California Court Holds that Excessive “Fee” is an Unconstitutional Tax

February 13, 2008

San Francisco tax practitioner William Hays Weissman writes about last month’s decision by the California Court of Appeal in Northwest Energetic Services, LLC v. Franchise Tax Bd.

The case involved an LLC with no “operations, property, employees, independent contractors, or customers in California, nor…any deliveries into California.” Nevertheless, the state assessed $27,458 in LLC “fees.”

The Court of Appeal held that the “fees” were in fact taxes. Weissman writes:

The court [wrote] that a tax raises revenue for general government purposes and is compulsory rather than based on a voluntary decision to seek benefits. In contrast, a fee funds regulatory programs or compensates for benefits provided by the government. The court posited that the issue “is whether the Levy is a compulsory payment imposed for the purpose of raising revenues for general government purposes, or whether it funds a regulatory program or compensates for government services or benefits voluntarily sought by the LLC.”

The court found that although [the statute] refers to a “fee,” it gives no indication of its purpose; that is, whether it funds general government services or compensates for a regulatory program. The court found that the statutory scheme does relate to the regulation of LLCs, but “does not, however, identify any connection between the Levy and this regulatory activity or its costs or benefits.” The court thus turned to the legislative history to answer that question.

The court said that the legislative history unequivocally demonstrated that the purpose of the levy was to raise revenue. It noted that “one need look no further than the FTB’s own analysis of SB 930 and SB 469, which lead to the enactment of the LLC Act.”

Because the fees paid by LLCs were in fact taxes, and because California taxed LLC income in full no matter where it was earned, the charges violate the U.S. Constitution’s Commerce Clause.

The decision sounds correct. The court accurately looked at the substance of the surcharges, not merely the words used by the legislators who enacted it. California wanted to hit up a politically vulnerable group of businesses for punitive taxation, and in this case it is unconstitutional.

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