California Court Limits Application of State’s Franchise Tax on Certain Out-of-State Businesses by Karen A. Lake, CPA

Posted on June 29, 2017 by Karen Lake

A recent decision by the California Superior Court limits the economic nexus the state may assert over certain pass-through entities that have a presence in the state and provides qualifying entities with an opportunity to file a claim for a refund of a previously paid California franchise tax.


The matter of Swart Enterprises, Inc. v. California Franchise Tax Board centered around the interpretation of Section 23101 of California’s Revenue and Tax Code, which defines the term “doing business” within the state as “actively engaging in any transactions for the purpose of financial or pecuniary gain or profit.”


In 2010, the California Franchise Tax Board applied this definition and franchise tax treatment broadly to Swart Enterprises, a family-owned corporation based in Iowa that lacks a physical presence and any sales activity in California but does own a 0.2 percent membership interest in a multi-member, manager-managed limited liability company (LLC) investment fund based in the state.  In its 2017 decision to award a tax refund to Swart for $1,106.72 in previously paid franchise taxes, fees and penalties, the court made a distinction between taxpayers who are general partners or managing partners of LLCs and those who hold passive, non-managing interest and lack the right to manage or control the entities’ decision making processes. The court noted that just because an LLC elects partnership treatment for federal tax purposes does not mean that the LLC members should be treated as general partners actively engaged in the business. Yet, depending on the specific facts and circumstances of a California LLCs structure, its non-managing members may still have a requirement to file state tax returns and report their distributive share of source income from the LLC.


The California Franchise Tax Board is narrowing apply the Court of Appeal’s decision in Swart to companies that have identical fact patterns as Swart Enterprises. These fact pattern are summarized as the following:

1.     Company has .002 or less membership interest in a manager-managed LLC that is doing business in California

2.     Company acquired its .002 or less membership interest in manager-managed LLC after the original members made the decision to be manager-managed,

3.     Company’s sole connection to California is the above interest in a California LLC.


Entities that previously filed and paid California corporate franchise taxes on a passive, minority investments in LLCs based in the state should consider filing a protective claim for a tax refund. Moreover, passive investors “doing business” through an LLC in any state should consider how the Swart decision may carry over to those states’ nexus assertions.


About the Author: Karen A. Lake, CPA, is an associate director of Tax Services with Berkowitz Pollack Brant, where she helps individuals, businesses and non-profit entities navigate complex federal, state and local taxes, credits and incentives. A state and local tax expert, she can be reached at the Miami CPA firm’s office at (305) 379-7000 or via email at