Existing law, law imposes a minimum franchise tax of $800, except as provided, on every corporation incorporated in this state, qualified to transact intrastate business in this state, or doing business, as defined, in this state, and an annual tax in an amount equal to the minimum franchise tax on every limited liability company registered, qualified to transact business, or doing business in this state, as specified. Existing law provides that certain corporations, the activities of which are limited to the receipt and disbursement of dividends and interest on securities, are not considered as doing business in this state. Existing law requires every limited liability company subject to that annual tax to pay annually to this state a fee equal to specified amounts based upon total income from all sources attributable to this state. Existing law requires every partnership to file a return that includes specified information, verified by a written declaration made under the penalty of perjury and signed by one of the partners, within a specified time period.

This bill would take effect immediately as a tax levy.

Existing law, imposes a minimum franchise tax of $800, except as provided, on every corporation incorporated in this state, qualified to transact intrastate business in this state, or doing business, as defined, in this state, and an annual tax in an amount equal to the minimum franchise tax on every limited partnership, limited liability partnership, and limited liability company registered, qualified to transact business, or doing business in this state, as specified. Existing law provides that certain corporations, the activities of which are limited to the receipt and disbursement of dividends and interest on securities, are not considered as doing business in this state.

Existing law, imposes a minimum franchise tax of $800, except as provided, on every corporation incorporated in this state, qualified to transact intrastate business in this state, or doing business in this state, and an annual tax in an amount equal to the minimum franchise tax on every limited partnership, limited liability partnership, and limited liability company registered, qualified to transact business, or doing business in this state, as specified.

This bill would make nonsubstantive changes to the provision imposing an annual tax on limited liability companies.

Date of Hearing: May 18, 2015

ASSEMBLY COMMITTEE ON REVENUE AND TAXATION

Philip Ting, Chair

ABPCA Bill Id:AB 799

Author:(Travis Allen) – As Amended Ver:March 26, 2015

Majority vote. Fiscal committee. Tax levy.

SUBJECT: Income taxes: annual tax: limited liability company

SUMMARY: Provides that a limited liability company (LLC) classified as a holding company is not an LLC doing business in California. Specifically, this bill:

1. Provides that an LLC holding or organized to hold stock or bonds of any other corporation or corporations, and not trading in stock or bonds or other securities held, and engaged in no activities other than the receipt and disbursement of dividends from stock or interest from bonds, is not an LLC doing business in this State.

2. Provides that an LLC holding or organized to hold stock or bonds of any other corporation or corporations, and not trading in stock or bonds or other securities held, and engaged in no activities other than the receipt and disbursement of dividends from stock or interest from bonds, is not an LLC for purposes of the annual tax and fee imposed on an LLC.

3. Expands the activities that would not constitute doing business in the State by adding those described in Corporations Code Section 191 (c).

4. Takes effect immediately as a tax levy.

EXISTING LAW:

1. Provides that a corporation is not doing business in the state under certain conditions. This exemption is provided when the corporation is holding or organized to hold stock or bonds of any other corporation or corporations, and not trading in stock or bonds or securities held, and engages in no activities other than the receipt and disbursement of dividends from stock or interest from bonds.

2. Provides that “doing business” for income and franchise tax purposes means either of the following:

1. Actively engaging in any transaction for the purpose of financial or pecuniary gain or profit; or,

2. Sales of the taxpayer within the state exceed the lessor of $500,000 or 25% of the taxpayer’s total sales. Sales of the taxpayer include sale by an agent or independent contractor of the taxpayer;

3. The real property and tangible personal property of the taxpayer in this state exceed the lesser of $50,000 or 25% of the taxpayer’s total real property and tangible personal property;

4. The amount paid in this state by the taxpayer for compensation exceeds the lesser of $50,000 or 25% of the taxpayer’s total real property and tangible personal property; and,

5. The amount paid in this state for compensation exceeds the lessor of $50,000 or 25% of the total compensation paid by the taxpayer.

3. Imposes franchise tax on all corporations doing business in California equal to 8.84% of the taxable income attributable to California. A minimum franchise tax of $800 is imposed on all corporations that are incorporated under the laws of California, qualified to transact intrastate business in California, or are doing business in California. Taxpayers must pay the minimum franchise tax only if it is more than their regular franchise tax liability.¹

4. Provides exceptions with respect to imposition of the minimum franchise tax. For instance, credit unions and nonprofit organizations are not subject to the minimum franchise tax and a corporation is not subject to the minimum franchise tax for its first taxable year. However, even though a corporation is not subject to the minimum tax in its first taxable year, it will be subject to franchise tax in its first taxable year based on its taxable income.

