California Limited Liability Company Fee Held Unconstitutional

March 10, 2006

Most limited liability companies ("LLCs") are classified as partnerships for United States federal and California income tax purposes, and therefore are exempt from federal and California income taxes. However, any LLC that is organized, registered, or doing business in California generally is required to pay an $800 annual franchise tax as well as an "Annual Fee" based upon the LLC's total income.1 The Annual Fee can be as high as $11,790 for an LLC with total income of $5,000,000 or more, and is zero for LLCs with total income below $250,000.2

On March 2, 2006, in Northwest Energetic Services, LLC v. California Franchise Tax Board, a California Superior Court held that the Annual Fee violates the United States Constitution because it is based upon an LLC's total income, rather than solely upon that portion of the LLC's income that is fairly apportioned to California.3 As a result, LLCs may not be required to pay the Annual Fee and may be eligible for refunds of amounts paid in prior years.

The facts in Northwest Energetic Services were particularly extreme because the taxpayer LLC was registered to do business in California, but did not actually have any operations or conduct any business within the state. The court's opinion addressed only the consequences to the taxpayer LLC and therefore did not address the extent to which the Annual Fee could constitutionally be imposed on LLCs that do have California business or operations. With respect to such LLCs, it is possible that the courts would deem the Annual Fee unconstitutional in its entirety, so that it cannot be applied even to LLCs that conduct all of their business and operations within California. Alternatively, it is possible that the courts would hold that the Annual Fee is partially constitutional, insofar as LLCs may be required to pay a portion of the Annual Fee based upon the percentage of their business and operations within California. It is even possible that the original holding will be overturned on appeal.

Furthermore, at least on a prospective basis, it would not appear difficult for California to revise the Annual Fee so that it satisfies constitutional requirements. By incorporating a constitutionally acceptable apportionment mechanism (such as already exists for other California taxes), and adjusting the overall Annual Fee rate, the state could even match its revenues from LLCs to historical levels.

Thus, the precise impact of Northwest Energetic Services will be uncertain for some time to come. In the immediate term, however, LLCs that are or have been organized, registered, or doing business in California must consider whether to pay the Annual Fee and whether to apply for a refund of Annual Fees paid in prior years. For some taxpayers, the amount of the Annual Fee is small relative to the costs of seeking a refund, particularly for those LLCs actually conducting substantial business or operations in California and whose rights under Northwest Energetic Services are therefore the most uncertain. On the other hand, particularly for groups of affiliated LLCs, the potential refund may be quite large relative to the costs involved. Finally, LLCs may be entitled to refunds only for "open" tax years, which potentially means that the decision to seek a refund for the most distant open years must be made quickly. Thus, each LLC should promptly consult with its tax advisor to determine the most appropriate course of action.

This Client Alert is intended only as a general discussion of the information presented and should not be regarded as legal advice. For more information, please contact your Fund Services Group attorney.


1 The Annual Fee does not apply to LLCs that elect to be classified as corporations for California income tax purposes.

2 California Revenue & Tax Code Section 17942.

3 In reaching this conclusion, the court first held that the Annual Fee is actually a disguised tax.