The Long Arm of California’s Franchise Tax Board

December 12, 2020 |

Police Officer with whistle

In two recent decisions, both of which will be precedential, the California Office of Tax Appeals (OTA) ruled against taxpayers and in favor of the California Franchise Tax Board (FTB), as the FTB demonstrated its long reach when it comes to collecting taxes.

In its opinion in The Matter of the Appeal of Aroya Investments I, LLC, issued on July 7, 2020, the OTA held that an out-of-state limited liability company (LLC) was “doing business” in California, and therefore subject to the $800 annual minimum franchise tax charged LLCs, based solely on the LLC’s ownership of a 0.78% membership interest in a California manager-managed LLC.

Aroya Investments I, LLC is a Delaware LLC based in New York. For tax year 2016, Aroya’s only connection to California was its ownership of a 0.78% membership interest in 1155 Island Avenue LLC, a Delaware LLC which owned and managed property in San Diego, California. Both LLCs were taxed as partnerships. Aroya had earlier paid the $800 minimum franchise tax, but then filed an amended return seeking  a refund of the $800 tax on the basis that it was not “doing business” in California.

To make its argument, Aroya relied on Swart Enterprises, Inc. v. FTB, and its interpretation of Rev & Tax Code Section 23101(a). In Swart, the court found that a corporation that held a 0.2% membership interest in a manager-managed LLC was not “doing business” in California under the standard set forth in Section 23101(a). The court found that such a passive interest, with no management authority, did not meet Section 23101’s standard of “actively engaging in any transaction for the purpose of financial or pecuniary profit or gain.”

The OTA, however, noted that Swart involved a tax year prior to 2011, when Section 23101 was amended to add new economic nexus “doing business” tests. These tests are based on an LLC’s sales, payroll, or property ownership in California. If any of the threshold tests in Section 23101(b) are met, then the taxpayer is “doing business” in California.

Under Section 23101(b), if an LLC’s real and tangible property exceeds $50,000 (adjusted for inflation, $54,771 in 2016), the LLC is “doing business” in California. Under Section 23101(d), the LLC’s property includes the LLC’s “distributive share of pass-through entities.” Aroya, therefore, would need to include 0.78% of 1155 Island Avenue’s property.

The OTA found that the San Diego property owned by 1155 Island Avenue was worth $61,500,000. That made the value of Aroya’s property in California, under Sections 23101(b) and (d), $481,000, significantly over the $54,771 threshold. Therefore, the OTA held that Aroya was “doing business” in California and subject to the $800 franchise tax.

In its opinion in The Matter of the Appeal of L. Mazer and M. Mazer, issued on July 23, 2020, the OTA held that a taxpayer who moved to Malaysia for 13 months for a job was still a resident of California, and therefore was taxed on his entire taxable income, and not just income from California sources.

Mazer moved to Malaysia in February of 2013 pursuant to an employment agreement. The employment agreement had a term of two years, but Mazer terminated his employment and returned to California in March of 2014. Mazer and his wife filed a joint tax return in California for 2013, but subtracted $57,307 from taxable income, which represented one-half of the wages that Mazer earned in Malaysia. The FTB issued an assessment for the subtracted wages, but the Mazers contested the assessment arguing that Mazer was a non-resident during 2013 and therefore not liable for tax on earnings sourced in Malaysia.

California residents are taxed on their entire taxable income, regardless of source, while nonresidents are only taxed on income from California sources. Rev & Tax Code Section 17014(a) defines a California “resident” as including: (1) every individual who is in California for other than a temporary or transitory purpose; or (2) every individual domiciled in California who is outside California for a temporary or transitory purpose. An individual may have several residences, but only one domicile. The statutory definition of “resident,” therefore, contains two alternative tests,  one for those domiciled in California, and the other for those within the state but not necessarily domiciled in the state.

Mazer argued he was not domiciled in California during the 13 months he was in Malaysia. The OTA noted that “[a]n individual who is domiciled in California and leaves the state retains his or her California domicile as long as there is a definite intention of returning to California, regardless of the length of time or the reasons for the absence. In order to change domicile, a taxpayer must: (1) actually move to a new residence; and (2) intend to remain there permanently or indefinitely [citations omitted].”

The OTA found that Mazer’s wife continued to live in their home in California during the time Mazer was in Malaysia, and that was the address used for their joint tax returns. When Mazer’s time in Malaysia ended, he returned to his home in California indicating no intent to remain in Malaysia permanently. Accordingly, the OTA held that Mazer was domiciled in California during his time in Malaysia.

Finding that Mazer was domiciled in California, the question was whether he was in Malaysia for a “temporary or transitory purpose.”  The OTA noted that an absence from the state for a duration of two years or less has previously been held to be only temporary and transitory. But the OTA added that a stay of less than two years will not automatically indicate a temporary or transitory purpose if the reason for the shortened stay is not inconsistent with an intent that the stay be long, permanent, or indefinite.

The OTA examined a list of connections with the state, including registrations and filings, personal and professional associations, and physical presence and property. The OTA found that Mazer did not sever his connections with California, and although he made connections in Malaysia, these were all contingent on his employment and paid for by his employer. The OTA held that Mazer’s stay was for a temporary or transitory purpose, and therefore he was a California resident in 2013, and he owed taxes on his entire taxable income, including the income earned in Malaysia.

Legal disclaimer: The information in this article (i) is provided for general informational purposes only, (ii) is not provided in the course of and does not create or constitute an attorney-client relationship, (iii) is not intended as a solicitation, (iv) is not intended to convey or constitute legal advice, and (v) is not a substitute for obtaining legal advice from a qualified attorney. You should not act upon any of the information in this article without first seeking qualified professional counsel on your specific matter.

William F. Webster

William F. Webster

When I’m not practicing law, I’m playing guitar and bass in various rock and blues bands. Playing music is something I’ve done for most of my life. I also enjoy skiing at Squaw Valley, cycling in the foothills, and hiking in the Sierras.
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Robert R. Rubin

Robert R. Rubin

I love to golf and try to play almost every weekend. Playing Cypress Point was a highlight for me, but I’ve also enjoyed having the chance to play courses in Scotland like the Old Course, Carnoustie and Turnberry. My typical golf outing is much closer to home, though.
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