California LLC Gross Receipts Fee Declared Unconstitutional

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CALIFORNIA LLC GROSS RECEIPTS FEE
DECLARED UNCONSTITUTIONAL BY APPELLATE COURT;
FTB MAY APPEAL TO CALIFORNIA SUPREME COURT

On January 31, 2008 the First Appellate District of the California Court of Appeals affirmed a San Francisco City and County trial court ruling that the gross receipts fee is unconstitutional because the levy is measured by the LLC's total income, regardless of whether the income derived from or is attributable to business within California. The LLC gross receipts fee is separate from and does not include the annual $800 tax. Without a fair apportionment calculation of the fee, the Court found that the fee violates the Commerce Clause and Due Process Clause of the United States Constitution. The Franchise Tax Board ("FTB") has until mid-March 2008 to decide whether it will appeal to the California Supreme Court.

If the FTB does not appeal, LLC taxpayers may file a claim for refund to remedy the discrimination or unfair apportionment. Cal. Rev. & Tax. Code § 19394. If the FTB does appeal, litigation could extend for several years. To protect the ability to file a claim for refund for any currently open tax years, LLC taxpayers should submit a Protective Claim for Refund of those payments. The Protective Claim will withhold any action on the claim while the litigation is still pending. That way, the claim may be filed at the outcome of the lawsuits even if the claim if beyond the four-year time limitation on refund claims. In the event the gross receipts fee is found to be unconstitutional, the taxpayer will be able to pursue the refund of all protected claims. The procedure for filing a Protective Claim is found below.

There is no need to file a Protective Claim for 2007. Legislation that became effective on October 10, 2007 and applies to tax years beginning January 1, 2007 limits application of the LLC gross receipts fee to income "derived from or attributable to California". AB 198; Cal. Rev. & Tax. Code § 17492. Prior to enactment of AB 198, the gross receipts fee was based on the California LLC's total income from all sources, regardless of whether the income was derived from California sources or sources outside of the state.

"Total income from all sources derived from or attributable to California" is determined using the existing rules for determining the source of the sales for the purpose of allocating income. Sales of tangible personal property are generally deemed to be made in California if the property is shipped to a purchaser located within California. Cal. Rev. & Tax. Code § 25135. Sales of services and sales of other than tangible personal property are generally deemed to be made within California if the income-producing activity is performed in California. If the income-producing activity is performed in more than one state but the greatest proportion of the activity is performed in California, then the income is deemed to be derived from California. Cal. Rev. & Tax. Code § 25136.

For the LLC with multistate operations, application of the rules is less clear. Experts believe the following allocation scheme is appropriate.

Personal Services

• Allocate income from multistate personal service LLCs based on hours worked;

• Allocate income from investment portfolios according to the resident managers of the LLC;

Rentals

• Allocate income from the sale, rental, leasing, licensing or other use of real property according to the state in which the property is located

Other

• The sales factor is a fraction, the numerator of which is the total sales of the taxpayer in this state during the taxable year, and the denominator of which is the total sales of the taxpayer everywhere during the taxable year. Cal. Rev. & Tax. Code § 25134. Generally, the numerator of the sales factor is a good indication of the amount of total income from California sources.

The LLC gross receipts fee structure follows:

PROCEDURE TO FILE A PROTECTIVE CLAIM FOR REFUND

To submit a Protective Claim for Refund, you may fax a letter to California Franchise Tax Board at (916) 845-9796. The letter must provide the following information:

• LLC Name and identification number issued by the California Secretary of State (typically a twelve-digit number beginning with the year of initial filing);
• Statement that this is a protective claim;
• The taxable years involved;
• Statement of the issue: "The LLC fee is unconstitutional";
• The amount of the claim; and
• Name of the person to contact, phone number and fax number.

The letter must be signed by the LLC's managing member or by a representative with power of attorney. You should receive an immediate faxed receipt from the Franchise Tax Board.