There has been a flurry of activity in California regarding LLCs since the beginning of the year. In this update we will try to sum up the three biggest issues.
The LLC Fee being ruled unconstitutional,
Foreign LLCs requirement to pay the $800 LLC tax and
Series LLCs in California.
LLC Fee is Unconstitutional
First of all let’s make sure we all understand that California has two charges that it imposes on LLCs. It imposes an LLC fee and an LLC minimum tax. The LLC minimum tax is the $800 LLCs must pay if they are registered in California. The LLC fee is an amount in addition to the $800 based on the gross receipts of the LLC (many LLCs do not have high enough gross receipts to be required to pay this fee). It is this additional fee that was ruled unconstitutional. If your LLC only paid the $800 minimum this case does not affect you.
In the case of Northwest Energy Services, LLC v. FTB the San Francisco Superior Court ruled that fee was not actually a fee but a tax and as a tax it violates both the Due Process Clause and the Commerce Clause of the US Constitution.
Northwest was an LLC organized in the state of Washington that registered to do business in California with the California Secretary of State. This was sufficient to trigger the LLC fee under R&TC §17942, which, according to the FTB, is computed on total worldwide income without apportionment. The court held that, because the fee is not apportioned, it is unconstitutional. However, since Northwest did not do business in California, the decision is not ideal for determining the outcome for other LLCs that have paid the fee.
While the court ruled that the fee violates the Commerce Clause and the Due Process Clause of the U.S. Constitution, and the Due Process Clause of the California Constitution, it is not clear whether the statute itself is invalid or whether the statute will stand if the fee is calculated using an apportionment method. If the latter, the Northwest decision will only affect multi-state LLCs — those with income both within and without California. If the statute is ruled invalid it will affect all LLCs that pay (and have paid) the fee.
Although the outcome of the Northwest case was a clear victory for one taxpayer, the effect on the LLC fee for other taxpayers is unclear. For now, the decision does not apply to other taxpayers. The FTB must continue to enforce the LLC fee until a Court of Appeal or higher court declares it unconstitutional. This means that, for LLCs that filed protective claims, the waiting game is on. If the FTB does not appeal Northwest, the decision will apply only to Northwest, LLC, and you will have no recourse other than to file in superior court or wait for another taxpayer to file suit.
If the FTB appeals Northwest, there are a number of possible outcomes. First, the appeals court could overturn the lower court’s decision and side with the FTB. Second, it could side with the lower court but even that entails multiple possible outcomes.
• The court could rule that the entire statute (R&TC §17942) is unconstitutional. In that case, the result would be that no LLC, whether operating interstate or solely within California, would be required to pay the fee and the FTB would be forced to act on refund claims.
• The court could find that the unconstitutional provisions are severable from the rest of the statute. For example, they could find that the statute is valid generally in that it does not preclude a requirement for apportionment. In that case, the decision would apply only to LLCs doing business in multiple states.
Since it is possible that the decision may affect all LLCs that paid the fee, you should file a protective claim for refund of the entire amount of those fees for all years open under the statute of limitations.
Cautions: Please observe the following:
• Northwest addressed the constitutionality of the annual LLC fee only, not the $800 annual tax levied under R&TC §17941.
• The decision does not affect LLCs that have elected to be taxed as corporations because they do not pay the annual fee under R&TC §17942.
• You must continue to pay the LLC fee without apportionment; and you must pay the fee before filing the claim (see below).
If your LLC has paid this fee in prior years please contact our office to file a protective claim of refund. This will put your LLC on record as to have filed for a refund before the statute of limitations runs out and will preserve your right to claim a refund if the Appeals Court upholds this ruling.
Foreign LLCs
California law requires foreign LLCs (LLCs not organized in California) to register with the Office of the California Secretary of State (SOS) before entering into any intrastate business in California. The SOS may not deny recognition of an LLC because the laws of the LLC’s home state or foreign country differ from California’s laws, except in the case of professional service LLCs, which are not allowed to register as LLCs in California (Corp. Code §§17451, 17452).
For California taxation purposes, a foreign LLC must use a “doing business” test instead of the “transacting intrastate business” test that is used for determining registration requirements. “Doing business” means “actively engaging in any transaction for the purpose of financial or pecuniary gain or profit” (R&TC §§17941, 23101).
In a member-managed LLC, every member of an LLC is an agent of the LLC for conducting the usual business of the LLC, unless the articles of organization or operating agreement restrict the scope of the agent’s authority (Corp. Code §17157). A non-member may become an agent through precedent authorization or ratification by the LLC’s member-managers (Civil Code § 2307). It is therefore presumed by the FTB that California LLC managers are conducting LLC business while in California.
It is not clear whether a California resident who is a non-managing member of a foreign LLC with no managing members in California forces the entity to meet the “doing business” test.
