SECOND DECISION BY CALIFORNIA COURT OF APPEALS AFFIRMS TRIAL COURTS RULING IN FAVOR OF LIMITED LIABILITY COMPANY TAXPAYERS
by Glenn A. Fuller, Esq. & Stanley E. Heyman, Esq.
The Beverly-Killea Limited Liability Company Act ("LLC Act") was enacted in California to regulate the formation operation of limited liability company ("LLC") operating in California. The LLC Act requires that any LLC that registers in California pay an annual minimum tax set forth in Section 17941 of the California Revenue & Tax Code ("Section 17941"). (Currently, an Eight Hundred Dollar ($800) annual fee) and for each LLC to pay a "levy" proscribed by Section 17942 of the California Revenue & Tax Code ("Section 17942"). Specifically, subdivision (a) of Section 17942 provided that "every limited liability company subject to tax under Section 17941 (in other words, qualified to do business in California) shall pay annually to the State a fee between $900 to a maximum of $11,790 per year, depending upon the gross receipts of the limited liability company." (Emphasis added.)
From the outset, Section 17942 was controversial in that it makes no distinction between gross revenues earned from California sources and those earned outside of California. In addition, the fee imposed by Section 17942 applied as long as the LLC registered to do business in California, and the rate was applied without regard to the amount of business the taxpayer actually does within California, if any.
The principal legal challenges to Section 17942 came from two key cases: (i) Northwest Energetic Services, LLC v. Franchise Tax Board (San Francisco Sup.Ct. No. CGC-05-437721, March 3, 2006) ("Northwest Case") and Ventas Finance I, LLC v. Franchise Tax Board(San Francisco Sup.Ct. No. CGC-05-44000, November 7, 2006) ("Ventas Case").
NORTHWEST CASE
The plaintiff in the Northwest Case was a company called Northwest Energetic Services, LLC, a Washington limited liability company ("Northwest"). Northwest was organized in the state of Washington and registered to do business in California. Northwest conducted no business activities in California, owned no property or maintained any inventory in California and had no employees or other agents undertaking any business in California.
Notwithstanding the fact that Northwest had such tenuous contacts with the State of California, Northwest paid the $800 minimum tax imposed on LLCs by Section 17941; however, it never paid the levy imposed by Section 17942.
The California Franchise Tax Board ("FTB") claimed that Northwest owed the State of California the levy imposed by Section 17942 based on its total worldwide receipts. Northwest paid the assessment, filed a refund claim with the State of California and, after exhausting its administrative remedies, filed suit in superior court.
The Superior Court in the Northwest Case found the levy imposed by Section 17942 was a violation of the United States Constitution, and awarded Northwest a full refund of all the amounts Northwest had paid under Section 17942. California's FTB sought review of the trial court's decision in Northwest Energetic Services, LLC v. Franchise Tax Board (159 Cal.App.4th 841). The First Appellate District, Division Five, rejected the FTB's position and affirmed the trial court's ruling.
VENTAS CASE
The Ventas Case involved a LLC called Ventas Finance I, LLC, a limited liability company organized in Delaware ("Ventas"), headquartered in Kentucky and qualified to do business in California. Ventas did not challenge that it did not owe the State of California any funds pursuant to Section 17942; however, Ventas claimed that the amount it owed should only be proportioned to its business activities in California. When Ventas was unable to secure a refund of the amounts paid that it claimed were disproportional to its business activities in the State of California, Ventas sued.
As in the Northwest Case, the California FTB contended that the levy imposed by Section 17942 was a "fee", not a "tax." In both the Northwest Case and the Ventas Case, the trial courts flatly rejected the FTB's position.
The Ventas Case has also been upheld on appeal pursuant to an August 11, 2008 state appellate court ruling (Ventas Finance I, LLC v. California Franchise Tax Board, Cal.Ct.Appl, No. A116277, 08/11/08). Attorneys for Ventas have indicated that they will file a petition for rehearing with the California Court of Appeal on the issue of if Ventas was only entitled to a partial refund of amounts paid to the State of California for activities outside the state or if Ventas should have been entitled to a full refund of all sums paid.
