Does a California investment partnership owe nonresident withholding or the LLC fee?

What makes a partnership an investment partnership

Section 17955 is a sourcing statute for nonresidents. Notwithstanding the general sourcing sections, 17951 through 17953, a nonresident's gross income from sources within California does not include dividends, interest, or gains and losses from qualifying investment securities in the situations the statute lists, one of which is an individual whose only contact with California is a broker, dealer, or investment adviser here (section 17955(a), (a)(1)). The one that matters for funds is a partner's distributive share of income from qualifying investment securities where the partnership qualifies as an investment partnership, "whether or not the partnership has a usual place of business located in this state" (section 17955(a)(2)).

The definition has two tests, both floors at 90 percent. The asset test is measured by cost, not value: no less than 90 percent of the partnership's cost of its total assets must consist of qualifying investment securities, bank and financial institution deposits, and office space and equipment reasonably necessary to carry on its activities as an investment partnership (section 17955(c)(1)(A)). The income test is measured by gross income: no less than 90 percent must be interest, dividends, and gains from the sale or exchange of qualifying investment securities (section 17955(c)(1)(B)). A partnership with 85 percent of its asset cost in qualifying securities and 15 percent in assets outside the list fails, however passive the remainder.

What counts as a qualifying investment security is a list (section 17955(c)(3)(A)): common stock, including preferred or debt securities convertible into common stock, and preferred stock; bonds, debentures, and other debt securities; foreign and domestic currency deposits or equivalents; mortgage- or asset-backed securities secured by federal, state, or local governmental agencies; repurchase agreements and loan participations; foreign currency exchange contracts and forward and futures contracts on foreign currencies; stock and bond index securities and futures contracts and similar financial securities; options on any of those; and regulated futures contracts. Two absences matter. Real property is not on the list, so real estate counts against the asset test, and a partnership whose real estate exceeds a tenth of its asset cost cannot qualify. And a partnership interest is not a qualifying investment security unless that partnership is itself an investment partnership (section 17955(c)(3)(B)), so an interest in a fund that is not itself an investment partnership counts against the 90 percent tests, tested one tier at a time. The list is not read narrowly: the Franchise Tax Board ruled for one taxpayer that commodity-linked derivatives held by a master fund were qualified investment securities (Chief Counsel Ruling 2010-1 (Mar. 25, 2010)).

The line between a debt security and real estate is finer than it looks. In a ruling dated December 28, 2000, issued to one taxpayer on its facts, the Franchise Tax Board treated notes secured by California real estate, acquired from third parties and held long term as the partnership's only assets, as debt securities under section 17955, reasoning that the real estate security was "of no importance since the income is produced by the notes," and concluded that no withholding was required (Chief Counsel Ruling 20-0531). The ruling called the acquisition of the notes critical to its determination. A partnership that originates loans, or forecloses and holds the collateral, is a fact pattern the ruling does not reach.

An LLC classified as a partnership is treated the same way. The Form 568 instructions state that nonresident members' income from qualifying investment securities of an LLC that qualifies as an investment partnership is generally income from sources other than California, and that the LLC should tell its nonresident individual and foreign members whether their distributive share comes from qualifying investment securities and whether it is sourced to California (2025 Form 568 Booklet, General Information O). Item F(2) of Schedule K-1 (568) is checked when the LLC qualifies as an investment partnership as defined in sections 17955 and 23040.1 (2025 Schedule K-1 (568) instructions).

Why withholding falls away for nonresident partners

California's withholding statute, section 18662, and the regulations under it require withholding on payments and distributions of California source income to nonresidents (FTB Publication 1017 (rev. 02/2026)). For domestic nonresident owners of a pass-through entity, the regime the library's article on domestic pass-through withholding describes is 7 percent of the gross payment or distribution, with withholding optional on the first $1,500 paid to a payee in the calendar year (Cal. Code Regs., tit. 18, section 18662-4(a)(2), (a)(3)). The operative phrase is California source income. Section 17955 removes a qualifying partnership's interest, dividends, and securities gains from the nonresident partner's California source income, and the regulation closes the loop under the heading "Income from Qualified Investment Securities": withholding at source "is not required on payments of income from qualified investment securities excluded from taxable income of a nonresident or part-year resident under Revenue and Taxation Code sections 17955 and 23040.1" (section 18662-4(b)(13)). The Franchise Tax Board's withholding publication says the same: income earned by partners in investment partnerships from the buying, selling, or holding of qualified investment securities is not derived from California sources and is not subject to withholding (Publication 1017, Question 103).

