If I form an LLC in another state, when do I need to register it in California?


By:  Tamara B. Pow, Esq.

When I first started practicing law, it was not uncommon to advise a client to form an LLC in another state in order to avoid California franchise taxes.  This was especially true if the business did not own property in California.  Over the years, the Franchise Tax Board realized the amount of revenue they were missing out on as a result of companies that they considered to be doing business in the state not registering here in California.  Now, with increased information technology and automation, the FTB’s ability to identify out of state taxpayers with California filing requirements has increased and the FTB’s audit of multistate businesses has increased, resulting in past taxes and fees.  According to Spidell Publishing, Inc., the FTB is using multiple sources to find taxpayers including: federal returns filed with a California address, EDD, BOE and DMV filings, property tax information, 1099s and other information returns, Schedule K-1s and Schedule EOs (Pass-Through Entity Ownership).

Your LLC is doing business in California if it meets any one of three tests:

  1. Actively engaged in any transaction for the purpose of financial or pecuniary gain or profit;
    A single profit motivated transaction will satisfy this requirement, it does not need to have actual profit, just motivated by gain, and it does not need to be regular or ongoing.
  2. Commercially domiciled in California; or
    If the business of the LLC is directed or managed in California, the LLC must register in California.
  3. It meets any of these economic nexus thresholds.
    Sales over $561,951 (2017 value), or 25% of total sales, are in California;
    Real and personal property in California exceeds $56,195 in value, or 25% of total real and personal property; or

Compensation paid in California exceeds $56,195 (2017 value), or 25% of total compensation paid by the company.

However, the FTB has gone even further than these tests with LLCs taxed as partnerships rather than corporations.  In Legal Ruling 2014-01, the FTB took the position that if an LLC has a California member it is doing business in California and must pay the $800 minimum tax.  The FTB even refused to distinguish between managing members and non-managing members.  Even if the LLC’s operating agreement gave the non-managing California member no rights or control over the business of the entity, the FTB claimed they have the right to participate even if only by relinquishing control to a manager.  The FTB also took the position that all LLC members, managing or not, are considered to be doing business in California if the LLC they own an interest in is doing business in California.

The FTB’s position has been rejected by a California court of appeals (Swart Enterprises, Inc. v. FTB (January 12, 2017) 7 Cal.App.5th 497), a case in which the out of state member held only a 0.2% ownership interest in a California investment fund LLC.  Regardless, the FTB refused to revise Legal Ruling 2014-01 and will only issue refunds to taxpayers with the same facts as Swart  – which is obviously very limiting.  Fortunately, the FTB’s position is being challenged again in a potential class action suit before the courts, filed in San Francisco County Superior Court in September 2016 (Rasmussen Company, Inc. v. FTB).  In that case the taxpayer is a member in a manager managed Texas LLC that is a member of another manager managed Texas LLC that is registered to do business in California.  The class action suit is for out of state passive LLC investors, and is still awaiting certification as a class.

The FTB can impose significant penalties for late filing of California LLC returns, including per-partner penalties ($18 per partner, per month for up to 12 months), late filing penalties (5% per month up to 25% of net income), late payment penalties (up to 5% of the unpaid tax plus 0.5% of the unpaid tax for each month unpaid up to 40 months, 25% maximum on net income), notice and demand penalty (for failure to file a return within 60 days of receiving a notice – up to 25% of the tax liability), and $2000 per year for failure to fie a California tax return when the LLC is not registered and failed to file upon notice and demand.  Unlike the IRS, California does not give any first-time abatements.

If you are doing business in California, register with the California Secretary of State and file California returns.  You may want to go back and file for previous years as well to avoid getting a notice from the FTB for previous years.  Talk to your CPA about the pros and cons of filing for previous years.  If your LLC has property or business in California, register with the Secretary of State and file California returns.  However, don’t file tax returns or register with the Secretary of State if you are considering using the FTB Voluntary Disclosure Program designed to encourage taxpayers who have not filed California returns to come forward and pay outstanding amounts in exchange for getting certain penalties waived. Registration in California means you are not eligible for that program.  Talk to your CPA about whether or not to file the Form 4925 Application for Voluntary Disclosure Program before proceeding.

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