FEE v. TAX
The key issue addressed by both courts was that the purpose of the "levy" imposed by Section 17942. The FTB argued that purpose of the levy imposed by Section 17942 was to impose a "regulatory fee" rather than a "tax." The FTB argued that California was justified in imposing the "fee" to limited liability companies making the voluntary decision to register in California and, as such, actively seek the benefits and privileges of doing business in the State of California. The FTB argued that it is reasonable and justifiable for California to charge a regulatory fee to defray the state's costs of LLCs making such a determination.
Both trial courts rejected this argument and maintained that the intention of Section 17942 was to raise revenue for unspecified general state purposes. If the levy created by Section 17942 was truly a "fee" for the state providing services, then the state could not collect more than the amount reasonably necessary to cover the cost incurred by the State (in other words, the purpose of the levy was not directly related to the specific purpose of the State of California to regulate or otherwise administer limited liability companies) and, thus, Section 17942 is clearly a "tax." As a "tax", Section 17942 (at least as it was applied to the plaintiffs in both cases), was found to be unconstitutional because it was not "fairly apportioned," and as stated by the court in the Northwest Case, any "(tax) must be calibrated to the level of activity in the State."
Having established that Section 17942 was a "tax", not a "fee", both courts maintained that the way Section 17942 was applied to both plaintiffs violated the "Commerce Clause" of the United States Constitution (U.S. Const., art. 1, § 8, cl. 3) (the Commerce Clause prohibits state taxation or regulation that discriminates against or unduly burdens interstate commerce and thereby 'imped[es] free private trade in the national marketplace.'") (General Motors Corp. v. Tracy (1997) 519 U.S. 278, 287.)
Both courts in question found that the California regulatory scheme imposed a greater burden to "interstate" commerce than to "intrastate" commerce because, if every state imposed a similar tax, LLCs registered to do business in more than one state would have greater overall tax liability than those only doing business in a single state. As such, fair apportionment would dictate that Ventas would have to pay some LLC tax in California (since it did some business in California), but the apportioned amount would be less than the amounts it was required to pay by the FTB (since this was based on its worldwide business rather than just for its business related to its activities in California) while Northwest, who conducted no business in California, should not be required to pay any sums under Section 17942.
In response to the trial court's decision in the Northwest Case, the California legislature proposed amendments to Section 17942 and on October 10, 2007, the Governor signed Assembly Bill No. 198 that amended Section 17942 effecting the tax year covering on January 1, 2007. The amendment modified the language of Section 17942 (a) from "total income from all sources reportable to this state" to "total income from all sources derived from or attributable to the state."
AB 198 further included a provision to deal with the appellate pendency of both the Northwest and Ventas matters indicating that if former Section 17942 is "dispositively determined to be unconstitutional" the FTB is directed to recognize the sums due under Section 17942 "only to the extent necessary to remedy the discrimination or unfair apportionment."
BAKERSFIELD MALL CASE
There is still an open question if the recent legislative changes will salvage the Section 17942 levy as it is applied to gross receipts generated from in state sources.
In the case of Bakersfield Mall, LLC v. Franchise Tax Board (San Francisco Sup. Ct., Case No. 462728), the limited liability plaintiff concedes that all of its income has been derived from California sources has claimed that even unapportioned, the levy imposed by Section 17942 violates the Commercial Clause of the United States Constitution and the Due Process Clauses and Equal Protection Clauses of the California and United States Constitution.
Taxpayer Remedies
As a result of the Northwest decision, California has established an administrative process for LLCs to file protective refund claims (via a Public Service Bulletin issued March 31, 2006). A potential claim is an administrative procedure to toll the statute of limitations on any while an audit or litigation is pending. Jackson DeMarco Tidus & Peckenpaugh advises taxpayers who plan to seek tax refunds to file protective claims immediately, notwithstanding the fact that the current cases are subject to appeal since the statute of limitations to file claims for a tax refund will generally expire four (4) years from the date the tax return was filed.
For more information, please contact Glenn A. Fuller, Esq. at (805) 418-1926 or by e-mail gfuller@jdtplaw.com or Stanley E. Heyman, Esq. at (805) 230-0023 or by e-mail sheyman@jdtplaw.com.
