CPAs need to be aware of current tax developments in key states to properly advise taxpayers doing business in multiple jurisdictions. Below is an overview of some key developments in California and Texas.
Revised nexus bright-line/doing business thresholds.
The California Franchise Tax Board (FTB) has announced adjustments to its bright-line “nexus/doing business in California” thresholds, for income/franchise tax purposes, to reflect changes in the California Consumer Price Index as annually required by statute. The revised threshold values for taxable years beginning on and after January 1, 2019, are as follows:
- Taxpayer’s in-state sales exceed the lesser of $601,967 (from $583,867 in 2018) or 25% of total sales
- Taxpayer’s real and tangible personal property in California exceeds the lesser of $60,197 (from $58,387 in 2018) or 25% of total real and tangible personal property
- Taxpayer’s in-state compensation exceeds the lesser of $60,197 (from $58,387 in 2018) or 25% of the total compensation paid.
Disregarded limited partnerships no longer subject to filing requirement or annual tax.
On November 20, 2019, the FTB issued Legal Ruling 2019-02, which stated that a limited partnership (LP) disregarded for federal income tax purposes is not required to pay California’s annual $800 minimum tax on LPs or required to file a California partnership return.
Historically, the FTB’s position has been to include disregarded limited partnerships (DLP) under the purview of California Code, Revenue and Taxation Code (CRTC) section 17935, requiring the entities to file and pay tax. DLPs challenged the FTB’s assessments, proclaiming that it lacked authority to require filing and annual tax payment, as CRTC section 23038 states, “If the separate existence of an eligible business entity is disregarded for federal tax purposes, the separate existence of that business entity shall be disregarded.”
In addition, the FTB issued Notice 2019-06, which explains the process for a taxpayer to substantiate that it is properly disregarded entity for federal income tax purposes in order to claim refunds for open tax years (usually four years). The FTB requires DLPs to submit certain documents to establish no California filing or payment requirement, which includes the following:
- The certificate of limited partnership, partnership agreement, organizational chart of ownership, and federal returns of the partners for the particular taxable year or years in question; or
- A declaration signed under penalty of perjury by the general partner of the limited partnership under local law. If the limited partnership’s general partner under local law is a limited liability company (LLC), then the manager or, if there is no manager, the authorized member of the general partner LLC must sign the declaration. The declaration must clearly identify the general partner and must state that the entity was disregarded for federal income tax purposes during the respective tax years.
CPAs should be aware that this only applies to disregarded limited partnerships, and that the refund process can be initiated without receiving a Filing Enforcement Notice from the FTB.
A foreign LLC is not doing business.
Jali LLC, a Washington LLC, acquired an ownership interest in Bullseye Capital Real Property Opportunity Fund LLC (Bullseye). Jali held between a 1.12% and a 4.75% direct capital interest for the 2012–2016 tax periods. Bullseye, formed in Delaware and a manager-managed LLC, conducted business in California. The FTB determined that Jali must file a tax return based solely on its ownership interest in Bullseye. After filing the returns and paying the taxes, Jali filed a claim for refund that was denied by the FTB because Jali did not meet the facts of Swart Enterprises Inc. v. Franchise Tax Board (7 Cal. App. 5th 497). Jali appealed the FTB’s decision with California’s Office of Tax Appeals (OTA).
In Swart, the court held that “passively holding a 0.2% ownership interest, with no right of control over the business affairs, did not constitute doing business in California within the meaning” of CRTC section 23101(a). Using the court’s statement, the FTB established a bright-line test wherein membership interest above 0.2% is qualified as actively doing business in California. The FTB thus argued Jali had exceeded the ownership interest threshold for doing business.
Jali also relied on Swart by arguing that the facts were similar. Bullseye was a manager-managed LLC, and Jali was not one of the elected directors, did not have any management authority, and was not personally liable for Bullseye’s debts or liabilities. Like the argument in Swart, Jali established that it was more like a limited partner or a passive investor than a general partner.
The OTA agreed with Jali, rejecting and reversing the FTB’s decision that Jali was “doing business” and subject to the LLC tax based solely on its membership interest percentage in a partnership that conducts business in California. The OTA rejected the idea that Swart created a bright-line test wherein a specific amount of membership interest alone could distinguish between passive and active ownership in an LLC. Instead, the OTA took a holistic approach, considering all relevant factors regarding the relationship between the member and the LLC, including factual inquiries into the management of the LLC, whether the member holds a managing member interest, and whether the member is actively involved with the business decisions. The OTA stated that while Jali’s ownership interest was greater than the ownership interest in Swart, both were still minority interests, and there was no evidence Jali was actively engaged in Bullseye’s business activities.
CPAs should remember this ruling when evaluating whether their clients are doing business in California and subject to the LLC tax.
New economic nexus rules.
On December 20, 2019, the Texas Comptroller of Public Accounts adopted amendments to the “nexus” section of its franchise tax regulations [34 Texas Administrative Code (TAC) section 3.586] establishing the ways in which a non-Texas entity can create nexus in the state notwithstanding a lack of physical presence. The amended rules provide that a “foreign taxable entity” that does not have physical presence in Texas will have nexus in Texas and be subject to the franchise tax if it had gross receipts from business done in Texas of $500,000 or more during that federal income tax accounting period [34 TAC section 3.586(f)]. Texas gross receipts are determined using the Comptroller’s rules for calculating franchise tax apportionment. A “foreign taxable entity” is defined as a taxable entity that is not chartered or organized in Texas [34 TAC section 3.586(b)]. Moreover, the economic nexus rule applies to federal income tax accounting periods ending in 2019 or later [34 TAC section 3.586(f)].
The amended rules also provide a rebuttable presumption of franchise tax nexus for foreign taxable entities holding Texas use tax permits [34 TAC section 3.586(e)].
Other Texas changes.
The amended rules clarify that “nexus is determined on an individual taxable entity level” [34 TAC section 3.586(c)].
They also provide the following criteria for determining the date when a foreign taxable entity begins doing business in the state:
(g) Beginning date. A foreign taxable entity begins doing business in the state on the earliest of:
- the date the entity has physical nexus as described in subsection (c) of 34 TAC section 3.586;
- the date the entity obtains a Texas use tax permit; or
- the first day of the federal income tax accounting period in which the entity had gross receipts from business done in Texas in excess of $500,000.
Texas requires unitary business groups to file combined returns. CPAs with clients that must now file in Texas as a result of the new regulations will need to review the state’s combined reporting rules to determine whether any affiliates need to be included. To this end, the $500,000 gross receipts test is determined on an individual taxpayer entity level (i.e., group members do not combine receipts for purposes of determining economic nexus).