Entity structure on out-of-state rentals and no CA franchise tax?

29 Replies

This topic is just in regard to California residents with properties *outside* of California. Assume a California resident sets up an out-of-state trust, which in turn is the only member (and manager) of an out-of-state LLC that holds out-of-state rental property. Is there any reason to believe that the California taxpayer in this case will be required to pay the annual $800 minimum franchise tax to California?

There is so much mixed information out there on the CA franchise tax, so it would be really helpful if folks could weigh in along with any authoritative sources of information, e.g. tax code / legislation, previous court cases, or even FTB publications. I've read through quite a bit of those sources myself and have yet to find anything suggesting that the minimum franchise tax would be assessed on this kind of entity structure. And no one I've spoken to has been able to offer a compelling argument otherwise. Yet many on BP have claimed in other threads that there’s no getting around it as a California resident. Obvious disclaimer: I'm not an attorney or accountant. I'm just a dude with an inclination to sort through mixed messages until I get the story straight. And I fully admit I could be missing something- am I?  


This was actually a topic of discussion in a post that was recently removed, presumably because the OP appeared to be selling something. It's a shame that the rest of the conversation was taken down with it, so I figured I would start a new thread on this particular topic, and invite those that had been previously involved or mentioned in the discussion:
@Christopher Smith , @Greg O'Brien , @Eamonn McElroy , @Basit Siddiqi , @Michael Plaks@Katie Lepore and @Brian Schmelzlen 



@Rob C. We primarily represent CA investor buyers...this is not my language, but copied from a CA CPA's post on this topic...thought you may find some value. Here it is:

California is a sort of beastly state when it comes to taxes and filings. Even if you create a non-CA LLC, if you are managing the business from California, you will be deemed to be "doing business" in California and therefore subject to CA taxes. California charges a minimum tax of $800 a year per LLC, and more if you have gross receipts in excess of $250k. So, if you create an LLC in another state, you will need to register it as a foreign LLC in California. Though, this process will be the same for the other state (if you created a CA LLC you will need to register it as a foreign LLC in the state in which you are doing business/holding property). This means that you will need to pay registration and filing fees in at least 2 states if you don't buy CA property.

Be sure to tell your accountant that you now need to file non-resident income tax returns in each state where you own property as well. As a California resident, I would recommend hiring a CA CPA or at least one familiar with CA laws. California tends to be more complex than most other states from a tax standpoint (well really all standpoints it seems) and as a California resident, you will be taxed on ALL your income in California. In Ohio or another state where you own property, you likely will only be taxed on the income earned in that state and need to file a nonresident return rather than a resident tax return.

Most likely the state where the property is located is where lawsuits would be brought if they are something for personal injury like a trip and fall or something of that nature because the "cause of action" arose in that state. California tends to have more laws on the books and requirements and restrictions that it can be a good idea to form a CA LLC for out of state property so that you as a CA resident are covered, and to try to have your contracts fall under the purview of CA courts. It also is helpful to have a California LLC in case you ever sell that property and move into another state so that you do not need to form a new LLC altogether with new operating agreement, just re-register in the new state as a new foreign LLC. But, that is not always the right answer and you should speak with someone familiar with your personal situation to get advice specific to you.

Let me know if you need referrals for attorneys or accountants in Southern California.

*This post is informational only and is not to be relied upon. Readers are advised to seek professional advice. This post does not create an attorney-client or CPA-client relationship.

@Brandon Sturgill , the post you shared is consistent with many opinions I’ve heard and read. However, the more I learn the more I become convinced that may just be a common misconception that’s not entirely true. When discussing this matter with an advisor he pointed me to this link to show how the law defines "doing business in California": https://leginfo.legislature.ca.gov/faces/codes_displaySection.xhtml?sectionNum=23101&lawCode=RTC. Is there anything in that (or the rest of the law for that matter) to suggest an out-of-state LLC holding out-of-state rental property is doing business in California just because its member/manager manages the business from California?

The closest thing I've found that relates to that perspective is the "Doing Business in California" section on this page : https://www.ftb.ca.gov/forms/misc/3556.html#Doing-Business-in-California . We can debate later perhaps on whether the FTB's interpretation of the law here is even constitutional and/or would stand up in court (similar to how the prior post diverged), but let's assume it is just for sake of advancing the discussion; in that case I could understand why someone might say that a California resident acting as a member/manager of an out-of-state LLC results in an $800 minimum franchise tax. However, if we instead make the member/manager an out of state trust with the California resident as either its trustee or beneficiary, on what grounds could the FTB try to collect any franchise tax in that case?

