Although LLCs are have some distinct advantages over corporations and partnerships there are some peculiar California tax rules which lessen those advantages. If you have a business (corporation, LLC, LP) that is "doing business" in California then that business is required to pay a minimum franchise tax of $800 per year--just for the opportunity to do business in this state. However, in addition to that fee, LLC's doing business in the Golden State must also pay an additioinal minimum tax based on the LLC's gross receipts ranging from $0 to $11,790 annually.
Often, Californians find it desirable to invest in property in neighboring states. In an attempt to avoid these franchise taxes and fees, owners often incorporate or organize business entities in these states. They then argue that because the principal assets are out of state, and are in fact owned by a non-California entity, that there is no possible way that the foreign entity is “doing business” in California.
Unfortunately, the threshold of “doing business” in California can be quite low. This is illustrated by a non-precedential 2006 State Board of Equalization decisions called Appeal of Mockingbird Partners, LLC. In Mockingbird, there were California residents who established a Montana LLC, which in turn purchased Montana real property. The LLC even hired a Montana based property management company to handle the day-to-day management of the property. Believe it or not, the BOE declared that the LLC was in-fact, doing business in California and so the LLC would be subjected to franchise taxes and fees. The BOE held that property purchase negotiations conducted by the California residents as well as loan negotiations between the LLC and its California owners were sufficient to meet to the “doing business” test. The BOE stated that it is not where property is located that is most germane to determining whether the LLC was conducting business in California, but where the activity of the business that owns that property occurred.
It is important to note, however, that in the Mockingbird case, the LLC was established as “Member-Managed” LLC, which has the implicit assumption that it’s owners are the managers, even though they may hire out managers for day-to-day operations. Thus, it would like have been preferred to establish a “Manager-Managed” LLC in that case. Alternatively, it remains to be seen whether Californians should purchase the property individually, and then, post-closing, form the foreign LLC so that it can be demonstrated that during all times of the LLC’s existence, its owners did not do business in California.
California residents who have foreign LLCs that are NOT paying California franchise taxes or fees should seriously consider how they are structured and whether an alternative arrangement may be beneficial.