California Court of Appeals Affirms Annual LLC Fee an Unconstitutional Tax

In a recent decision, the California Court of Appeals (the "Court") affirmed a trial court decision that California’s annual levy on limited liability companies (LLCs) imposed under Revenue and Taxation Code, Section 17942 was in fact a tax and, as imposed on an LLC based outside the state, violated the Commerce Clause of the U.S. Constitution. With respect to the issue of attorney’s fees, the Court reversed and remanded the lower court’s decision on an upward adjustment to the lodestar.

In the instant case, the LLC was organized under the laws of the State of Washington and had no operations, property, employees, or sales in California. However, the LLC had registered with the California Secretary of State and paid the minimum tax imposed under Section 17941. It did not pay any amounts under Section 17942 based upon its “total income from all sources reportable to this state for the taxable year.”

In a de novo review, the Court first addressed whether or not the levy imposed under Section 17942 constituted a tax or a fee. Based upon the legislative history, the Court concluded that the levy “more closely resembles a tax.” The state advanced several arguments that the levy was in fact a fee and not a tax. However, the Court determined it to be a tax, based on the fact that it was a mandatory payment imposed for raising general public revenues, rather than a payment made at the LLC’s option to compensate the government for services or benefits provided to them. In reaching this decision, the Court stated that “[t]he legislative history of the LLC Act demonstrates unequivocally that the Levy’s purpose was to raise revenue in order to make up for the loss of income tax proceeds that would result if entities were formed and operated as LLCs instead of corporations.”

Once the Court determined that the levy was a tax, rather than a fee, it then addressed the issue of whether or not the levy was unconstitutional. The state advanced several arguments that the imposition of the levy was constitutional and even presented an argument that Northwest Energetic Services, LLC (“Northwest”) should be barred from raising a Commerce Clause challenge to the levy.

Ultimately, the Court held that “[i]n sum, whether the Levy is called a tax or a fee, and whether we apply the internal consistency test, the external consistency test, or the Pike balancing test, the application of the Levy to Northwest in the Years in Issue violated the Commerce Clause.”

The statute has since been amended for the levy to be measured only on income derived from sources within California (Northwest Energetic Services, LLC v. California Franchise Tax Board (Cal. Ct. App. 2008) January 31, 2008).