5. Provides that LPs, LLPs, and LLCs that are doing business in California, registered or qualified to do business in California, or formed in this state, are subject to annual tax in an amount equal to the minimum franchise tax, currently set at $800. These entities (known as 'pass-through entities') are not subject to any tax based on taxable income. Rather, the items of income, gain, loss, deduction and credit are passed-through to the owners and reported on their respective income or franchise tax returns.

6. Provides that real estate mortgage investment conduits (REMICs) and financial asset securitization investment trusts (FASITs) are subject to and are required to pay the minimum franchise tax. Regulated investment companies (RICs) and real estate investment trusts (REITs) organized as corporations are also subject to and are required to pay the minimum franchise tax. RICs, REITs, REMICs, and FASITs are entities authorized by the federal government for special tax treatment. California conforms in large part to federal tax provisions but subjects each entity to payment of the annual minimum tax.

7. Provides that LLCs and certain small corporations, solely owned by a deployed member of the United States (U.S.) Armed Forces, are exempted until January 1, 2018, from the $800 annual tax and minimum franchise tax.

FISCAL EFFECT: The Franchise Tax Board (FTB) “estimated that approximately $25 million in minimum franchise tax was paid by corporations that are not registered with the Secretary of State. It was assumed that half of these taxpayers would be exempt from tax under the provisions of this bill. It was further assumed that there would be an equal amount of LLCs that would be exempt from paying the annual tax and fee. It is unknown how many of the corporate taxpayers affected currently pay more than the minimum tax or how many more entities would be able to restructure their operations to take advantage of this exemption. It was assumed that these factors would increase the revenue loss from this bill by 60 percent to approximately $40 million per year”

COMMENTS:

1. Author’s Statement. The author has provided the following statement in support of this bill:

AB 799 would clearly define Investment LLC’s in California State Law and amend existing language to include LLC’s created solely to hold investments in existing tax standards relating to “doing business” in California.

2. Minimum Tax. The minimum franchise tax, the annual tax, and annual fee were enacted to ensure that all corporations and LLCs pay at least a minimum amount of tax for the privilege of conducting business in California, regardless of the businesses income or loss. Thus, the minimum tax is not an "income tax", but rather it is a tax on the right to exercise the powers granted to a corporation conducting business in California. Even when a business earns no income, it still receives the benefits of its corporate status, including the limited liability protection under the laws of this state.

3. What does this bill do? This bill would specify that and LLC holding or organized to hold stock or bonds of any other corporation or corporations, and not trading in stock or bonds or other securities held, and engaged in no activities other than the receipt and disbursement of dividends from stock or interest from bonds, is not an LLC doing business in this State. As such, an LLC that is not doing business in the State is not subject to the annual tax or the annual fee.

4. Purpose of the Bill: According to the author's office, LLCs can be used to pool funds together from individual investors, known as "angel investors," for funding small, start-up companies. The imposition of the annual tax, however, impedes many investors from forming an investment LLC. This is especially true for pooled funds that are less than $250,000. Because angel investors typically have to wait about 10 years before start-up companies become profitable, an LLC must pay the annual tax for each of those 10 years, which would be $8,000. If pooled funds are $250,000 and the partners pay $8,000 over the course of 10 years, the LLC would have to withhold about 3.2% of the funds to pay for the minimum franchise tax. That percentage would increase or decrease depending on the amount of pooled funds over the same 10-year period of time. By exempting certain investment LLCs from the definition of “doing business,” this bill hopes to encourage angel investors to invest in new start-up companies.

It should be noted that in order to invest in many start-up companies of this kind, a person is generally required to be an “accredited investor.” The Federal Securities Act, Regulation D, defines an "accredited investor" as an individual who has a net worth of at least $1 million, not including the value of his/her primary residence, or hs income at least $200,000 each year for the last two years (or $300,000 together with his/her spouse if married) and has the expectation to make the same amount this year. As such, this bill applies to a small section of the population.

5. Is this Bill Needed? As a way of getting around the $800 impediment, individual investors could choose to form a general partnership, which is not subject to annual tax. Supporters of this bill, however, believe that forming a general partnership is a non-starter because there may be situations where the underlying business start-up sues its own investors. If the holding entity is formed as a general partnership, individual owners may also be personally liable for the actions of other partners, potentially creating litigation among the members. Pooling the funds together under an LLC would remove a lot of the liability impeding investment.

6. LLCs. In general, LLCs provide limited liability, avoidance of double taxation, flexibility of income distribution, simplicity of formation and procedures, and no restrictions on ownership. Generally, members of an LLC are not liable for the debts, liabilities, or obligations of the firm. (Jonathan Macey, The Limited Liability Company: Lessons for Corporate Law, Washington University Law Review, Vol. 73, Issue 2, 1995.) Members are also not liable for tort or contractual obligations of other members of the firm even if incurred during the course of the firm’s business. (Id.) Before the advent of LLCs, angel investors would have likely formed as a partnership, if at all, allowing creditors and tort victims to go after the personal assets of the partners.