Foreign partners reach the same place by a different statute. Section 18666 requires withholding on California source income allocable to a foreign (non-U.S.) partner (Publication 1017, Questions 114 and 115), and the Form 568 instructions state that foreign members generally are not taxed on income from qualifying investment securities of an LLC investment partnership (2025 Form 568 Booklet, General Information O). Income that is not California source gives the foreign partner regime nothing to reach.

Two consequences follow. First, the answer does not depend on the distribution base: a Franchise Tax Board proposal to move the domestic regime from distributions to distributive shares has been pending for years, and under either base there is nothing to withhold on when the income is not California source. Second, the exclusion is item by item, not entity-wide. A partnership can qualify with up to 10 percent of its gross income from other sources, and that income, if California source, is withheld on in the ordinary way: a fund holding a California rental building inside the 10 percent band withholds on the rent it distributes.

Two neighboring rules should not be confused with this one. The general intangible rule treats a nonresident's income from stocks, bonds, and notes as not California source unless the property has acquired a business situs here (Publication 1017, Question 18); section 17955 matters because a nonresident partner's share of a partnership doing business in California would otherwise be sourced through the partnership. And an LLC's payment of tax for nonconsenting nonresident members does not relieve it of the duty to withhold, though an LLC paying that tax for all of them may request a waiver (Publication 1017, Question 101).

The exceptions that bring the income back

The carve-out is drafted around the nonresident's other California activity rather than the partnership's. Section 17955 does not apply to income from investment activity that is interrelated with any trade or business activity in California of the nonresident, or of an entity in which the nonresident owns an interest, whose primary activities are separate and distinct from acquiring, managing, or disposing of qualified investment securities; nor does it apply if the securities were acquired with working capital of a California trade or business in which the nonresident owns an interest (section 17955(b)). The Franchise Tax Board's publication restates both limbs (Publication 1017, Question 103). The first reaches a fund partner who also runs a California operating business intertwined with the investment program; the second, a California business that parks working capital in a partnership. Neither turns on the partnership's own California management. In the 2000 ruling, loan servicing on the notes was held insufficient to constitute more than investment activity, whether or not the servicing was attributable to the partnership.

Corporate partners are governed by a parallel statute with stricter conditions. Section 23040.1 gives a corporate partner the same exclusion, and the Franchise Tax Board states its conditions this way: it holds where that income is the corporation's only California source income (2025 Schedule K-1 (568) instructions), and a bank or corporation is taxed on its share if it participates in the management of the investment activities or is engaged in a unitary business with another taxpayer that participates in managing them or has income from California sources (Publication 1017, Question 103). The library's article on corporate limited partners in investment funds covers how a California-domiciled blocker loses the exclusion; for withholding, section 18662-4(b)(13) cross-references both statutes, so a corporate partner that fails section 23040.1 is back inside the ordinary regime.

The partnership is the withholding agent, and section 18668 makes it liable for the withholding required (Publication 1017). The 90 percent tests are measured on its own books; the subdivision (b) exceptions and the section 23040.1 conditions turn on facts it does not hold, what else each nonresident partner does in California and how a corporate partner's unitary group is composed. A fund that relies on the exclusion without asking its nonresident partners anything is relying on facts it has never seen.

The LLC fee does not follow the sourcing exclusion

The LLC annual tax and fee are imposed by a different chapter with a different trigger. An LLC owes the annual tax if it is doing business in California or its articles of organization have been accepted or its certificate of registration issued by the Secretary of State (section 17941; 2025 Form 568 Booklet). The tax is $800 in the ordinary case; legislation enacted in 2026 sets a $400 amount for an LLC's first taxable year for taxable years beginning on or after January 1, 2027 and before January 1, 2030 (Stats. 2026, ch. 23). Doing business includes being organized or commercially domiciled in California (section 23101; 2025 Form 568 Booklet), so an LLC fund managed from California, or organized or registered here, owes the tax before any sourcing analysis begins. Every LLC subject to the tax also owes the fee once its total California income reaches $250,000: $900 from $250,000, $2,500 from $500,000, $6,000 from $1,000,000, and $11,790 from $5,000,000 (section 17942; 2025 Form 568 Booklet).

