Corporate Close-Up: The Burden of California’s Taxes and Fees on Limited Liability Companies

The limited liability company, or LLC, has become a popular form for organizing a business.  Using an LLC generally avoids the double layer of taxation encountered with a corporation while providing limited liability for its members, and offers more flexibility than S corporations in which corporations may not be shareholders.  When choosing a particular business structure, taxpayers also must consider taxes and fees imposed on the entity itself.

In California, limited partnerships, corporations, S corporations and LLCs must all pay the annual minimum franchise tax of $800.  An LLC, however, is subject to an additional fee, imposed under Cal. Rev. & Tax. Code § 17942(a).  The fee is based on an entity’s total income for a taxable year, basically gross revenues, and ranges from $0, if total income is less than $250,000, to $11,790, if total income is $5 million or more.  Even a single member LLC, which generally does not report income separately from its owner, is still liable for California’s minimum franchise tax and annual LLC fee and must file an annual state tax return under California’s filing guidelines.

In fact, the California Franchise Tax Board’s most recent revenue estimate projects total annual revenue from LLC taxes and fees to range from $610 million in fiscal year 2010-2011 to more than $750 million in fiscal year 2014-2015.

A decision released this month by the California State Board of Equalization illustrates the challenges businesses face when trying to reduce their liability for taxes and fees in California.  A company filing two-short period returns in tax year 2010 unsuccessfully protested the imposition of the minimum tax and LLC fee in each short period. [In re Bay Area Gun Vault, LLC, No. 631038 (Cal. State Bd. Equal. July 17, 2014), released Nov. 12, 2014]

In 2010, Bay Area Gun Vault, LLC converted from a two-member LLC that was taxed as a partnership into a single-member LLC treated as a disregarded entity after one of the two original members was caught embezzling money from the company and was removed as a member effective March 31, 2010.  As a result of the conversion, the company filed two short-period returns for 2010, one as a two-member LLC for the first three months of the year and the second as a single-member LLC for the remainder of 2010.

With the first return, the company timely paid the annual tax of $800 and an LLC fee of $2,500 on $711,425 of income.  When appellant filed its return for the second short period, the company reported more than $1.9 million of income resulting in an LLC fee of $6,000.  The company remitted only $3,500, however, subtracting the $2,500 paid for the first short period, and also did not pay the LLC annual tax.

The company argued that, although it filed two tax returns for 2010, the income reported on those returns was for the same business that had the same tax ID number and assets and was conducting business operations in the same location.  Accordingly, the company should owe only $800 in tax and an LLC fee of $6,000 based on total income for the entire year of $2.6 million.

Unfortunately for the appellant, the removal of the embezzling member caused a technical termination of the original LLC under I.R.C. § 708, which is incorporated into California law under Cal. Rev. & Tax. Code § 17851, because 50 percent or more of the interests in the LLC changed hands during 2010.  As a consequence, the two-member LLC was required to file a short period return for its final taxable year and pay the minimum tax and appropriate fee.  The resulting single-member LLC was a new entity for tax purposes and similarly owed the minimum tax and LLC fee for its own taxable year, which the Board held was separate from that of the original LLC.

The logic of the company’s argument is appealing: LLC taxes and fees should not be imposed twice in the same year on the same business.  The Board, however, found no statutory support for appellant’s position and suggested the California legislature as the forum to address a public policy argument advocating a change in how LLCs are taxed.

Continue the conversation on Bloomberg BNA’s State Tax Group’s LinkedIn page: Should the California legislature put an end to double taxation of LLCs?

By:  Mike Dazé

For more information about state taxation of LLCs and other pass-through entities, sign up for a free trial of the Bloomberg BNA Premier State Tax Library.