Analysis: When are Out-of-State Investors “Doing Business” in California?
Evolving case law from the California Office of Tax Appeals (OTA) provides some clarity for determining when out-of-state investors are considered to be “doing business” in the state.
Out-of-state investors can be surprised to find that they are “doing business” in California and subject to state taxes through their indirect investments in California property. Investors in California pass-through entities are often required to pay the state’s $800 annual pass-through entity tax despite having only limited ownership interests in the California businesses. Evolving case law from the California Office of Tax Appeals (OTA) provides some clarity for determining when these out-of-state investors are considered to be “doing business” in the state.
Annual Tax on Corporations and Pass-Through Entities
California imposes an annual fee of $800 on limited partnerships (LPs), limited liability partnerships (LLPs), and limited liabilities companies (LLCs) that are organized under California laws, registered to do business in California, or “doing business” in the state. (Section 23153 of the California Revenue and Taxation Code (R&TC) imposes the $800 minimum franchise tax on corporations, and Section 17941 of the R&TC applies Section 23153 to LLCs in addition to an LLC fee).
The “doing business” element widens the reach of the tax to apply to businesses that are not organized or registered under California law. R&TC Section 23101 provides two alternative standards for determining whether an entity is “doing business” in California.
Standards for “Doing Business” in California
Section 23101(a) provides the general rule under which a company is “doing business” in the state if it is “actively engaging in any transaction for the purpose of financial or pecuniary gain or profit.” Section 23101(b) adds four factor presence nexus standards for “doing business” for taxable years beginning on or after January 1, 2011: (1) the company is organized or domiciled in California; (2) its sales in California for the taxable year exceed the lesser of $500,000 or 25 percent of its total sales; (3) its real property and tangible personal property in California exceed the lesser of $50,000 or 25 percent of its total real property and tangible property; or (4) the compensation it paid in California exceeds the lesser of $50,000 or 25 percent of the its total compensation paid. (The California Franchise Tax Board (FTB) adjusts the threshold amounts for inflation.) The FTB’s broad interpretation of Section 23101(a), and the factor presence nexus standards in Section 23101(b), have led to some confusion about the “doing business” standard among taxpayers with small, passive interests in pass-through entities.
Generally, whether an out-of-state owner is “doing business” under Section 23101(a) depends on its degree of control over the in-state business. This determination is not made based on an ownership share only, but also depends on the relationship between the out-of-state owner and the in-state entity. Under the Section 23101(b) factor presence nexus standards, an out-of-state owner is doing business if it meets the “bright-line” ownership thresholds under the statute through its pro rata or distributive shares of the entities. This “bright-line” threshold applies no matter how small the ownership share or the degree of control over the entity. These general rules are derived from several recent OTA decisions.
Degree of Control over a California Business under Section 23101(a)
In Swart Enterprises, Inc. v. Franchise Tax Board, a California court of appeals held that an out-of-state corporation whose only connection with California was a 0.2 percent ownership interest in a manager-managed (rather than a member-managed) California LLC investment fund was not “doing business” in the state. The court held that “passively holding a 0.2 percent ownership interest, with no right of control over the business affairs of the LLC, does not constitute ‘doing business’ in California” under Section 23101(a).
While the FTB interpreted the decision in Notice 2017-01 as a “bright-line” threshold of 0.2 percent for a passive interest in a California LLC, the OTA rejected that interpretation in the 2019 case In the Matter of the Appeal of Jali LLC, which involved an out-of-state LLC with an interest in a manager-managed California LLC of 4.75 percent, 3.19 percent, and 1.12 percent in different years. The taxpayer was not personally liable for any debt, obligation, or liability of the LLC; had no power to participate in its management, or bind or act on behalf of it in any way; and had no interest in any specific property of the LLC. The OTA applied the Swart analysis and decided that the taxpayer was not doing business in California due to its lack of control over the in-state LLC. The OTA stated that “[w]hile ownership percentages may be a factor in nexus determinations, it is not necessarily dispositive, as one must still generally conduct a fact-intensive inquiry into the relationship between the out-of-state member and the in-state LLC.”
Furthering the emphasis on degree of control, the OTA found in Wright Capital Holdings, LLC, another case that a disregarded entity that was a single-member, out-of-state LLC with a 50 percent interest in a California LLC was doing business in the state. The OTA noted that although 50 percent was not a controlling interest, it was the largest interest in the LLC and the taxpayer would have had “significant authority over the activities” of the entity.
“Bright-line” Ownership Thresholds in a California Business under Section 23101(b)
Most recently, the OTA established that the Section 23101(b) factor presence nexus standards established “bright-line” ownership thresholds for “doing business” no matter how small a member’s ownership share and without distinction between active versus passive ownership interests. In the 2021 case In the Matter of the Consolidated Appeals of: La Hotel Investments #3, LLC and La Hotel Investments #2, LLC, a Louisiana LLC owned a 5.41 percent interest in a California LLC that owned $25.3 million in buildings and other depreciable assets in California. A second Louisiana LLC owned a 2.56 percent interest in one year and a 5.13 percent in two additional years in a different California LLC that owned $51.4 million in land, buildings, and depreciable assets in California. Considering the owners’ pro rata or distributive share of the entities under Section 23101(d), the OTA found that it was “doing business” in California because its distributive share of its investment in California property through a lower tier-company exceeded the $50,000 statutory threshold under Section 23101(b)(3).
What Can Out-of-State Members in California LLCs Do?
Out-of-state taxpayers with an ownership interest in a California LLC should understand these cases to determine whether they are required to file a California tax return and pay California taxes, or whether they may qualify for a refund. They should also continue to monitor these OTA decisions as these nexus rules continue to develop.