The California Office of Tax Appeals (OTA) recently ruled that an out-of-state member that owned a 50% interest in a limited liability company (LLC) doing business in California was also considered as doing business in California.
This precedential opinion follows two prior decisions where the OTA ruled that LLC members owning nominal interests in California LLCs were not considered as doing business in California. It is, however, important to understand that the limits on the “doing business” inquiry presented by the recent OTA decisions do not apply if the member has independently exceeded California’s bright-line “factor presence” sales, property, or payroll threshold in effect for that particular tax year. For the 2019 tax year, the “factor presence” thresholds, which are indexed to inflation, are:
- Sales of $601,967;
- Property of $60,197; or
- Payroll of $60,197
Evolution of California Law
An LLC “doing business” in California is required to file and pay the annual minimum franchise tax of $800 in addition to California’s “LLC fee.” California has two alternative tests to determine whether an entity is “doing business.” The first test defines “doing business” as actively engaging in any transaction for the purpose of financial or pecuniary gain or profit. The second test defines “doing business” as:
- Being organized or domiciled in California;
- Sales exceeding $500,000 or 25% of total sales;
- Property exceeding $50,000 or 25% of total property; or
- Payroll exceeding $50,000 or 25% of total payroll.
A 2017 California court case held that an out-of-state member that held a 0.2% non-managing interest in a manager-managed LLC that was an investment fund in California was not “doing business” in California simply because of that member’s interest in the LLC. The court reasoned that the member was not “doing business” in California because it had no interest in specific property of the LLC, was not personally liable for the LLC’s obligations, played no role in the LLC’s management, and had no right to act as an agent for the LLC or bind the LLC in any way. Effectively, the court found that the taxpayer was more akin to a limited partner than a general partner, and Californian law is clear that the doing business status of a limited partnership is not attributed to a partnership’s limited partners.
In a 2018 non-precedential case before the OTA, an out-of-state LLC member with a 25% interest successfully argued that it was not “doing business” in California, using the 2017 case as a template. Even though the out-of-state member held a 25% interest in the California LLC, the OTA determined it was a non-managing member minority interest, which had no power or authority to participate in the LLC’s management or operations.
In an OTA opinion that became precedential in October 2019, an out-of-state member held between a 1.12-percent and 4.75-percent ownership interest in the LLC that was doing business in California during the tax years at issue. The OTA ruled that, while ownership percentages may be a factor in a California “doing business” determination, they are not necessarily dispositive. It is also necessary to conduct a fact-intensive inquiry into the relationship between the out-of-state member and the California LLC. The analysis includes whether the out-of-state member holds a non-managing interest and whether the out-of-state member is actively involved in the business activities of the California LLC.
The OTA issued another opinion in 2019, this time regarding whether an out-of-state member that had a 50% interest in the California LLC. The court determined that the out-of-state member was “doing business” in California since it was actively engaging in a transaction for the purpose of financial or pecuniary gain or profit. Additionally, the out-of-state member did not show that it was not a managing member of the California LLC. Since it held a 50% ownership in the California LLC, the out-of-state member had significant control over the activities of the California LLC. Although the out-of-state member’s interest was not a controlling interest, no other member had a larger interest, so the out-of-state member could have presumably blocked the California LLC from taking action that it disagreed with. Ultimately the out-of-state member did not satisfy its burden of proving that it lacked the power or authority, directly or indirectly, to participate in the California LLC’s management or operations.
The California OTA has now provided a limited road map to determine when an out-of-state member with less than a 50% ownership interest in a California LLC is considered doing business in California. Further, the 2019 opinion also sets forth some of the criteria to apply when an out-of-state member with a 50% or more interest in a California LLC could meet its burden of proving that it is not doing business in California. Nonetheless, the OTA decisions are also clear that it is a case-by-case factual determination.
- California income and franchise tax is imposed on an out-of-state member in a California LLC if the member independently exceeds certain bright-line factor-presence standards. If the out-of-state member exceeds any of those thresholds, then the “doing business” analysis under OTA’s decisions is inapplicable.
- Determinations of whether owning an interest in an LLC “doing business” in California creates a filing requirement for the member, including an $800 minimum tax and LLC fee liability, and should be evaluated on a case-by-case basis, using the factors identified by the OTA is its recent decisions.
- The reasoning of the OTA in the decisions addressed in this alert may also be applied to out-of-state limited partners with interests in limited partnerships doing business in California.