So what all this means is that if an LLC has a member manager that is a California resident the LLC is assumed to be doing business in California and must register and pay the $800 tax. To avoid this, the member manger must travel outside of California to conduct business for the LLC. The member manager should keep meticulous logs of the business conducted and where the business was conducted. They should also be prepared to substantiate the travel with hotel, airline and or gas receipts. In addition the LLC should have its bookkeeping and tax returns prepared outside of California and its bank account should be outside of the state as well.
Another option is to have a person outside of California be the LLC manager and leave any California members as non-managing members. This option is based on our interpretation of the FTB’s ruling that LLC managers are agents of the LLC and therefore are conducting the business of the LLC. Non-manger members are not engaged in the business of the LLC and therefore would not lead to the assumption that their residency in California automatically assumes that the LLC is doing business in California. As said earlier this is based on our interpretation and to this point in time we are not aware of any rulings or guidance from the FTB as to how they would treat this situation, so caution should be used in determining whether or not to use this option.
To some of us taking steps to avoid the extra $800 per year LLC tax may be more of a nuisance than the $800 itself and it is just easier to register and pay the $800 to California. But what if you have several LLCs outside of California? Now we are not just talking about $800 but maybe 5, 10 or more times $800. An additional $8,000 (if you had 10 LLCs) may turn your entire investment strategy upside down. An option for this is to create a holding company LLC outside of California in which you are the member manager. This LLC would be registered in California as a foreign LLC and pay the annual $800 tax. All of your other non-California LLCs would be owned and managed but this new holding company LLC. It is our opinion that this structure would only require one $800 payment to California, however as with the non-manger member strategy we discussed earlier; to this point in time we are not aware of any rulings or guidance from the FTB as to how they would treat this situation, so caution should be used in determining whether or not to use this option
There is one safe and proven option for avoiding all of this and that is to leave California!
Series LLCs
It is standard practice to put assets into separate LLCs to isolate potential liability. This can be an expensive proposition entailing multiple administrative costs and, in California, multiple annual taxes and multiple total-income fees.
Many advisors are now recommending the “Series LLC” as a means of accomplishing many of the same objectives with a single round of administrative costs and taxes. The question is, does it work to eliminate multiple taxes and fees in California?
Series LLCs are now allowed in Iowa, Illinois, Nevada, Oklahoma, and Delaware. However, the Delaware law was the first and is the best known.
A Series LLC is one that places its assets in separate “series,” which function like separate businesses and are, in fact, required to keep separate books and records (Delaware Limited Liability Company Act §18-215). In addition, each series can operate different kinds of businesses and have different managers, members, and ownership percentages. A series can make distributions to its own members without regard to members of the LLC’s other series. Most importantly, the law provides that the debts and obligations of one series are enforceable against that series only.
A Delaware LLC is required to register with the SOS prior to doing business in California. Generally, the California courts will apply California law to all disputes regarding the entity except for those regarding internal governance. Under California Corporations Code §17450(a), “The laws of the state or foreign country under which a foreign limited liability company is organized shall govern its organization and internal affairs and the liability and authority of its managers and members.” As such, the separate treatment of series LLCs will apply in California for purposes of internal governance.
However, that doesn’t mean that the series laws will apply for creditors, claimants, and other California third parties who have not agreed to be bound by those laws. In fact, some legal commentators believe that the series laws would have little chance of working even for California tenants who sign a lease agreement stating that they must respect the series limitations given California’s heavy consumer- and tenant-protection laws.
So it appears that in California a series LLC will not provide separation of assets but instead the courts will more than likely open up the entire LLC to satisfy a judgment. If that was not bad enough wait until you see how the FTB will treat a Series LLC.
According to the FTB, each series is considered a separate LLC that must file its own FTB Form 568, and pay a separate LLC annual tax and fee if it is registered or doing business in California. The FTB compares the series LLCs to the separate series of a single trust, which have been regarded as separate taxpayers as found in National Securities Series-Industrial Stock Series v. Commissioner (13 TC 884) and Revenue Ruling 55-416.
It is our opinion that Series LLCs are only good in the state in which they were organized; and certainly not in California and not for California residents that may, as discussed earlier, need to register their foreign LLC in California. Someday California may adopt its own Series LLC law and at that time we may change our opinion.
Please note that the opinions and options mentioned are our best guess as to what the FTB might do and as such should not be relied upon solely in determining what actions if any should be taken in your individual circumstances. Our opinions are not intended be by legal opinions. Our purpose is only to make you aware of these issues and as always we suggest you consult your attorney as to how this may or may not apply to you. If you have any questions on this information or would like discuss this in more detail on how to proceed under your specific circumstances please contact our office.
Tel: 623-209-0012
Fax: 623-537-9184
13933 W. Grand Avenue, #302, Surprise, Arizona 85374
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