As a public policy, the goal of providing limited liability appears to be the state’s need to promote investment by transferring risk from investors to creditors. Providing limited liability to small businesses, presumably with limited assets, may cause owners of the LLC to only consider those marginal costs and benefits associated with the investments that they will internalize. In other words, “limited liability allows investors to pursue extremely risky projects and to profit from the pursuit of a ‘heads I win; tails you lose’ strategy of project finance.” (Id.) The idea that people will take on greater risk because someone else will pay for the costs is known as “moral hazard.” (Id.) This tends to occur when businesses are shielded from liability, but also when businesses lack financial resources to provide adequate compensation to creditors. (Id.) Clearly, as noted by supporters of this bill, angel investors are unlikely to pool funds without the protection of limited liability. Investors are also unwilling to pool funds without the elimination of the $800 minimum franchise tax. In essence, this bill will provide angel investors the benefits of limited liability free of charge.

7. Recent Litigation: A California Superior Court recently issued a ruling in favor of the taxpayer in Swart Enterprises, Inc. v. California Franchise Tax Board (Case Number 13CECG02171). The court concluded that an Iowa corporation, whose only connection to California was its passive membership in the manager-managed California LLC, was not “doing business” in California and was therefore not subject to the $800 minimum franchise tax under Revenue and Taxation Code (R&TC) Section 23151. The taxpayer in this case held a 0.2% ownership interest in Cypress Equipment Fund (Fund), an LLC taxed as a partnership for income tax purposes. The LLC was managed by Cypress Equipment Management Corporation, a management corporation with complete and exclusive authority in management and control of the Fund. The operating agreement provides that members other than the manager were prohibited from taking part in the control or operation of the Fund.

R&TC Section 23101 defines “doing business” as “actively engaging in any transaction for the purpose of financial or pecuniary gain or profit.” FTB argued that Swart is subject to the $800 minimum franchise tax because “doing business” includes the purchasing and selling of securities in California, Swart had purchased an interest in an LLC, and an interest in an LLC constitutes a security. The court disagreed in FTB’s analysis. First, the court noted that FTB was assessing the minimum franchise tax for the current tax year and Swart had purchased an interest in the Fund a few years ago. Therefore, Swart’s only connection to California for the relevant tax year was its passive holding of investment in the Fund. Second, the court noted that not every investment of a security falls within the meaning of “doing business.” Specifically, “the mere receipt of dividends and interest by a corporation and the distribution of such income to its shareholders does not constitute ‘doing business.²’ ” According to the court, this supported the finding that passively holding an investment in an LLC made in a prior year does not constitute active participation in a transaction for the current taxable year. Finally, the court explained that Swart was not doing business in the state because Swart had no interest in specific property of the Fund, was not personally liable for the Fund’s obligations, played no role in the Fund’s management, had no right to manage the Fund, and could not act as an agent for the Fund or bind the Fund.

In light of Swart, it appears that certain investment LLCs may not be subject to the annual tax. As noted above, in order to be “doing business” a company has to be actively engaged in transactions for the purpose of financial or pecuniary gain or profit but the mere receipt of dividends and interest by a corporation and the distribution of income to its shareholders does not constitute “doing business.” As provided by the author and supporters of this bill, an investment LLC does nothing more than hold an interest in a corporation. In many cases, because the company is a start-up, dividends and funds are not even passed through to the LLC for the first few years of the start-up’s existence. More importantly, as explained in Swart, the right to manage and exercise control over the underlying company is an important factor in determining the whether an investment LLC is “doing business” for purposes of the annual tax. Although additional information is needed to determine whether investment LLCs have control over the underlying entity, from conversations with supporters, it appears that such authority is not granted. As such, investment LLCs are likely not doing business in California, and are therefore not subject to the annual tax.

8. Ongoing Litigation: The Swart decision was issued by a trial court; and although the decision provides some guidance, it is not binding on FTB and is not citable as precedent by other taxpayers. The FTB recently appealed the decision to the Court of Appeal. Depending on how the Court of Appeal rules, additional guidance with respect to the definition of “doing business” is likely forthcoming. As such, the Committee may wish to consider whether it is appropriate to modify an existing definition that may be affected by pending litigation.

REGISTERED SUPPORT / OPPOSITION:

Support

None on file

Opposition

None on file

Analysis Prepared by: Carlos Anguiano / REV. & TAX. / (916) 319-2098