February 18, 2015 | By Keith Martin in Washington, DC

CALIFORNIA may have to pay refunds to passive investors in limited liability companies that own projects in California after a state superior court judge held in November that such investors are not “doing business” in California.

The state Franchise Tax Board is expected to appeal.

The case is called Swart Enterprises, Inc. v. California Franchise Tax Board. Swart, a corporation formed in Iowa, operates a 60-acre farm in Kansas that feeds cattle for beef sales. Swart invested $50,000 for a 0.2% interest in a fund, called Cypress Equipment Fund XII LLC, that leases equipment to lessees in California. Swart has no other ties to California.

The state collects a minimum tax of $800 from members in LLCs doing business in the state. The Franchise Tax Board has been sending overdue tax notices to LLC members. The notices ask for $2,000 to $3,000 once penalties and interest are added.

Every corporation that is formed in California, qualified to do business there, or actually doing business in California must pay a minimum annual franchise tax of $800.

“Doing business” is defined as “actively engaging in any transaction for the purpose of financial or pecuniary gain or profit.” Anyone holding an interest in an LLC that is a partnership for tax purposes is considered by the Franchise Tax Board to be doing business in California if the LLC is doing business in California. Partners are normally considered to do directly what the partnership does.

A state superior court judge in Fresno County ruled that holding a passive interest in an LLC is not doing business in the state.

Another state tax agency, the State Board of Equalization, takes the position that a limited partner in a limited partnership is not doing business in California solely by reason of holding the partnership interest. The Franchise Tax Board used to follow the same approach, but changed its position in a ruling while the Swart case was pending. Its current position is that each partner in a partnership – including an LLC treated as partnership – is considered to engage in whatever business the partnership does. The ruling is Legal Ruling 2014-01.

The court said there is “no legal authority for this conclusion.”

The LLC in which Swart invested put sole control over the LLC in the hands of a manager rather than leaving management to the members. The Franchise Tax Board said Swart relinquished a more active role by agreeing to give the manager control. The court dismissed the suggestion; Swart invested two years after the LLC was formed.

The state could owe millions of dollars in tax refunds unless the decision is overturned on appeal.

Keith Martin in Washington