The base is where the assumption that an investment partnership pays no fee fails. Total income for the fee is gross income, plus the cost of goods sold paid or incurred in connection with the trade or business, and the California portion is determined "using the rules for assigning sales under R&TC Sections 25135 and 25136 and the regulations thereunder, as modified by regulations under R&TC Section 25137, if applicable, other than those provisions that exclude receipts from the sales factor" (2025 Form 568 Booklet, Schedule IW instructions, describing section 17942). The instructions add that the rules in section 25137(c) that remove items from assignment in their totality do not apply. Interest, dividends, and gains are gross income. The measure contains no business or nonbusiness screen and no cross-reference to section 17955 or section 23040.1. The excluded-receipts clause bears on an investment vehicle in particular, because the gross receipts exclusions under section 25120 reach securities transactions (Cal. Code Regs., tit. 18, section 25136-2(b)(7)) and the fee computation does not apply them. The only exclusion the instructions describe is for allocations, distributions, or gains from another LLC that was already subject to the fee.

Applying the assignment rules to a fund's income produces a California number unrelated to where its members live. Interest from investments other than loans is assigned to California if the investment is managed in California (section 25136-2(d)(1)(A)2.a.), so an LLC whose manager sits in California assigns its portfolio interest here in full. Interest from loans follows the location of the real property securing them or, for unsecured loans, the borrower (section 25136-2(d)(1)(A)2.b., c.). Dividends are assigned by looking through to the payor's California payroll and property factors, or its sales factor where intangibles make up more than half of its assets, with the payor's commercial domicile as the fallback where that information is unavailable (section 25136-2(d)(1)(A)1.a., b., e.). Sales of marketable securities are assigned to the location of the customer, an individual's billing address or a business entity's commercial domicile, and reasonably approximated where neither can be determined (section 25136-2(f)(2) to (4)). The regulation's 2025 amendments apply to taxable years beginning on or after January 1, 2026 (section 25136-2(j)(3)).

The Franchise Tax Board has not published guidance applying these rules to an investment partnership LLC by name. What it has said points away from the no-fee assumption: its instructions state that for apportioning purposes income from an LLC investment partnership is generally considered business income, and that such an LLC doing business in and outside California apportions on Schedule R (2025 Form 568 Booklet, General Information O). An argument that the income is nonbusiness income excluded from the fee base has to overcome a measure that never asks the question and instructions that answer it the other way. The result is asymmetric: section 17955 protects nonresident members from California income tax on the LLC's portfolio income, and section 17942 charges the LLC a fee on that same income where it is managed from California. The fee is capped at $11,790, but timing matters: the estimated fee is due by the 15th day of the sixth month of the taxable year, and the penalty is 10 percent of the amount by which the year's fee exceeds the timely estimated payment, unless that payment was at least the prior year's total fee (2025 Form 568 Booklet). A fund organized as a limited partnership owes the limited partnership annual tax but no counterpart to this fee.

Texas: a different test, and no LLC need apply

Texas has no investment partnership rule; it has a passive entity rule, and the two are not interchangeable. A passive entity is outside the franchise tax, and to qualify it must be a partnership or trust, other than a business trust, for the entire accounting period and must meet a 90 percent passive income test (Tex. Tax Code section 171.0003; Comptroller, Franchise Tax Frequently Asked Questions, Passive Entities). An LLC cannot qualify, and one converting to a limited partnership may not qualify for the period of the conversion. The income rules differ as well: the Comptroller treats unrecaptured section 1250 gain, a capital gain on real property, as passive income, while rent is not (section 171.0003(b)), and California counts real estate against its asset test. Compliance survives the exemption: for 2024 and later reports, a passive entity registered or required to register with the Secretary of State or the Comptroller files an annual report affirming its status, though not a Public Information Report (Comptroller, Passive Entities FAQ).

Practice notes

The two California questions are answered on two different sets of books. Investment partnership status is established on the partnership's own balance sheet and income statement, at cost for the asset test and gross income for the income test, and a computation kept current each year supports the item F(2) answer on each Schedule K-1 (568) and any auditor's question. The section 17955(b) exceptions and the section 23040.1 conditions rest on the partners' facts, which subscription documents and annual partner certifications collect: whether a nonresident individual owns an interest in a California trade or business interrelated with the investment program, whether the capital contributed was working capital of a California business, and, for a corporate partner, whether it participates in management or has other California source income through its unitary group. A partner who fails those conditions is withheld on in the ordinary way, and the partnership carries the liability if it is not. The LLC fee is computed as though section 17955 did not exist: gross income, assigned under the sales assignment rules without the gross receipts exclusions, with the estimated fee paid by the sixth month; a fund choosing between a California LLC and a limited partnership is choosing, among other things, whether to owe it. An LLC fund that is an investment partnership in California is not a passive entity in Texas. G&G State Tax Group provides investment partnership qualification, nonresident withholding, and LLC fee analysis for funds and their partners alongside its state and local tax practice.