BILL ANALYSIS Ó
AB 799
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Date of Hearing: May 18, 2015
ASSEMBLY COMMITTEE ON REVENUE AND TAXATION
Philip Ting, Chair
AB 799
(Travis Allen) - As Amended 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.
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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:
a) Actively engaging in any transaction for the purpose of
financial or pecuniary gain or profit; or,
b) 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
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contractor of the taxpayer;
c) 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;
d) 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,
e) 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.
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<1>According to the FTB, for taxable years beginning on or after
January 1, 1997, only taxpayers with net incomes of less than
approximately $9,040 pay the minimum franchise tax because the
amount of measured tax owed would be less than $800 ($9,039 x
8.84% = $799).
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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
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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,
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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
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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.
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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
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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,
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<2> California Code Regulation, Title 18, Section 23101 (b).
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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
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