Was a nonresident private-equity founder's entire allocable share from a management LLC California-source income when all LLC business and the founder's services occurred in California?

Plain-English summary

California Chief Counsel Ruling 2013-04 held that a nonresident private-equity founder had to treat 100% of the income allocated from a California management LLC as California-source income.

The LLC conducted all of its trade or business in California, and the founder stipulated that all services for the LLC were performed here.

The separate private-equity fund's possible status as a qualified investment partnership did not change the sourcing of income from the management LLC.

Fund and management structure

The nonresident taxpayer was a founder and managing participant in a private-equity organization.

The organization included:

• a private-equity fund holding investments largely outside California; and
• a separate LLC managing the fund and its portfolio companies.

The fund's investors and portfolio companies were predominantly outside California, but the management LLC's principal office, managers, professional staff, and administrative staff were in California.

Taxpayer's two income streams

The taxpayer received Schedule K-1 income from two separate partnerships.

From the management LLC, the taxpayer received ordinary partnership income under I.R.C. section 704(b) and guaranteed payments under section 707(c). The taxpayer supplied management and oversight services and had relatively little capital invested in the LLC.

From the fund, the taxpayer received investment-partnership income from an entity represented to qualify under Revenue and Taxation Code section 17955(c).

Why the LLC income was separate

The management LLC earned substantially all income by providing services to the fund and portfolio companies.

It was not itself a qualified investment partnership.

The special investment-partnership characterization therefore did not govern the separate service-business income allocated from the LLC.

California sourcing rule

Section 17951 limited a nonresident's California gross income to income from California sources.

Regulation section 17951-4(a) treated all net income from a business, trade, or profession conducted wholly within California as California-source income.

All of the LLC's trade or business was conducted in California, and the taxpayer performed LLC services only here.

Holding

The taxpayer had to allocate 100% of the entire income share from the management LLC to California.

That included the LLC ordinary income allocation and guaranteed payments described in the ruling.

The holding did not recharacterize or decide the separate private-equity fund income beyond noting its distinct qualified-investment-partnership status.

What this means for you

Nonresident LLC members

Investor and portfolio geography did not control income from a separate management business conducted wholly in California.

Private-equity and investment managers

Separate fund returns from management-company compensation and test each entity's actual trade or business and service locations.

Partnership tax teams

Maintain entity-by-entity income streams, partnership agreements, office and employee locations, member service records, capital interests, guaranteed payments, and support for any qualified-investment-partnership classification.

Common questions

Q: Did the out-of-state fund investors make the LLC income non-California source?

A: No.

Q: Did the fund's out-of-state portfolio investments control?

A: No. The ruling focused on the separate management LLC's business.

Q: How much of the LLC income was California source?

A: One hundred percent.

Q: Did that include guaranteed payments?

A: Yes, as part of the LLC income described in the ruling.

Citations and references

• I.R.C. §§ 704(b) and 707(c)
• Cal. Rev. & Tax. Code §§ 17951, 17955(c), and 21012(a)(1)
• Cal. Code Regs., tit. 18, § 17951-4(a)

Source

• Landing page: California FTB Chief Counsel Rulings
• Official PDF: Chief Counsel Ruling 2013-04

Original ruling text

chair John Chiang | member Jerome E. Horton | member Michael Cohen

Legal Division MS A260
PO Box 1720
Rancho Cordova, CA 95741-1720

tel: (916) 845-3306 fax: (916) 845-3648
ftb.ca.gov

12.30.13
CHIEF COUNSEL RULING 2013-04

Re: Request for Chief Counsel Ruling for *****

Dear M. **,

This is in response to your Chief Counsel Ruling Request of February 8, 2013, wherein you seek guidance as to the proper California taxation of income of a nonresident taxpayer received from a limited liability company.

FACTS

*** (Taxpayer), a nonresident of California, is a Founder and *
** of *. The *** organization includes a number of legal entities that operate as a private equity fund (PEF) that manages over $
** invested by general and limited partners. Of the total of over $ ** of investment commitments made by the partners of ***, over ninety percent (90%) will be received from partners located outside of the State of California. Of the total amount actually invested, over ninety percent (90%) of funds have been invested in the equity of portfolio companies that are not incorporated or headquartered in the State of California. However, PEF operates from a principal office located in ***, California.