By the way, I didn't think of this structure by myself. It was suggested to me by the aforementioned advisor. I'm just trying to find any flaws in it before I consider adopting it for my business. Are there any? So far I've come up empty.

@Rob C. one thing to consider is the tax implications of holding a cash flowing propery in a non grantor trust vs a SMLLC and paying the $800. Likely the trust set up costs and non grantor trust income tax brackets could outweigh the $800 savings (if it held up with FTB).

Hello @Rob C. . As you pointed out that is a pretty controversial topic. I am not a lawyer or CPA but as a CA investor, I also faced the same situation. It is unfortunate but according to CA tax law, if you are "managing" a "business (ie. your properties ) from CA, you will be "doing business" in CA, hence be responsible for the FTB fees. This matter had been argued in court and won by the state. At the same time, depending on your risk tolerance and your CPA interpretation of the law, you could chose one path or the other. 

Thanks for the heads up @Greg O'Brien . I was under the impression from the advisor I spoke with that it could be set up in a way that is pass-through so all the rental activity goes to Schedule E on my personal return. Do you disagree?  

Thanks for weighing in @Saleh Riazi . Which part of the law are you referring to? Is it part of RTC 23101, which I linked to above? Or a different section altogether? 

Also, Are you familiar with any court cases where the FTB has prevailed on this matter (especially with the aforementioned combination of trust and LLC)? I've heard the same thing from others that the FTB has and always will win in court, but no one I've talked to has been able to point to any such cases that I can read up on to verify. I've also spent a fair share of time trying to search google and justia for them myself, but I've come up empty. Conversely, I've come upon cases like the ones described here (which I acknowledge is not the same context): https://www.thetaxadviser.com/... I’m not an attorney, but I would be grateful to be directed to any case law I can read for my own edification if it shines more light on this topic.

Originally posted by @Rob C. :

@Brandon Sturgill , the post you shared is consistent with many opinions I’ve heard and read. However, the more I learn the more I become convinced that may just be a common misconception that’s not entirely true. When discussing this matter with an advisor he pointed me to this link to show how the law defines "doing business in California": https://leginfo.legislature.ca.gov/faces/codes_displaySection.xhtml?sectionNum=23101&lawCode=RTC. Is there anything in that (or the rest of the law for that matter) to suggest an out-of-state LLC holding out-of-state rental property is doing business in California just because its member/manager manages the business from California?

The closest thing I've found that relates to that perspective is the "Doing Business in California" section on this page : https://www.ftb.ca.gov/forms/misc/3556.html#Doing-Business-in-California . We can debate later perhaps on whether the FTB's interpretation of the law here is even constitutional and/or would stand up in court (similar to how the prior post diverged), but let's assume it is just for sake of advancing the discussion; in that case I could understand why someone might say that a California resident acting as a member/manager of an out-of-state LLC results in an $800 minimum franchise tax. However, if we instead make the member/manager an out of state trust with the California resident as either its trustee or beneficiary, on what grounds could the FTB try to collect any franchise tax in that case?

By the way, I didn't think of this structure by myself. It was suggested to me by the aforementioned advisor. I'm just trying to find any flaws in it before I consider adopting it for my business. Are there any? So far I've come up empty.

BUT...Trusts pay taxes in CA also. If the Trust is out of state, but is managing property from a seat/office in CA it would be paying taxes to CA, and would be responsible for the taxes for its drop down--the LLC. The Grantor-Trustor/Trustee of the Trust would be responsible for filing those taxes.

 

@Rob C. I think one thing I have learned over the years is the the folks collecting tax revenue are very good at their jobs, lol. I would not be surprised if an $800 bill appears in your mailbox...even with the trust in place.

@Rob C. without knowing what he told you, its hard to answer. 

However:

1) If a grantor, revocable trust, you 100% have to pay the CA fee IMO.  For tax purposes, the trust doesn't really exists and you don't even need an EIN in most cases.  You would report this on your personal tax return.

2) If non grantor, irrevocable w/ out of state trustees, your tax situation may not be great. The Trust files a 1041 and the rental income is reported on the 1041. Taxation to the beneficiary depends on various factors. Doing this to avoid an $800 fee would probably not work in your favor. You created a 2nd tax return which will run you $1k+ and potentially higher overall taxes.

