Note: The following is an excerpt from the introduction to the article as published in The Tax Lawyer. Author citations have been omitted for brevity. Tax Section members may read the article in its entirety in Adobe Acrobat format.
Using Retroactive Taxes to Cure Budget Shortfalls
Kathleen K. Wright*
New legislation limiting the amount of refunds available for limited liability companies (LLCs) who have qualified to do business in California and have paid the fee based on unapportioned gross receipts is being questioned by both the taxpayers who paid the unconstitutional fee and by their practitioners. The reason is that A.B. 198 was signed into law by the Governor and includes a new California Code section 19394 which retroactively limits the amount of refund of LLC fees previously paid on worldwide gross receipts to only the portion that relates to the receipts that had been unfairly apportioned
to the state.
California is not alone in its refusal to issue full refunds when a state statute has been declared unconstitutional. Cases discussed in this Article will show a tendency of both the state tax administrative agencies and the courts to actively defend the fiscal stability of the states. In the case of California’s unconstitutional LLC fee, the revenue estimates of a full refund of the unconstitutional fees paid for prior years could not be ignored in a year where the state is already facing a $14 billion deficit for the upcoming fiscal year budget. The Franchise Tax Board (FTB) estimates that the aggregate refunds of total LLC fees paid would total $1.3 billion. Under California Code section 19394 the refund would be limited to $280 million, resulting in a potential General Fund savings of $1.1 billion.
The problem started when California’s fee based on worldwide gross receipts of an LLC without apportionment was struck down as an unconstitutional tax by the court of appeal in Northwest Energetic Services, LLC v. Franchise Tax Board (NES II). In addition to NES II, there are two more cases pending in the courts on the same issue. The legislature was compelled to act to mitigate further losses from refund claims adding to the already bleak financial scenario forecast for the 2008 fiscal year, and act they did. In what has come to be known as a “midnight special” (or a bill enacted at midnight of the last day of the legislative session), A.B. 198 was passed to address the issue. A.B. 198 limits refund claims to only the unconstitutional portion of the LLC fee payment and provides sourcing rules to determine gross receipts sourced to California going forward.
This Article discusses the historical background of significant state and local cases which discuss remedies that offer acceptable compromises for taxpayers who have paid unconstitutional taxes. The Article specifically analyzes A.B. 198, the legislature’s response to the LLC fee-tax dilemma and evaluates whether or not the steps taken by the legislature fall within the scope of constitutional remedies.
*College of Business, California State University Fullerton