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California Franchise Tax Board Issues Guidance on Unity in Pass-Through Entity Structures
The California Franchise Tax Board (FTB) issued Legal Ruling 2021-01 on October 25, 2021, addressing the pertinent tests and considerations for determining whether a pass-through entity holding company is unitary with its underlying pass-through investment(s) in various situations. The ruling focused its analysis on the “three unities test” (unity of ownership, unity of operation, and unity of use) and the “contribution or dependency test” that arose from Butler Brothers and Edison California Stores1 to help determine unity among separate businesses. The FTB acknowledged that certain indicia of unity can be viewed differently for holding companies than for traditional operating companies. Referencing PBS Building2, the FTB indicated flows of value and contribution or dependency for a holding company may result from overlap of officers and directors, insulation of liability, acting as a conduit for ownership, intercompany financing, shared tax benefits, improved creditworthiness, and covenants not to compete. Holding and controlling a single unitary business will constitute unity for a holding company and its subsidiaries. However, holding several disparate and unrelated operating businesses will not constitute unity.
Analyzing these indicia, the FTB differentiated the unitary determination for pass-through holding companies from traditional C corporation holding companies. While more than 50 percent common ownership is required for unity with a C corp holding company, the FTB advised majority ownership and control is not necessary for a pass-through holding company. It can still be unitary to the extent of its ownership interest by demonstrating other indicia of unity, such as providing value and support. To further its analysis, the FTB provided examples demonstrating the importance of the functions, roles, and substance of holding companies in tiered pass-through structures. These examples show that evidencing integral functions the holding companies perform for their underlying operating entities, such as control of management and policy decisions and management of or assistance in the day-to-day operations, effectively substantiates a unitary relationship. In addition, the ruling specifically addressed limited partnership structures, contrasting the duties of holding companies acting as limited and general partners. Regardless of the controlling interest in the limited partnership, the general partner’s decision-making authority and active management lead to operational control and unity, whereas a limited partner with no active participation or value is a passive investor that cannot be seen as unitary.
The FTB’s legal ruling offers important clarity and considerations for investors in pass-through structures. For more information, reach out to your BKD Trusted Advisor™ or submit the Contact Us form below.
1 Butler Brothers v. McColgan (1941) 17 Cal.2d 664, 678, affd. (1942) 315 U.S. 501; and, Edison California Stores, Inc. v. McColgan (1947) 30 Cal.2d 472, 481 ↩
2 Appeal of PBS Building Systems, Inc. and PKH Building Systems, Inc., 94-SBE-008, Nov. 17, 1994, "(PBS Building)" ↩