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New Tax Developments for California and California Related LLCs

by Amanda Han on February 7, 2014 · 9 comments

  
New California Tax Law

I wanted to first let you know that this article is not for everyone as it specifically addresses CA related issues. So who should read this article? You may want to read this if

  1. You are a CA resident, or
  2. You are thinking about becoming a CA resident, or
  3. You have a CA LLC, or
  4. You have investment properties located in CA, or
  5. You plan on having investment properties in CA

Two weeks ago I attended a California CPA training class that was put on by one of the nations’ leading educational resources for CPAs. In a room of over 300 CPAs, we were all very shocked by California’s new aggressiveness in collection of CA fees from LLCs that are formed, owned, or somehow related to CA. From time to time, I meet people who work with non-California based tax or legal advisors and end up with complex structures that were intended to “avoid CA taxes”. If this describes your situation, please be cautious of the advice you receive and proceed with caution. If you are a California resident, chances are high that your entities may have CA filing requirements.  Keep in mind that CA tax law, just like any other tax code section, is extremely complex. This article is aimed to provide you with the general rules and exceptions to CA filing requirements.  If you have questions or feel this may impact your filing requirements, please be sure to seek the advice of your tax and legal advisors.

So who needs to file tax returns in CA and pay the $800 per year LLC fee?

Well, if you ask the California Franchise Tax Board (FTB) the answer is: just about everybody. If you have property in CA, if you are a CA resident manager, or if you are doing business in CA, then you are probably required to register, file, and pay CA.  Over the last few years, I have seen many FTB notices to entities that have never registered in CA. CA has taken a large effort in coordination with the IRS and other agencies to identify foreign entities that may be required to register and pay CA fees. In fact, the FTB has recently started to impose a penalty of $2,000 for foreign entities that fail to register in CA when required.  Later on we will go over some specific examples that the FTB has given us to determine who requires CA registration and filing. But first let’s go over the basics.

If you formed your LLC in CA, that entity may be required to file in CA and pay the annual fee. This is true regardless of whether you made any money or not during the year. If you have had a CA entity for years and years and are now just getting notices for payment, then you may want to seek out legal advice sooner rather than later. There may be a potential legal strategy I have seen used by attorneys known as the “poor man’s dissolution” where a LLC is dissolved without having to pay its back taxes and fees. This has been allowed in past court cases due to the fact that the entity never made any money or held any assets. The key for this to work is that the taxpayer must show there were no assets in the LLC at the time the taxes and fees would have been due. Now what if your entity was not formed in CA? Well, here is the latest development as defined by the CA Franchise Tax Board. A foreign LLC is required to register, file, and pay if it’s “doing business in CA”. CA considers an LLC to be “doing business” in CA if:

  1. If the LLC is operating a business in CA (for example owning a rental property in CA), or
  2. If the LLC’s members or managers conduct business in CA on behalf of the LLC. Here is one example: James is a Nevada resident. He owns a rental property in CA and the property is held by a Nevada LLC. In this example, since the rental property is located it CA, it is deemed to be “doing business in CA”. As such, this Nevada entity may be required to register in CA and is subject to the CA annual taxes and fees.

Let’s go over another example:

John, a California resident, owns a condo in Iowa. The property is held by an Iowa LLC and John is the manager of that LLC.  John uses the condo himself part of the year and rents it out for part of the year.  Since John rents the property and he is the manager of this LLC, the activity may be considered to be doing business in CA because the LLC’s managing member is deemed to be “managing” this entity and its operations from CA.

If you are a CA resident with out of state properties held in out of state entities, there are potential strategies to help you avoid CA fees and taxes. One of these would be to show that you actually go out of state to conduct the LLC’s business. For example,  if John was able to show that he only manages his Iowa property and LLC when he is not in CA (for example, he flies to Iowa to speak with his property manager or tenants), then he may be able to demonstrate that he does not “conduct business in CA”.  Keep in mind that you as the managing member would want to keep receipts, log of travels and business activities conducted outside of California for your support in case of an audit. In this scenario, if the managing member travels to other state and performs no services, including oversight of property manager or paying bills, in California, then this entity may be able to avoid CA filing requirements.

Here is another common scenario. Jane, a CA resident, is a 1% passive investor in a Utah LLC that owns Utah rental property.  Jane is not a manager in this LLC and the other 99% of the owners and managers are not in any way connected to CA. In this scenario, the Utah LLC is not required to register and file in CA since it does not “do business in CA”.

