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 report. 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 report said.

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.”

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