Originally posted by @Rob C. :

@Lynnette E., when you say trusts pay taxes in CA also, are you referring to income tax? franchise tax? both?

All of them.  The Trust would pay all taxes owed by the Trust assets.  That could be property tax, income tax, franchise tax, any taxes owed.  When assets are placed in a Trust, it is just placing them under a certain title.  It does not remove tax liability in any form.  All the taxes are still  owed, and often higher that if they were held personally...except when you get to inheritance and estate taxes, which may be avoidable!  The federal Trust income tax rate is higher than most people's personal income tax rate.  But depending on how the Trust is set up, during your lifetime you may claim the Trust assets and pay its taxes on your individual tax form.

 

Thanks for the follow-ups @Greg O'Brien and @Lynnette E. . The trusts I’ve heard suggested are revocable living trusts and personal property trusts. My understanding is that they would fall under the grantor, revocable trust classification, and therefore wouldn’t have any bearing on taxes as Greg describes. I will doublecheck on this part though. Greg, I appreciate you pointing out the differences between the two.

Where did you see that trusts (or at least grantor, revocable trusts) were subject to the franchise tax fee? Everything I’ve read only points to the franchise tax being assessed on the corporate entities as shown in Appendix 3 on this page https://www.ftb.ca.gov/forms/m... 

Originally posted by @Rob C. :

Where did you see that trusts (or at least grantor, revocable trusts) were subject to the franchise tax fee? Everything I’ve read only points to the franchise tax being assessed on the corporate entities as shown in Appendix 3 on this page https://www.ftb.ca.gov/forms/m... 

The Trust is subject to any and all taxes to what ever the taxing entity is for all the assets within the Trust. Since you have an LLC within the Trust the Trust is responsible for the LLC's taxes. The Trust and LLC are being managed from CA, you owe the CA LLC taxes. You can try something creative, but when you get caught you will pay the taxes plus interest and penalties. The federal and state tax data bases share and compare data to each other, and many states share data with each other.

The Trust and LLC are being managed from CA, you owe the CA LLC taxes. You can try something creative, but when you get caught you will pay the taxes plus interest and penalties

@Lynnette E. - get caught breaking what rule(s) specifically? Have you viewed the links I’ve included above to the tax code, and FTB’s interpretation thereof- are you able to point to anything in that tax law (or even FTB’s interpretation) that shows a California resident would be breaking the rules if they don’t send $800 to the FTB for managing an out-of-state trust, which in turn manages an out-of-state LLC, which in turn manages out-of state property? Or, are there any other sections of the tax code, FTB publications, or case law you can point us to that have shaped your opinion?

@Rob C. Again a RLT is disregarded by states and the Feds. RLT=You under all tax laws. You=CA nexus. Now an IRT is a different story but a RLT is disregarded for income tax purposes.

@Greg O'Brien , I follow that the RLT would be disregarded for *income tax* purposes. Are you suggesting though that because the RLT is disregarded that any LLC underneath it in this structure would be subject to the *franchise tax*? If so, where are you getting that from? From a purely logical perspective I don't see how that would make sense; i.e. by logical extension that would mean all LLCs set up as disregarded entities avoid the franchise tax (LLC = "you under all tax laws")

Originally posted by @Brandon Sturgill :

@Rob C. We primarily represent CA investor buyers...this is not my language, but copied from a CA CPA's post on this topic...thought you may find some value. Here it is:

California is a sort of beastly state when it comes to taxes and filings. Even if you create a non-CA LLC, if you are managing the business from California, you will be deemed to be "doing business" in California and therefore subject to CA taxes. California charges a minimum tax of $800 a year per LLC, and more if you have gross receipts in excess of $250k. So, if you create an LLC in another state, you will need to register it as a foreign LLC in California. Though, this process will be the same for the other state (if you created a CA LLC you will need to register it as a foreign LLC in the state in which you are doing business/holding property). This means that you will need to pay registration and filing fees in at least 2 states if you don't buy CA property.

Be sure to tell your accountant that you now need to file non-resident income tax returns in each state where you own property as well. As a California resident, I would recommend hiring a CA CPA or at least one familiar with CA laws. California tends to be more complex than most other states from a tax standpoint (well really all standpoints it seems) and as a California resident, you will be taxed on ALL your income in California. In Ohio or another state where you own property, you likely will only be taxed on the income earned in that state and need to file a nonresident return rather than a resident tax return.

