June 2016 edition of Tax News, we looked at an out-of-state taxpayer that does business both in and outside of California and focused on the sole owner of a disregarded entity doing business in California. In this article, we will focus on those out-of-state taxpayers that are members of multiple-member limited liability companies classified as partnerships for tax purposes.
In this article, we use general terms like “out-of-state taxpayer” when discussing issues that can apply to a nonresident, an out-of-state formed partnership (general or limited), an out-of-state-formed (foreign) limited liability company (LLC), an out-of-state-formed (foreign) corporation (C corporation or an eligible entity that has elected to be taxed as an S corporation).
What has not changed?
In California, an out-of-state taxpayer must file tax return(s) if the taxpayer is doing business in California or has income from sources within California. Failure to recognize this filing requirement can be quite expensive, especially when demand penalties are factored in. This statement is especially true for pass-through business entities, such as partnerships, LLCs
2 , and S corporations.
Similar to federal law (IRC Sections 6698 and 6699), California law (Revenue and Taxation Code (R&TC) Sections 19172 and 19172.5) imposes a late filing penalty for the late filing of pass-through business entity returns (Forms 565, 568 and 100S).
 These penalties are imposed even if all taxes have been paid or as is the case with a general partnership, no taxes are imposed.
For returns required to be filed on or after January 1, 2011, the partnership/S corporation late filing penalty is $18 for each month or part of a month (for a maximum of 12 months) multiplied by the total number of partners, members, or shareholders in the entity during any part of the taxable year for which the return is filed after its due date. This penalty is in addition to the late filing penalty discussed below.
If we sent the business entity a demand-to-file notice, we may impose a $2,000 penalty per tax year (R&TC Section 19135) on nonqualified,
 suspended, or forfeited business entities doing business in California, if they do not file a tax return within 60 days after we send them a legal demand (i.e. FTB 4684 or FTB 4685) to file their return. The penalty is in addition to the demand and delinquent penalties and the filing enforcement fee.
We also impose a demand penalty if a business entity does not file a tax return after we send them a formal legal demand (i.e. FTB 4684 or FTB 4685) to do so. The demand penalty (R&TC Section 19133) also applies to individuals. In this article, we only discuss the demand penalty for business entities and their failure to file a return.
The amount of the demand penalty is 25 percent of the lesser of the tax shown on the:
- Notice of Proposed Assessment (NPA), before applying any payments or credits.
- The tax shown on the return before applying any payments or credits.
If the business entity files its original return after the NPA goes final and the tax on the return, before refundable credits, is less than the proposed assessed tax, we will reduce the penalty. Please note that since the penalty is computed before applying credits and payments, the business entity may owe penalties and interest even if the tax return shows that a refund is due.
In addition to the demand penalties (R&TC Sections 19135 and 19133), and the penalties for a taxpayer's failure to timely file a return (R&TC Sections 19131, 19172, and 19172.5), there is a penalty for failure to timely pay tax (R&TC Section 19132). The law requires us to impose this failure to timely pay penalty, which is based on unpaid taxes if this penalty is greater than the sum of the penalties imposed under R&TC Sections 19131 and 19133. The cost of not filing a timely return depends on the business entity’s actual facts and business type. The following is an example of the amounts:
Example: Assume the following business entities did not file their 2015 tax return by the extended due date, only owe the minimum/annual tax, and were owned by two shareholders/members/partners, with no payments made, including estimate payments. This chart also assumes that each entity received a notice and demand penalty pursuant to R&TC Section 19133, non-qualified, suspended, or forfeited penalty pursuant to R&TC Section 19135, or had a filing enforcement (FE) fee imposed. Other penalties and interest may apply.
|Estimate Tax Penalty
|Shareholder / Member Penalty:
|Filing Enforcement Fee
After a late filed return is processed, we will send a bill, including penalties and interest.
No Reasonable Cause - No "First-Time" Penalty Abatement
The IRS has an administrative policy that provides for a first-time abatement procedure. Pursuant to the first-time abatement procedure, the IRS will abate timeliness penalties, based on compliance history, without making a separate reasonable cause determination, if the taxpayer had not previously been required to file a return or if no prior penalties (except the estimated tax penalty imposed under IRC Section 6655(a)) have been assessed in the prior three years. The R&TC has no provision similar to this federal first-time abate policy, nor do we have any formal administrative policy that is similar to the federal policy.
California law generally requires penalties to be imposed, unless the taxpayer can show their failure to comply is due to reasonable cause and not due to willful neglect. You or your clients may use either form below to request penalty abatement due to reasonable cause:
- FTB 2917, Reasonable Cause – Individual and Fiduciary Claim for Refund
- FTB 2924, Reasonable Cause – Business Entity Claim for Refund
For more information on penalties we may assess, see FTB 1024, Penalty Reference Chart.
What has changed? - Enforcement
Each year, we compare our records of filed tax returns with millions of records, contacting people and business entities that may have a filing requirement, but did not file a California income tax return. Generally, we will issue a Notice to File LLC Return to nonregistered foreign LLCs that are members/partners in another pass-through entity that has filed a return in California.
Here is a tax professional’s question we received as an example:
What is the FTB’s position regarding a prior/current member who receives a Schedule K-1 but was not a member at the time the LLC did business in California? Are members considered to be doing business based on the activities of the LLC prior to and/or after their affiliation?
If an LLC is considered doing business in California at any time during its year, the LLC is required to file a return and must disclose gross income and deductions of the entity, the number of members, their identification, and whether they are California resident or nonresident members. A Schedule K-1 is required to be provided to each member who held an interest at any
time during the year in the LLC.
A taxpayer that is treated as a partnership for tax purposes that had ownership changes during the year would need to consider whether those membership changes caused a technical termination for both federal and state purposes, under IRC Section 708, which would in turn require the filing of short period return(s).
A nonregistered foreign LLC that is solely a nonresident partner/member of another pass-through entity would not be considered to be doing business in California if their membership is only for a portion of a year, and the pass-through entity did not do business in California for the portion of the year they were a member.
Voluntary Disclosure Program (VDP) and
Filing Compliance Agreement (FCA)
The Voluntary Disclosure Program (VDP) allows qualified entities, qualified shareholders, or beneficiaries that may have incurred an unpaid California tax liability or an unfulfilled filing requirement to disclose their liability voluntarily.
If you or your client is a business entity, partnership, or trust described in RT&C Section 19192 and you are not eligible for VDP, you may apply to enter into a Filing Compliance Agreement (FCA).
For more information, search VDP and FCA on our website.
These penalties can also be assessed if you file the returns without required information.
This penalty apply to corporations (C and S) and LLCs, including LLCs that are disregarded or taxed as a partnership. It does not apply to partnerships, general (GP), limited (LP), or limited liability partnerships (LLP).
 For this penalty to apply, a nonqualified business entity must be “doing business” in California and the business entity must have been required to register with the Secretary of State (SOS) pursuant to California’s Corporations Code.