California tax on LLCs has been declared unconstitutional | Norton Rose Fulbright
A CALIFORNIA TAX on limited liability companies has been declared unconstitutional. Companies need to file refund claims. California collects an annual fee on limited liability companies doing business in the state. The fee runs from $900 for LLCs with incomes between $250,000 and $500,000 up to $11,790 for LLCs with incomes above $5 million a year. The state makes no attempt to determine how much of the income was earned in California as opposed to other states.
A California superior court ruled in March that this failure to base the fee solely on income earned in the state makes the fee unconstitutional. The commerce clause of the US constitution requires that a state limit any tax to business activities within the state. The court said the LLC “fee”was in reality a form of tax. The state is expected to appeal the decision.
In the meantime, LLCs that have paid the fee should file refund claims. There is a fouryear statute of limitations in California on audits and refunds. The four years begin to run on April 15 of each year or, if later, when a tax return was filed. Thus, most LLCs should be able to file refund claims back to 2002. Some may still be able to seek refunds for 2001 taxes depending on when their returns were filed in 2002. The maximum refund for four years of fees is only $59,000, but back interest could double the amount. The case is Northwest Energetic Services, LLC v. California Franchise Tax Board. A second LLC fee case, called Ventus Finance I LLC v. California Franchise Tax Board, was scheduled for trial on May 8.
LLCs that are registered to do business in the state must also pay a minimum franchise tax of at least $800 each year — in addition to the LLC fee.
Separately, the California State Board of Equalization ruled in March that an out-ofstate LLC that owns interests in other LLCs and partnerships in California is itself doing business in California and must pay both the annual LLC fee and minimum franchise tax.The ruling was in a case called In re International Health Institute LLC. The board takes a broad view of what it means to be doing business in the state.
In an unrelated development, a California appeals court held in April that Toys “R” Us could not count as sales income both the principal and interest payments that its treasury department earned from investments in short-term instruments to manage cash flow. The toy company earns most of its income around Christmas. Its treasury department then invests the funds until they are needed to start rebuilding inventory during the summer.
California, like other states, figures out what share of income a multinational company like Toys “R” Us earned in California by looking, among other things, at the share of its total sales that are in California. The company’s treasury department is in New Jersey. The appeals court said it could count as sales revenue the interest earned on the investments, but not repayments of principal.
The court said that if principal also counted, a company could cause a huge shift of allocable income outside the state merely by moving its treasury department with a handful of employees across state lines. The case is Toys “R” Us Inc. v. California Franchise Tax Board.