PEF is managed by ***, LLC (LLC). None of the limited partners of PEF own an economic interest in LLC.

LLC has its principal administrative office in *****, California, where its Managing Directors, Principals, Associates, and administrative staff are employed. The principal business of LLC consists of providing services to PEF and the portfolio companies owned by

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Chief Counsel Ruling 2013-04
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PEF, a group of companies resident in various locations around the world. As a result of its services-based business model, LLC requires no substantial assets and virtually no investment of capital by its owners.

The Managing Directors of LLC take part in the day-to-day management of LLC and its subsidiaries, with Taxpayer retaining control of LLC's activities. Employees provide various services to LLC and several entities related to LLC, including human resources, insurance, benefits, IT, legal, accounting, and procurement. All of the trade or business of LLC is conducted in California. Taxpayer stipulates that he provides services for LLC only in California.

Over eighty percent (80%) of Taxpayer's federal taxable income is derived from the separate partnerships of ** and is reported on the Schedules K-1 issued by LLC and PEF. In general, the items reported on those Schedules K-1 may be divided into two groups:

First, as a Member, Taxpayer receives an annual allocation of the taxable income of LLC. LLC is taxed as a partnership and earns substantially all of its income by providing services to PEF and the various portfolio companies owned by PEF. As a Founder and Member of LLC, Taxpayer provides management and oversight services to LLC, but has a relatively insignificant investment of capital in LLC. LLC maintains an office in ****, California. For federal income tax purposes, substantially all of the net taxable income of LLC constitutes ordinary income which is allocated to the members as either partnership income under the rules of Internal Revenue Code (IRC) section 704(b) or as guaranteed payments under the rules of IRC section 707(c).

Second, as a Partner, Taxpayer receives an annual allocation of the taxable income of PEF, which operates as a "qualified investment partnership" as defined in California Revenue and Taxation Code (CRTC) section 17955(c).

ISSUE

Does Title 18 of the California Code of Regulations (CCR), section 17951-4(a) operate to source Taxpayer's income from LLC to California?

HOLDING

Under CRTC section 17951, the gross income of a nonresident includes only the gross income from sources within California. Further, under CCR section 17951-4(a), if a nonresident's business, trade or profession is conducted wholly within California, the entire net income therefrom is deemed to be derived from sources within this state. In his case, Taxpayer's income from LLC is thus properly sourced wholly to California under CCR section 17951-4.

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DISCUSSION

As applied to Taxpayer, the income streams generated within the legal structures of PEF and LLC reflect two pools of income: income from a trade or business conducted within LLC, and income from ownership in a qualified investment partnership conducted within PEF. As noted in the following discussion, even if PEF continues to operate so as to qualify as a qualified investment partnership, the income from LLC should be allocated to California.

Taxpayer's Income from the Trade or Business of LLC Should Be Allocated Based on Where the Business of LLC is conducted.

Although LLC's primary activities involve management services for PEF, LLC is not a qualified investment partnership. Therefore, Taxpayer must use the rules under CRTC section 17951 to determine the sourcing of his income from LLC.

Under the provisions of CRTC section 17951, a nonresident individual is subject to income tax in California on all income that is derived from sources within California. When a nonresident's business is conducted wholly within California, the net income has a source in California under CCR section 17951-4(a).

Here, all of the trade or business of LLC is conducted in California. Taxpayer stipulates that he only provides services for LLC in California. Under these facts, Taxpayer should treat one hundred percent (100%) of his allocable share of the entire income of LLC as California- source income.

Please be advised that the tax consequences expressed in this Chief Counsel Ruling are applicable only to the named taxpayer and are based upon and limited to the facts you have submitted. In the event of a change in relevant legislation, or judicial or administrative case law, a change in federal interpretation of federal law in cases where our opinion is based upon such an interpretation, or a change in the material facts or circumstances relating to your request upon which this opinion is based, this opinion may no longer be applicable. It is your responsibility to be aware of these changes, should they occur.

This letter is a legal ruling by the Franchise Tax Board's Chief Counsel within the meaning of paragraph (1) of subdivision (a) of section 21012 of the Revenue and Taxation Code. Please attach a copy of this letter and your request to the appropriate return(s) (if any) when filed or in response to any notices or inquiries which might be issued.

Very truly yours,

Natasha Sherwood Page
Tax Counsel