FRESNO, Calif. — A California appeals court has ruled that the
state is not legally authorized to attach its franchise tax on
out-of-state entities simply based on its investment in a
limited-liability company doing business in the state.
In rendering its verdict in Swart Enterprises Inc. v. Franchise
Tax Board, the Court of Appeal for the 5th Appellate District found
that the state’s $800 minimum franchise tax does not extend to the
Iowa-based company merely having an investment in the state-run
entity, according to a report
on JD Supra's website.
The ruling potentially opens the state up to the prospect of
having to repay millions in such tax refunds collected from other
out-of-state companies over the years.
“We probably will be seeing a lot of refund claims based on this
decision,” Douglas Schwartz, a partner and tax specialist with
Nossaman LLP and author of the JD Supra report, told the Northern
California Record. “The decision was somewhat anticipated,
but I expected that it would be a much narrower verdict.”
As it is, California now has two parallel taxes for corporations,
known as “franchise” and “income,” according to the JD Supra
The state seeks to impose the franchise tax on all businesses doing
business in the region and the income tax on all other corporations
found to be generating income from California-based entities.
With that, any company earning a profit in California must pay a
local tax and file a California return reporting that income.
In the Swart case, the fundamental argument revolved around the
question of what legally constitutes “doing business” for
purposes of satisfying the franchise tax requirement, the JD Supra
After investing at least $50,000 in local company Cypress
Equipment Fund XII LLC, Swart decided to challenge the legality of
the statute, arguing
that it had “no connection to the state other than its passive
interest in Cypress.”
Swart's officials also maintained they have never filed tax
returns in California because the company had no California
source of income.
Ultimately, the trial court sided with Swart, concluding
on cross-motions for summary judgment that the company was not “doing
business” in California and “the relationship between Cypress LLC
and Swart supports the conclusion Swart was a quintessential passive
investor,” with no say as it related to the regular operations of
the company or control of the Fund that supported it.
All that led the court to conclude that Swart’s interest in
Cypress amounted to that of a limited partner, which jurists found
does not constitute doing business in a specific locale or region.
The FTB could now petition to have the case heard by the
California Supreme Court, but there is no guarantee the state's high
court will agree to a relitigation of the issues in dispute.
“As broad as it is, this verdict opens the FTB up to being hit
with a lot of refund claims, so I would absolutely anticipate them
moving to be heard by the high court,” Schwartz said. “Beyond
that, you can never predict what the Supreme Court might do or if
they will even hear the case.”