Most likely the state where the property is located is where lawsuits would be brought if they are something for personal injury like a trip and fall or something of that nature because the "cause of action" arose in that state. California tends to have more laws on the books and requirements and restrictions that it can be a good idea to form a CA LLC for out of state property so that you as a CA resident are covered, and to try to have your contracts fall under the purview of CA courts. It also is helpful to have a California LLC in case you ever sell that property and move into another state so that you do not need to form a new LLC altogether with new operating agreement, just re-register in the new state as a new foreign LLC. But, that is not always the right answer and you should speak with someone familiar with your personal situation to get advice specific to you.

Let me know if you need referrals for attorneys or accountants in Southern California.

*This post is informational only and is not to be relied upon. Readers are advised to seek professional advice. This post does not create an attorney-client or CPA-client relationship.


I read this one too... pretty sure it was @katie Lepore

Originally posted by @Brandon Sturgill :

Not positive @Todd Rasmussen I failed to capture her signature and regret I can't give due credit...maybe she will come forward to confirm...

This is what @Katie Lepore had to say: https://www.mmpph.com/wp-conte...

"The California Franchise Tax Board takes a
broad interpretation of what constitutes “doing
business” in California. Therefore, managing
the LLC or performing activities on behalf of the
LLC constitutes doing business in California and
subjects the LLC to tax in California. As a
result, even if the owner forms the LLC in
another state or hires an out-of-state property
manager, if he or she is managing the business
and/or making business decisions from
California, the LLC will be subject to California
tax (the analysis is the same even if the rental
property is located outside California)." 

I’m surprised by how idle this thread has become. @Lynnette E. and @Greg O'Brien , I hope you didn’t interpret my previous questions as rhetorical. I’m genuinely interested in understanding where you’re coming from.

@Katie Lepore - are you able to weigh in on how your published opinion reconciles with the situation / structure I’ve described?

@Eamonn McElroy and @Basit Siddiqi - since you seemed certain at the outset of the previous/removed thread that the franchise tax would be owed, it’d be great to hear your elaboration. Also, since that thread wasn’t nearly as specific as this one when you commented, I’m curious if the additional context changes the matter in your mind at all. I’m sure that as accountants you’re more familiar with the tax code than most and it would be great to understand which parts support your opinions

I've had 3 attorney's tell me there is no way around the $800 fee if you are a CA resident.  Living in CA = Doing business in CA.  Can you get away with it?  Maybe.  FTB is super aggressive, I don't want to mess with them.  I'll just pay it and not worry about it. 

Originally posted by @Rob C. :

I’m surprised by how idle this thread has become. @Lynnette E. and @Greg O'Brien , I hope you didn’t interpret my previous questions as rhetorical. I’m genuinely interested in understanding where you’re coming from.

@Katie Lepore - are you able to weigh in on how your published opinion reconciles with the situation / structure I’ve described?

@Eamonn McElroy and @Basit Siddiqi - since you seemed certain at the outset of the previous/removed thread that the franchise tax would be owed, it’d be great to hear your elaboration. Also, since that thread wasn’t nearly as specific as this one when you commented, I’m curious if the additional context changes the matter in your mind at all. I’m sure that as accountants you’re more familiar with the tax code than most and it would be great to understand which parts support your opinions

 I took your comments as you have already decided what you want to and are going to do.  You are looking for someone to agree with what you want to do.  I am not that person.  I have worked with Trusts for many years, decades.  I am pretty confident in how Trusts work and what they do not do.  

I also had fun and games with the CA Franchise tax board a few years ago.  They are HARD!  My case had nothing to do with a Trust, but I moved from CA, registered my vehicle in my new state, sent CA the 'I moved and registered my car in the new state form' which the DMV lost or at least did not process.  Eventually the FTB wanted the money for my vehicle registration and late fees.  They sent mail demanding money to my new house, so they knew where I lived and it was not in CA and they could have checked and saw that the vehicle was registered in my new state.  I sent them many letters showing I moved, sold my house before the registration was due, reregistered in the new state before the CA one expired and within days of moving, sent in the form...still they wanted a few years worth of registration and penalties!  I only got it solved by writing to the Director of the DMV, and sending him all the information.  I received a letter back from the director saying they fixed it, sorry, and they did!  FTB was like a pit bull, just give us money and we will let go!  No reasoning with them at all.

I won't tell you want you want to hear, but what you need to hear, and there are already many people who have told you the same thing.  So I did not see any reason to continue with the thread.