Let’s make a slight modification to this scenario. What if instead of owning this in her personal name, Jane formed a new Utah LLC to hold her 1% share of the Utah LLC? Would Jane’s new Utah LLC be required to file in CA? Well, the answer is it depends. If Jane is the manager of her new Utah LLC, then yes it is deemed to be doing business in CA. In order to get around this, Jane would need to demonstrate that she does all of her business and management activities while outside of CA.

“Doing Business in California”

It’s important to note that “doing business in CA” is at the heart of the state’s reason for foreign entities needing to file and register in CA. If your entity is not “doing business” then there is no reason for the entity to register in CA.

For example, Ben, a California resident, owns a condo in Hawaii which he uses as a second home. It is owned by his Hawaii single-member LLC. Ben does not rent out his condo. Therefore, Ben’s LLC is not doing business in California and is not required to register in California, or pay the annual taxes or fees. Even though Ben pays bills related to the Hawaii condo from California, he is not engaging in a “business” since it’s just his second home.

As you can see, there are countless ways to structure legal entities and countless possibilities when it comes to filing and payment requirements in California.  Even though California has become increasing aggressive in their reach of foreign entities, not all taxpayers have made the decision to register and pay in the state. If you are concerned with the new CA penalties and want to make sure you are structured correctly, be sure to meet with your advisory team to get their assistance.

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{ 9 comments… read them below or add one }

Tim February 7, 2014 at 11:10 pm

Here’s a legal workaround the evil CA FTB and avoid the $800 fee altogether: Establish an irrevocable trust which is exempt from the $800 annual fee and have it hold the interest in the CA property, investment or business. Has to be irrevocable. You will need to get a EIN from the IRS. It will file its own return. Best to set up so that’s its an IDGT (intentionally defective grantor trust) in which the taxes flow through to the beneficiaries. The only caveat: the beneficiaries must be individuals and cannot be an LP, LLC or a corporation. Trustee can be any person other than grantor/beneficiary.

Reply

Amanda Han February 10, 2014 at 2:36 pm

Thanks Tim! Glad to have an attorney weigh in on this topic. Can you share your thoughts on any asset protection differences with an IDGT vs CA LLC?

Reply

Tim February 10, 2014 at 2:50 pm

Sorry is I misled, but I am not an attorney. This suggestion to use an irrevocable IDGT came from my accountant. At the advice of my attoney, I use both an IDGT and a two-member LLC for AP purposes. The two IDGTs hold membership interests in the LLC. This provides for more AP than either alone. I would consult your attorney for further questions.

Reply

Shaun February 9, 2014 at 4:08 pm

I love what ifs!

1) John doesn’t fly to Iowa to conduct business, however he lives 10min from the Nevada border and only calls and emails his PM in IA from a Starbucks just over the border?
2) Jane is the 99% owner of the LLC but not a manager. The 1% owner is a managing member and via the OA makes all decisions related to the LLCs management and Jane only gets distributions?

Reply

Amanda Han February 10, 2014 at 2:45 pm

Hi Shaun:

Thanks for the comment. Yes I love #1….that should fall under the loophole to not be “doing business in CA”.

#2 may work if Jane can show that all communications with the manager are conducted outside of CA.

Reply

Jameson Triplett April 2, 2014 at 7:00 pm

Follow up on one of your scenarios:

So let’s use this scenario:
What if instead of owning this in her personal name, Jane formed a new Utah LLC to hold her 1% share of the Utah LLC? Would Jane’s new Utah LLC be required to file in CA? Well, the answer is it depends. If Jane is the manager of her new Utah LLC, then yes it is deemed to be doing business in CA.

How do the taxes get filed? The partnership sends Jane’s SMLLC a K-1, and where does that go? How does it avoid remitting a CA return? Does her SMLLC aggregate the income on a schedule C?

Reply

Amanda Han April 2, 2014 at 10:28 pm

Hi Jamison: Assuming the UT SMLLC is ownd by Jane then Jane would report that directly on her personal income tax return (this is because the SMLLC does not hae a federal filing requirement and is disregarded). Whether it is Sch C or E or other line items will just depend on where it appears on the K-1.

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Megan Malmstrom August 19, 2014 at 5:17 pm

Hi Amanda,

It is considered “conducting business” still if we do not own any property in CA but are wholesaling here?

Reply

Amanda Han August 20, 2014 at 10:21 am

Yes wholesale RE is considered active income from conducting a business just like wholesaling other items.

Reply

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