Recently, many LLCs owning an interest in an LLC that conducts business in California have been receiving billing notices with high penalties for failing to timely file California Form 568, Limited Liability Company Return of Income . Commonly, California identifies an LLC member of an LLC conducting business in California and sends a notice requesting the filing of Form 568 if the entity has not already done so.
Many LLCs that are not connected to California other than via investment interests in LLCs that are conducting business in California are unknowingly not complying with California's filing requirements, especially if the California apportioned net income is small or a loss. Once the return is filed, California sends a billing notice that includes a penalty that may be substantially higher than the original amount due with the return. How can this be? An analysis of this issue requires a review of California's treatment of LLCs.
California's Revenue and Taxation Code Section 17942 subjects California LLCs to an $800 annual tax plus an annual fee based on the amount of apportioned California gross receipts. The annual fee ranges from $0 for apportioned gross receipts below $250,000 to a high of $11,790 on apportioned gross receipts of $5 million or more. Apportioned gross receipts of a lower-tier LLC are disregarded in calculating the fee on an upper-tier LLC. The tax and annual fee are reported on California Form 568, which is due on the 15th day of the fourth month after the LLC's year end. Failure to make the annual filing subjects the LLC to a penalty of $18 per member per month up to a maximum of 12 months. In addition, the LLC is subject to a late-filing penalty of 5% per month (or part thereof) up to a maximum of 25% of the unpaid LLC tax and fee (if applicable) and a failure-to-pay penalty that begins at 5% and increases by 0.5% for each month the payment is late, up to a maximum penalty of 25%.
Furthermore, an LLC doing business in California that does not register to do business in California or whose right to do business in California has been suspended or revoked is now subject to a penalty of $2,000. The "failure to register" penalty is effective for tax years beginning on or after Jan. 1, 2013. This penalty can be assessed by the Franchise Tax Board annually (California Franchise Tax Board, Form 568 Booklet, 2013 , p. 3).
Example: LLC A , which has 100 members, invests in private-equity deals. In 2011, LLC A purchases a 1% interest in LLC B . For 2011, LLC B has $2 million of California gross receipts and a California taxable loss of $1 million. LLC B reports to LLC A that A' s share of the California gross receipts is $20,000 and its share of the California loss is $10,000. LLC A does not file a 2011 return with California assuming that it had a taxable loss and was not otherwise conducting business in California. In 2013, California sends LLC A a notice requesting the filing of Form 568. LLC A checks with its CPA who informs A that its ownership interest in B subjects A to the annual LLC filing in California. The CPA prepares California Form 568 for 2011 and files it along with the $800 annual tax. The annual fee is $0, as LLC A does not have any California apportioned gross receipts other than those reported by LLC B . Shortly after filing the return, LLC A receives a billing notice for the $800 tax plus a penalty of $21,600 plus interest less credit for the $800 payment made with the late-filed return.
The trap that LLC A fell into is that California considers a tiered entity as doing business in California if it is a nonregistered foreign LLC that is a member of an LLC that does business in California, in this case, LLC B . In fact, the instructions to Form 568 specifically state that for any year after Jan. 1, 2011, an LLC member or a general partner is considered to be doing business in California if the LLC or partnership is doing business in California. The problem is often compounded when multiple years are involved in the nonfiling.
California does permit taxpayers to request abatement of the penalty. However, the abatement process takes a long time, and California will not suspend collection action while the taxpayer waits for California to act on the abatement request. In some cases, taxpayers have had their bank accounts levied while waiting for a response on an abatement request. California advises taxpayers to pay the penalty and to ask for a refund on their abatement request. This is not a great position to be in given California's well-documented financial problems.
Interestingly, if LLC B had been organized as a limited partnership (LP) and not as an LLC and if LLC A' s interest had been an LP interest in LLC B , then LLC A would not have been subject to the LLC California filing requirement. This structure avoids the issue of the LLC doing business in California and relieves it of the requirement to register to do business and pay the LLC tax and fee. However, if the LLC has California-source income from its LP interest, it will still have a filing requirement ( Form 568 Booklet, 2013, p. 6). In these circumstances, the LLC is required to file California Form 565, Partnership Return of Income . Again, failing to file the required return will subject the LLC to the failure-to-file penalty of $18 per partner per month for up to 12 months.
California's distinction between investments in LLCs and LPs probably traces back to the ruling in Appeal of Amman & Schmid Finanz AG , No. 96-SBE-008 (Cal. St. Bd. of Equal. 4/11/96). The taxpayer was a C corporation whose only connection to California was its investment in several LPs that conducted business in California. At the time, California imposed a franchise tax on all corporations doing business in California. The Franchise Tax Board asserted that the general partner of the LPs in which the taxpayer was a limited partner engaged in transactions involving California property on behalf of all partners, and thus the limited partners were deemed to be doing business in California for purposes of the franchise tax. The California State Board of Equalization ruled in the taxpayer's favor, concluding that the LP interests did not constitute doing business in California. The basis for its conclusion was that limited partners did not possess an interest in any of the following three attributes:
One could argue that nonmanaging members of LLCs are no different from limited partners and thus should not be considered to be doing business in California merely through their investment in an LLC that is doing business in California. It will be interesting to see if a taxpayer will challenge California's position given the favorable franchise tax case. If California continues to assert its definition of doing business for purposes of the LLC fee, the risk grows that other states will adopt California's position, which could greatly reduce the usefulness of LLC structures.
While California is aggressively pursuing passthrough entities that, under its broad definition, are doing business within the state, and taxpayers need to be aware of the significant penalty exposure for failure to comply with California rules, many other states require passthrough entities that have income sourced to their states to file annual information returns. Those states also may impose significant penalties for failure to file the appropriate partnership information returns.
The increased complexity in the investment world and the vast expansion of private-equity and investment funds doing business as entities treated as partnerships or other passthrough entities, and the use of multitiered structures to make investments, has certainly increased the need for tax practitioners to be diligent in their practice. Tax practitioners should have engagement letters that clearly spell out their responsibility to prepare state and local returns (and other filings) on behalf of the client. The tax engagement letter should clearly state the returns the practitioner or firm is responsible for preparing. It should also clearly state that the client has not engaged the practitioner or the firm to determine whether the client is required to file any additional returns outside of the identified returns. Although tax practitioners are generally viewed as client advocates, the risk associated with failure to file the unknown returns is so great that practitioners must do all they can to protect their clients from these penalties and themselves.
Anthony Bakale is with Cohen & Co. Ltd., Cleveland.
For additional information about these items, contact Mr. Bakale at 216-774-1147 or tbakale@cohencpa.com.
Unless otherwise noted, contributors are members of or associated with Cohen & Co. Ltd.