State & Local Tax Bulletin (March 2006)
San Francisco Court Rules
LLC Tax Unconstitutional
By Craig A. Becker,
a tax partner in
the Palo Alto office of Pillsbury Winthrop
Shaw Pittman LLP.
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A San Francisco trial court has issued a tentative ruling concluding that California's Revenue and Taxation Code ("R&TC") section 17942 levy on limited liability companies ("LLCs") is an unconstitutional tax. Northwest Energetic Services, LLC v. California Franchise Tax Board (San Francisco Sup.Ct.No. CGC-05-437721, March 3, 2006).
The case concerned a Washington state LLC that never had any sales, property, payroll or other activity in California, other than registering with the California Secretary of State. The taxpayer had paid the annual $800 minimum tax under R&TC section 17941, but refused to pay the R&TC section 17942 levy based on gross LLC income from all sources, both within and without California. When assessed $27,453 for six years of back tax, interest and penalties, the taxpayer paid the assessment and sought a refund. After being denied relief by the State Board of Equalization (which concluded it had no authority to address constitutional issues, SBE No. 236696, October 19, 2004), the taxpayer sued for refund in superior court.
The court first concluded that this "levy" is a tax, not a fee. The court found that the levy bore no relationship to either the California benefit provided the taxpayer or the burden imposed on California. Indeed the California legislature specifically provided separate LLC filing fees to cover administrative costs. The court noted the levy was well beyond any potential regulatory cost as the annual proceeds generated by R&TC section 17942 exceed the entire budget of the California Secretary of State. Finally, the R&TC section 17942 legislative history confirms that this "levy" was intended to replace tax revenues lost by business usage of new LLC flow_through entities rather than C corporations.
The court then concluded this LLC tax violates the commerce clause and due process clause of the United States Constitution because it is based on worldwide gross receipts and not apportioned between income sourced within and without California. The court noted this failure to calibrate the tax to the taxpayer's California activity violates the four part test of Complete Auto Transit v. Brady, 430 U.S. 274, 279 (1977) (taxed activity must have nexus to the state, be fairly apportioned, not discriminate against interstate commerce and be fairly related to state provided services). The tax also fails to satisfy the required internal and external consistency tests as duplicate taxation would occur if other states applied the same taxing regime. See Oklahoma Tax Comm'n v. Jefferson Lines, Inc., 514 U.S. 175, 189 (1995).
The California Franchise Tax Board ("FTB") has asked the trial court to reconsider its decision, filing a March 20, 2006 brief claiming (among other things) that R&TC section 17942 is truly a fee (rather than a tax) because it is only imposed on those LLCs that choose to do business in California (a novel view that suggests that all California taxes are merely fees because they are paid by businesses choosing to operate or individuals choosing to reside in California). Accordingly, the FTB will no doubt continue to enforce and collect the R&TC section 17942 tax as long as any avenue of appeal remains. Even if the FTB were not contesting the decision, it would not be binding precedent as it is only a trial court decision. The taxpayer in Northwest Energetic had no California source income or any other California presence. While the decision appears to conclude that R&TC section 17942 is an unconstitutional tax on all LLCs, including those with California activities, it remains uncertain whether a California court would be as willing to conclude the tax was unconstitutional for an LLC that generated all (or most) of its income from California sources.
Practitioners have long thought that R&TC section 17942 was subject to constitutional challenge because of its failure to apportion the tax base between in-state and out-of-state activity. The FTB recently published guidance for taxpayers seeking to file protective refund claims (Cal.CCH ¶ 403-983, March 16, 2006). Taxpayers seeking to protect their right to recover past R&TC section 17942 taxes need to file refund claims within four years of paying the tax. R&TC §§ 19301 et seq. Taxpayers paying the R&TC section 17942 LLC tax should review their particular facts and circumstances and file protective refund claims for the entire amount of the taxes paid in accordance with the recent FTB guidance. We are available to assist in computing the potential recoveries and preparing necessary refund claims.
This material is not intended to constitute a complete analysis of all
tax considerations. Internal Revenue Service regulations generally
provide that, for the purpose of avoiding United States federal tax
penalties, a taxpayer may rely only on formal written opinions meeting
specific regulatory requirements. This material does not meet those
requirements. Accordingly, this material was not intended or written to
be used, and a taxpayer cannot use it, for the purpose of avoiding
United States federal or other tax penalties or of promoting, marketing
or recommending to another party any tax-related matters.
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