THE SWART CASE, AND WHAT IT MEANS TO THE OUT-OF-STATE INVESTOR
Whether sifting from mineral remnants in a pan or receiving stock certificates from a Silicon Valley company – California has been the beacon of investment and good fortune throughout our nation’s history. However, as Benjamin Franklin said, “…in this world nothing can be said to be certain, except death and taxes.” Accordingly, the California Franchise Tax Board has constantly sought to include out-of-state investors as “actively doing business” in California; therefore, making investors subject to a minimum annual franchise tax of $800. Fortunately for out-of-state investors, a recent appellate court decision limited who is required to pay this tax. Although this decision may foster a collective sigh of relief among out-of-state investors, the investor should tread lightly when seeking investment opportunities in the Golden State.
In 2014, the Franchise Tax Board (FTB) ruled that members of a Limited Liability Company (LLC) – when the LLC is treated as a partnership for tax purposes – are “doing business” in California, since members have the general right to participate in the management of the business. This ruling was concerning for out-of-state investors participating in equity investments – where the investor becomes a member of an LLC in exchange for the investment. This meant a passive, out-of-state investor would be subject to the $800 FTB tax. With this broad definition of “doing business”, the FTB could levy taxes on non-California investors, despite the extent of the investors’ interest in the LLC and/or the amount of the investment.
However, last week the California Court of Appeal for the Fifth District significantly narrowed the FTB’s position. In Swart Enterprises, Inc. v. California Franchise Tax Board, the court held that a taxpayer passively holding a mere 0.2 percent interest in a California LLC was not “doing business” in California; therefore, was not subject to the $800 tax. The court stated that a passive owner who is not personally liable for the obligations of an LLC, has no right to act on behalf of the LLC, and has no ability to participate in the management and control of the LLC, isn’t “doing business” in California under the Revenue and Taxation Code. While this holding discharged Swart’s obligation to pay the annual tax, out-of-state investors should still proceed with caution.
California has always been, and will always be, a good investment. However, with the highest income tax rate in the country, the ninth highest corporate income tax rate in the country, and the tenth highest sales tax in the country, California is definitely a ‘pay-to-play’ state. Despite a published court opinion – which may alleviate tax concerns for out-of-state investors and provide precedent – out-of-state taxpayers should still be cautious when investing in California. Nevertheless, the Swart decision is a victory for all out-of-state investors who seek to invest in our great state, as well as for Californians who seek investors. While taxes and death are a certainty, it is always preferable to minimize the risk and impact of both.
By Robert Prine, Law Clerk
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This post is for informational purposes only, and merely recites the general rules of the road. Lots of legal rules have exceptions, however, and every case is unique. Never rely solely on a blog post in evaluating your situation — always contact an attorney when your legal rights and obligations are on the line.