Alert: California LLC Gross Receipts “Fee” Declared Unconstitutional

March 21, 2006

In a pending case (Northwest Energetic Services, LLC v. California Franchise Tax Board), a California Superior Court recently found that the annual levy imposed by California on the gross receipts of limited liability companies (“LLCs”) is unconstitutional as applied on the facts before the court.  Due to the court’s decision, many LLCs that have paid the annual levy may wish to file “protective” refund claims. 

A protective refund claim is simply a refund claim where there is still legal uncertainty on a particular issue (such as the gross receipts fee on LLCs) at the time the refund claim is filed.  The website of the Franchise Tax Board provides a specific procedure for protective refund claims relating to the LLC fee:  www.ftb.ca.gov/forms/misc/3556.html#proclaim.

As background, California imposes a levy of up to $11,790 on LLCs that are organized in California, are registered with the Secretary of State to transact business in California or are doing business in California.  As noted in the below table, the amount of the levy increases depending on the gross receipts of the LLC, regardless of whether the LLC has income from California sources.

Total Revenue	Fee
Less than $249,999	None
$250,000 to $499,999	$900
$500,000 to $999,999	$2,500
$1,000,000 to $4,999,999	$6,000
$5,000,000 or more	$11,790

In the Northwest Energetic Services case, the court found that the levy violates the Commerce and Due Process Clauses of the United States Constitution because it imposes a tax on all of an LLC’s gross receipts, even if an LLC has virtually no contacts with California and has no income from California.

Attorneys for the Franchise Tax Board argued in part that the levy amounted to a reasonable fee for services provided by the State of California for which the state needed to be reimbursed, rather than a “tax” that needed to be apportioned based on the company’s connections with the state.  The court was unimpressed with this argument, observing that in many years the proceeds of the levy exceeded the “entire budget of the [California] Secretary of State.”

There is a great deal of uncertainty regarding the scope of the court’s ruling and whether it will be upheld on appeal.  In the case, the taxpayer’s only connection with California was that it had registered to transact business in the state.  For this reason, it is possible that the decision will not apply to LLCs that derive significant income from California.  On the other hand, an appellate court could find that the levy is unconstitutional on its face, as to all taxpayers. 

In light of the uncertainty surrounding the scope of the case and the fact that the decision may be reversed on appeal, taxpayers may wish to pay the levy with respect to the 2005 tax year and, with respect to 2005 and prior years, defer filing “protective” refund claims until the last date on which a refund claim may be filed with respect to the applicable tax year (which is generally four years from the date the return was filed).

For the 2001 tax year, the last date for most LLCs to file a refund claim is April 15, 2006.  Therefore, LLCs that wish to preserve the possibility of obtaining a refund with respect to the 2001 year will need to evaluate the issue quickly as they generally will need to file their “protective” claim for a refund for 2001 prior to April 15, 2006.