California LLC Franchise Tax is Unconstitutional

Court holds that part of the California LLC Franchise Tax is Unconstitutional
A San Francisco Superior Court dealt the Franchise Tax Board a blow last week when it ruled that a major portion of the California Franchise Tax violates both the Commerce Clause and Due Process Clauses under the United States Constitution. The case is almost guaranteed to be appealed given the magnitude of the decision.

The issue boiled down to whether the franchise tax imposed on LLCs under one or two major sections of the LLC act was a tax or a fee. If it is a fee, then the franchise tax would stand. If it was a tax, then the U.S. Constitution would kick in and certain rules would apply to protect the LLCs from being unfairly taxed.

The Impact of the Franchise Tax
According to the Court documents, the California Legislature added two revenue generating provisions in 1994 as part of the LLC Act to offset tax revenues that would be lost if companies operated as LLCs as opposed to Corporations. One provisons imposed an $800 minimum tax while the second imposed a levy based on the revenues of the LLC. The second provison was as issue.

Why does it matter if it is a tax or a fee?

In a nutshell, fees are imposed to fund a regulatory program - to cover the costs, if you will - or provide compensation for services and benefits received by the government while taxes raise revenue for typical governmental services (they are compulsory). Thus, a fee is incurred voluntarily to receive a benefit (i.e. you pay the Secretary of State a fee to receive the benefits of being an LLC) while a tax is compulsory (i.e. you pay just for being an LLC). Taxes, being compulsory, have more protections for taxpayers as they are imposed without choice.
The reason this is a big deal is because the Court held that the Secretary of State was collecting the fees relating to the LLC Act and that the proceeds generated by the Levy at issue EXCEEDED the ENTIRE budget of the Secretary of State in all years after 1999. Keep in mind that LLCs are only a small portion of what the Secretary of State's responsibilities.

So what if it is a tax?

If it is a tax, then the Due Process and Commerce Clause create a duty on the State to make sure the tax is applied to activities with a substantial nexus to the taxing state, that they be fairly apportioned (you should not get taxed by two states on the same dollar), that the tax does not interfere with interstate commerce and that it be related to the services provided by the state. The Court held that the tax was not fairly apportioned. The plaintiff in the case, a Washington State LLC registered to do business in California, was given a full refund plus interest as the levy could not "constitutionally" be applied to plaintiff.

Future Impact?
We will have to wait and see the fallout of the decision, but it does raise interesting issues for businesses, specifically, LLCs doing business in California. First, how do you preserve your right to refund if the statute is indeed struck down? Second, what impact will this decision have on the $800 minimum tax imposed?

For the first question, a taxpayer could preserve their rights to a refund by filing a protective claim. This tolls the statute of limitations until the case works its way through the appeal process. It is generally accomplished by stating on the face of the return that you are seeking a protective claim for refund based on (insert the case name). In this case, it would be "Protective Claim for Refund Based on the Outcome of Northwest Energetic Services, LLC." Have your preparer attach a statement and cite the case (case number CGC-05-437721). Use a professional.

As for the second question - only time will tell. We will have to wait and see how the legislature and other courts react to the decision.