California LLC Fee Ruled Unconstitutional

The California Court of Appeals has ruled that the state’s limited liability company (LLC) fee is an unconstitutional tax.  While the court’s opinion is somewhat diluted by the Legislature’s 2007 amendments to the LLC fee, it is an important victory for taxpayers.  

The taxpayer, a Washington LLC, operated in Washington and Oregon.  It distributed its product in Washington, Oregon, Montana and Idaho.  It did not operate in California and had no customers in California.  Nevertheless, the taxpayer registered as an LLC in California.  The taxpayer filed returns and paid the minimum franchise tax, but did not pay the LLC fee imposed on its total income.  The California Franchise Tax Board (FTB) assessed over $27,000 in unpaid LLC fees.  The taxpayer paid the assessment and filed for a refund, which the FTB denied.  After exhausting its administrative remedies, the taxpayer filed an action in court.  The trial court held that the LLC was unconstitutional because it was not apportioned, and ordered a full refund.  The trial court also awarded $3.5 million in attorney fees.  The FTB appealed.

The appellate court address three issues – (1) whether the levy was a fee or a tax; (2) whether the levy violated the due process and commerce clauses of the U.S. Constitution; and (3) whether the trial court erred in awarding attorney fees.  As for the first issue, the court determined that the levy was a tax and not a fee.  It applied to the LLC’s total income, wherever earned and without apportionment, with the proceeds deposited into the state’s general fund instead of funding a regulatory program.  On the second issue, the court held that the levy violated the commerce clause because it imposed a tax on income earned outside the state.  The levy also failed to apportion total income in accordance with the income earned within the jurisdiction – another violation of the commerce clause.  As a result of those findings, the court did not address the due process issue.  On the attorney fee issue, the court remanded to the trial court for a justification of the upward adjustment of the fee that the trial court had made.  Northwest Energetic Services, LLC v. Franchise Tax Board, 159, 2008 Cal. App. 4th 841, 71 Cal Rptr. 3d 642(Cal. Ct. App. Jan. 2008).