California Issues Legal Rulings Addressing Nexus And Apportionment Issues

The California Franchise Tax Board (FTB) has recently issued its first legal rulings in almost 24 months, dealing with complex nexus and apportionment concepts. In the first ruling, the FTB concluded through a series of examples that a business entity with a membership interest in a multiple-member limited liability company (MMLLC) that is classified as a partnership for tax purposes may have California return filing requirements and may be subject to the LLC tax and fee based solely upon the actions of the MMLLC.1 In the second ruling, the FTB concluded that proceeds from asset sales transactions which took place during a Chapter 11 bankruptcy plan of reorganization were not "occasional sales" and were includible in the taxpayer's sales factor.2

Tax Treatment of Membership Interests in MMLLCs Treated as Partnerships

The first ruling addressed the issue of when business entities holding membership interests in MMLLCs treated as partnerships have nexus for California franchise tax purposes. Despite their existence under civil law, LLCs generally are not recognized as an entity choice for tax purposes. Thus, the FTB applied in its ruling tax law principles that flow from the entity choice the LLC makes for tax purposes under the federal entity classification election system3 to reach a conclusion.

California tax law conforms to the federal entity classification election system by mandating that an eligible business entity be either classified or disregarded for California tax purposes.4 If an LLC with two or more members chooses to be treated as a corporation for tax purposes, then its members will be treated as shareholders of the corporation for tax purposes. However, if an LLC with two or more members does not check the box to be treated as a corporation, it is treated as a partnership for tax purposes by default and its members are treated as partners in that partnership for tax purposes.5

California Nexus

"Doing business" in California is defined as "actively engaging in any transaction for the purpose of financial or pecuniary gain or profit."6 For taxable years beginning on or after January 1, 2011, California significantly expanded its "doing business" statute to include an economic nexus standard. Under this standard, a taxpayer is considered to be doing business in California for a taxable year if any of the following conditions are satisfied:

(1) The taxpayer is organized or commercially domiciled in California;

(2) The taxpayer's sales applicable for the taxable year exceed the lesser of $500,000 or 25 percent of the taxpayer's total sales;

(3) The taxpayer's real property and tangible personal property in California exceed the lesser of $50,000 or 25 percent of the taxpayer's total real property and tangible personal property; or

(4) The amount of compensation paid by the taxpayer in California exceeds the lesser of $50,000 or 25 percent of the total compensation paid by the taxpayer.7

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