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Superior Court Finds LLC Fees Unconstitutional

 

March 24, 2006
By Phillip L. Jelsma

In Northwest Energetic Services, LLC v. California Franchise Tax Board, the Superior Court for San Francisco County found that California’s gross receipts fee applied to a Washington LLC with no business activities in California violated the Commerce Clause and Due Process Clause of the United States Constitution. The fee is calculated on the LLC’s total income. Generally, total income is the same as gross income, or gross receipts under Internal Revenue Code Section 61. The total income is not subject to any form of allocation or apportionment. The Court initially determined that the fee was in fact a tax. The Court also found that the fee had no reasonable relationship as to the benefits or prudence imposed on the taxpayer. Finally, the Court concluded that it violated the Due Process and Commerce Clauses because it was not fairly apportioned. Although it is highly likely that the opinion will be appealed, you should consider filing protective claims for refund or amended returns to prevent California’s 4-year statute of limitations from foreclosing your ability to recover any LLC fees. The State has established special procedures for LLCs filing protective claims for refund based on the Northwest decision. Again, these procedures are for the constitutionality of the LLC fee issue only. To file a protective claim, the Franchise Tax Board (“FTB”) has requested that the LLC or its representative fax a letter that provides:

  • The LLC’s name, address, and Secretary of State file number.
  • A statement that the letter constitutes a protective claim.
  • The taxable year(s) at issue.
  • That the grounds for the claim are based on the outcome of the Northwest Energetic Services, LLC decision and that the LLC fee is unconstitutional.
  • The amount of the claim, which should match the amount of the annual fee that the LLC paid.
  • A fax number that the FTB can use to contact the representative or LLC.

The letter must be signed by a representative with power of attorney (POA) or signed directly by a managing member or designated person of the LLC. The POA should be completed under normal procedures. You may fax a copy of the POA along with the letter. Upon receiving the faxed letter, the FTB will send a confirmation letter stating that it has accepted the claim or will request additional information needed to perfect the claim. However, the FTB cannot guarantee a confirmation letter in fewer than 21 days. Our firm recommends you send the claim via certified mail, return receipt requested, to the following address:

Address
Franchise Tax Board
P.O. Box 942857
Sacramento, CA 94257-0600

If you choose to fax, the dedicated FTB fax number to use for this procedure is: Fax 916.845.9796

Alternatively, you may file a protective claim for refund on an amended Form FTB 568. Be sure to check the “Amended Return” box on Side 1 of Form FTB 568 and set forth the grounds for the claim by attaching a letter. The FTB will not send a confirmation letter if you use this method of filing a protective claim. Unlike the letter method, in which you may make a claim for all eligible years, you must file an amended Form FTB 568 for each year for which you are filing a protective claim. The FTB will hold the claims until the final outcome of the decision. If the FTB decides not to appeal the Northwest decision, it will deny all claims and the LLC’s only recourse will be to file in court. The FTB will make refunds only if an appeals court sides with the taxpayer and provides a remedy. You may file a claim for all years open under the statute of limitations. For example, a timely filed 2001 return would have been filed on April 15, 2002. The statute of limitations would close on April 15, 2006. However, you must pay the fee prior to filing the claim. As such, if the taxpayer has not filed the 2005 return or paid the 2005 fee, do not include 2005 in the claim. File a separate claim later after filing the 2005 return and paying the fee. In addition, the FTB has allowed LLCs to deduct the fees as a business expense, whereas, if the Court is correct and it is a tax, the fees would have to be deductible for California income tax purposes. As a result, each member of an LLC might potentially have underpaid in all prior years.