold for a member of an LLC holding a 0.2 percent interest that distinguished whether a member held a passive or active business interest in an LLC, rather the Jali Court stressed that the SwartCourt clearly meant that whether a member of an LLC was doing business in California was grounded in the relationship between the out-of-state member and the in-state LLC. The Jali Court stated that the fact situation should be construed by the follow factors:

  1. Does the member have any interest in specific property of the in-state LLC;
  2. Is the member personally liable for the obligations of the in-state LLC;
  3. Does the member have the right to act on behalf of or bind the in-state LLC; and 
  4. Does the member have the ability to participate in the management and control of the in-state LLC?

Although the Jali holding confirms that an out-of-state investor holding a passive, minority interest in an LLC is not doing business in California, the Franchise Tax Board has not provided any guidance or regulations on the Jali holding. The Franchise Tax Board is known for being more aggressive than the IRS and less compromising in tax disputes. If an out-of-state business entity or person does not file a tax return, the Franchise Tax Board can theoretically come after the business forever because the statute of limitations never runs for auditing. If the business does file non-resident tax returns, the statute of limitations does run, and if after four years the Franchise Tax Board does not audit the business, the business is in the clear. Most people do not dispute paying the minimum franchise tax because of the high cost of fighting the Franchise Tax Board. 

Some businesses will pay the minimum franchise tax and appeal the tax payment on the grounds that they should not be subject to the franchise tax, but that too can be costly and time consuming, and most appeals fail. The Franchise Tax Board is known for its narrow interpretation or outright disregard for adverse judicial and administrative holdings, as indicated by the Franchise Tax Board’s narrow interpretation of the Swart holding. The Franchise Tax Board purportedly assesses more than 100,000 out-of-state companies per year, and that number will increase due to the Bindley holding.

Any business that does business with California clients or holds a minority interest in a California LLC should be mindful of any potential taxes that may be assessed by the Franchise Tax Board. 


Trang Pham

By

Trang grew up in the Dallas suburb of Grand Prairie Texas. For undergraduate studies, Trang attended the University of Texas at Arlington where she earned her Bachelor of Arts in Communication and Journalism. In 2014, Trang attended St. Mary’s University School of Law in San Antonio, Texas, where she earned her Juris Doctorate. During her time at St. Mary’s, Trang was a staff writer for The Scholar: St. Mary’s Law Review on Race and Social Justice, a law review focused on issues affecting marginalized communities. Prior to joining Pasha Law, Trang worked at CAPCO, where she gained experience in real estate compliance, banking, mortgages, and finance. At Pasha Law, Trang has experience in corporate governance, business law, mergers and acquisitions, and contract law.

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