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California Superior Court rules LLC "fee" unconstitutional.

In two recent decisions--Northwest Energetic Services, LLC (NES) v. Franchise Tax Board (FTB), Case No. CGC-05-437721 (4/13/06), and Ventas Finance I, LLC (Ventas) v. FTB, Case No. CGC-05-440001 (11/7/06)--the San Francisco County Superior Court held that the limited liability company (LLC) "fee" imposed by California Revenue and Taxation Code (CRTC) Section 17942 is unconstitutional. Although California law requires the FTB to continue imposing the fee until a final decision has been rendered by an appellate court, LLCs registered or doing business in California should consider filing protective refund claims, particularly if the statute of limitations for any year is about to close.

California's LLC Fee

In addition to the $800 minimum fee imposed by CRTC Section 17941 on all LLCs, CRTC Section 17942 also imposes a tiered fee on LLCs. The tiered fee is imposed on all LLCs doing business in California or, if they are not doing business there, that are organized or registered to do business there.

The fee is based on the LLC's total income, defined as gross income plus the cost of goods sold. The fee ranges from zero for LLCs with total income of less than $250,000, to $11,790 for LLCs with total income of $5 million or more. Importantly, there is no provision for apportioning total income when determining the fee. Thus, income earned outside of California's borders is not removed from the LLC's tax base; instead, the fee is calculated with reference to the LLC's entire income, wherever earned.

In both NES and Ventas, the taxpayers argued that the lack of an apportionment mechanism rendered the statute unconstitutional under both the Due Process and Commerce Clauses of the U.S. Constitution.


NES was an LLC organized under Washington state law. Although it was registered with the Secretary of State to do business in California, it conducted no business activities there and had no operations, property, inventory or place of business there. Further, it had no employees, agents or independent contractors acting on its behalf in that state.

For the calendar years 1997 and 1999-2001, NES paid the $800 minimum tax imposed on LLCs by CRTC Section 17941; however, it did not pay the Section 17942 fee. The FTB assessed NES for amounts statutorily required under Section 17942. NES paid the assessment, filed a refund claim and, after exhausting its administrative remedies, filed suit in superior court.

After determining that the "fee" constituted a tax, the court determined that the unapportioned fee violated the U.S. Constitution. Specifically, it determined that the fee violated the "fair apportionment" requirement imposed by the Due Process and Commerce Clauses, failing both the internal and external consistency tests.

"Internal consistency" test: The internal consistency test is a hypothetical one that asks whether imposition of the same tax by all 50 states would add a burden to interstate commerce that intrastate commerce would not also bear. The court noted that if one assumes that California's LLC fee was replicated in every state, an interstate LEG with the same total income as NES would pay the maximum tax in every jurisdiction in which it operated or registered to do business. On the other hand, an LLC operating wholly within a single state would pay the maximum fee only once. The court thus concluded that the statute failed the internal consistency test; under such circumstances, the statute would clearly place a greater burden on interstate than on intrastate commerce.

"External consistency" test: The external consistency test, on the other hand, asks whether a state tax reaches beyond that portion of value fairly attributable to economic activity within the taxing state. The court found that California's LLC fee also failed this test; while NES did not have any activity in California, it was still subject to the maximum fee, a clear indication that the fee was not calibrated to NES's instate activity.

While NES provided clear guidance with regard to an LLC that had no California activity, it did not address the viability of CRTC Section 17942 as applied to a taxpayer with activity in California. This issue remained unresolved until the decision in Ventas.


Ventas was an LLC organized under the laws of Delaware that was qualified to do business in California. Ventas maintained its headquarters in Kentucky and conducted only a small fraction of its business activities in California. According to Ventas's complaint, it would have had California apportionment percentages ranging between 6.94% and 8.34% for the years at issue.

For calendar years 2001-2003, Ventas paid both the minimum tax imposed on LLCs under CRTC Section 17941 and the fee imposed under CRTC Section 17942. For each of the three years, the LLC fee amounted to $6,000, $11,790 and $11,790, respectively. Ventas filed a refund claim and, after exhausting its administrative remedies, filed suit in San Francisco Superior Court.

After determining that the "fee" constituted a tax, the court held that the fee violated the U.S. Constitution as applied to Ventas. As in NES, the court reasoned that the fee violated the Due Process and Commerce Clauses, because it was based on Ventas's worldwide receipts, rather than its California activities.

The court then had to determine whether the statute was invalid in its entirety or could be reformed. The court determined that reformation of the statute by adding an apportionment mechanism would run counter to the express intent of the legislature, and that the statute was thus invalid in its entirety.

Effect on Taxpayers

As noted, both NES and Ventas are superior court decisions. Article III, section 3.5 of the California Constitution requires state agencies to continue to enforce statutes until they are either repealed or declared unconstitutional by an appellate-level court. Thus, the FTB must continue to enforce CRTC Section 17942 until an appellate-level court issues a final decision.

As such, the decisions in NES and Ventas do not change any current or prospective filing requirements. However, taxpayers should consider filing protective refund claims for all open years, to avoid expiration of the statute of limitations during the time an appellate-level decision is pending. A Notice of Appeal was filed by the FTB in NES on Sept. 13, 2006 and in Ventas on Dec. 19, 2006. These appeals may take one or two years before final resolution, making the filing of protective claims all the more important.

Protective Claim Procedure

A protective refund claim is filed to protect a taxpayer's right to a potential refund based on a contingent event, such as pending litigation. The effect of the claim is to prevent an (otherwise expiring) statute of limitations from closing.

In a Public Service Bulletin issued on March 21, 2006, the FTB indicated that LLCs wishing to file a protective claim related to NES and Ventas should fax a letter to the FTB at (916) 845-9796. The letter should state that it is a protective claim and should include the LLC's name and identification number, the tax years involved, a description of the issue, the claim amount and the name, phone and fax number of the person to be contacted.

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Title Annotation:STATE & LOCAL TAXES
Author:Thomas, Frederick
Publication:The Tax Adviser
Date:Mar 1, 2007
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