California’s LLC Tax: Current Litigation And Retroactive Legislation

Section 17942 of California's Revenue & Taxation Code 1 imposes an annual levy 2 on all limited liability companies ("LLC") registered to do business in the state. Currently, the levy is unapportioned, such that an LLC's liability for the fee is set by its total gross receipts worldwide, rather than its income attributable to business within California. The San Francisco Superior Court in Northwest Energetic Services, LLC v. Franchise Tax Board 3 ("Northwest") found the unapportioned levy unconstitutional, and awarded Northwest Energetic Services a full refund of the amounts it had paid under section 17942. While the superior court's decision in Northwest is legally binding only for the taxpayer that brought the suit, because California's Franchise Tax Board ("FTB") recently sought review of the trial court's decision, the case will likely determine the fate of section 17942 on appeal. Similarly, another case challenging the constitutionality of section 17942 under different facts, Ventas Finance I, LLC v. Franchise Tax Board 4 ("Ventas"), was recently decided by the San Francisco Superior Court. As in Northwest, the San Francisco Superior Court in Ventas ruled that section 17942 is unconstitutional because it is not apportioned.

In the wake of the Northwest decision, the California legislature proposed amendments to section 17942 in an attempt to remedy the unconstitutionality of the statute (A.B. 1614). The amended version of section 17942 would have continued to impose an annual levy on LLCs doing business in California; however, the amount owed would have been apportioned based on the amount of business that each taxpayer actually did within the state. Had the proposed amendments become law, they expressly would have applied retroactively as of 2001. Under the proposed amendments, some LLCs that paid the unapportioned levy in years 2001-2005 might have been entitled to a full refund. However, many would have received only a partial refund or no refund at all, depending upon the extent of the LLC's business activities in California. However, under the 2005 ruling by the California Court of Appeal in City of Modesto v. National Med, Inc. 5("NMI"), the retroactive apportionment provision in the proposed amendments may itself have been unconstitutional. 6

This article describes the challenges to section 17942 raised by the taxpayers in Northwest and Ventas, and discusses whether the legislature's proposed amendments to section 17942 would have been an adequate solution in light of the Court of Appeal's decision in NMI.

Section 17942

The levy imposed by section 17942 is referred to as an "annual fee" by the statute, and it is imposed on "every limited liability company subject to tax under Section 17941."7 The amount of the levy ranges from a minimum of $900 to a maximum of $11,790 per year. 8

As discussed in detail below, section 17942 is problematic in that it applies to any LLC that either does business in California or has simply registered to do business in California, and its rate is applied without regard to the amount of business the taxpayer actually does within the state during a given year. 9

Recent Litigation

Northwest Energetic Services, LLC v. Franchise Tax Board

In Northwest, the Superior Court for the City and County of San Francisco awarded plaintiff Northwest Energetic Services ("NES") a refund of $27,458.13, the total amount it had paid pursuant to section 17942 for tax years 1997, 1999, 2000, and 2001. The plaintiff, an LLC, was in the business of distributing explosives and explosive-related services. The plaintiff maintained business locations in Washington and Oregon only, and had no business activity, property, inventory, employees, or customers in the State of California. Nevertheless, it was subject to section 17942's levy by virtue of having registered to do business in California with the Secretary of State in 1997.

NES paid California's flat $800 minimum franchise tax under section 17941 for the four years at issue. However, NES did not pay anything under section 17942 until 2002, when the FTB notified NES that it owed a total of $27,458.13, including penalties and interest under the LLC fee provision. NES paid the full amount in order to receive a Tax Clearance Certificate, then promptly cancelled its registration in California and sought a refund of the taxes paid, which the FTB denied. On administrative appeal, the State Board of Equalization upheld the denial of NES's refund claim. Having exhausted its available administrative remedies, NES filed suit challenging the constitutional validity of section 17942, both on its face and as applied.

At trial, NES argued that the levy was a tax, not a fee, and that the tax was unconstitutional because it was not apportioned. The FTB maintained that section 17942 imposed a regulatory fee rather than a tax, and therefore it need not be apportioned, on the grounds that LLCs voluntarily decide how to organize and whether to register in California in exchange for privileges and benefits afforded by the state. The trial court decided in favor of the taxpayer on both issues.

The court first determined that section 17942 imposes a tax and not a fee, despite the fact that the statute refers to the levy as an annual "fee." The court explained that the determination of whether a levy is a fee or a tax is based upon its operation and intent, not upon its label. Taxes raise revenue for the state's general use, whereas fees are paid into specialized funds associated with a particular state service. Furthermore, fees serve to reimburse the state for specific costs associated with providing some benefit, service, or regulation, and cannot require the collection of more than the amount reasonably necessary to cover the cost of the state's regulatory activities. 10

The court reviewed the legislative history underlying section 17942 and determined that the primary purpose of the levy was to replace lost corporate income tax revenue. When the...