By Jeffrey M. Sulenski
Pahl & McCay
225 West Santa Clara Street
Suite 1500
San Jose, California 95113
408/286-5100 (phone); 408/286-5722 (fax)
jsulenski@pahl-mccay.com
Please understand that the information discussed in this Article is general in nature and is not intended to be legal advice. It is intended to assist owners and managers in understanding this issue area, but it may not apply to the specific fact circumstances or business situations of all owners and managers. You may need to consult applicable state and local laws. For specific legal advice, consult your attorney.
Since California first authorized limited liability companies under California law, the limited liability company as a form of entity has been continually compared to the corporation or the limited partnership in choosing a form for a business entity. Until the LLC sprang into existence, the usual choices for business entities were corporations, S corporations and limited partnerships. Those who had been using corporations, S corporations or limited partnerships are now wondering whether new ventures should be started using an LLC instead of one of these old forms they had been using.
In any comparison of these types of entities, the limited liability company seems to grade out very well, if only because of its enormous adaptability, which allows it to provide liability protection while at the same time being able to mimic all of the other kinds of entities, from general partnerships, to limited partnership, corporations and S corporations.
Despite its attractiveness, the California limited liability company does have one aspect that strikes a discordant note and discourages many from adopting it – the gross revenue fee.
In California, limited partnerships, corporations, S corporations and LLCs must all pay the annual minimum franchise tax of $800; however, the LLC is also subject to an additional “fee” that was included in the original legislation that authorized the formation of LLCs in California. This fee is found in Revenue and Taxation Code Section 17942(a), which imposes a fee, in addition to the minimum franchise tax, which is determined by an entity’s “total income,” basically its gross revenues. Under this Section, the amount of the fee is determined as follows:
$0 for LLCs with annual gross revenues of less then $250,000;
$900 for LLCs with annual gross revenues of at least $250,000 but less than $500,000;
$2,500 for LLCs with annual gross revenues of at least $500,000 but less than $1,000,000;
$6,000 for LLCs with annual gross revenues of at least $1,000,000 but less than $5,000,000;
$11,790 for LLCs with annual gross revenues of $5,000,000 or more.
It should be noted quickly, before thoughts of forming a Nevada limited liability company start taking shape, that the fee is assessed not only on LLCs formed under California law, but also on foreign LLCs qualified to do business in California and on foreign LLCs, whether or not they are qualified to do business in California, if they derive income from California based on intrastate business in California. In other words, if any LLC derives income that would be subject to taxation in California, that LLC is liable for paying the gross revenues fee in California.
The fee is assessed against “total income” as defined in Revenue and Taxation Code Section 24271, plus the cost of goods sold that are paid or incurred in the trade or business of the entity. Total income would not include any income that is otherwise subject to the gross revenue fee, so an LLC receiving reportable revenue from another LLC that is subject to the fee would not be subject to the fee.
If an entity is one of two or more commonly controlled entities and the FTB determines that the multiple entities were created primarily to reduce the amount of gross revenues fees, the FTB can require the entity to pay a gross revenue fee based on the total income of all of the commonly owned entities.
Taxpayers must use FTB Form 568 to report and pay the gross revenue fee on of before the 15th day of the fourth month following the close of each taxable year, the infamous April 15th for those who have a December 31 year-end.
Realistically, the amount of the fee is relatively small. At $250,000 in gross revenues the fee is 0.36% of revenues; at $500,000 it is 0.5% of revenues; at $1,000,000 it is 0.6% of revenues; and at $5,000,000 it is 0.2358% of revenues. On the other hand, the fee is assessed against gross revenues, so the fee is due notwithstanding profitability. For a business with high revenues but narrow profit margins, the fee would reflect a higher portion of the entity’s profitability than it would on a business that is highly profitable. Obviously, the fee would be particularly irritating for those entities that anticipate incurring losses in their early stages of development.
The question, at some point, becomes whether the advantages of the LLC as a form of entity offers enough advantages to justify its additional cost. For instance, if investors intend to have straight-forward income and loss allocations and cash distributions, there may be little or no advantage to an LLC over an S corporation. An LLC probably has an advantage over a limited partnership, however, because a limited partnership subjects its general partner to unlimited liability.
On the other hand, if investors are looking for more elaborate allocation and distribution schemes with preferential returns, etc., then the inherent flexibility of the LLC over the S corporation may well make paying the gross revenue fee worthwhile.
The choice of form of entity for any business should involve a more extensive inquiry into the advantages and disadvantages of all of the different forms of entities depending upon the particular facts for each new business. The gross revenues tax that is assessed against LLCs doing business in California, however, should not, in itself, prevent a business from adopting the LLC as a form of business until all of these factors are considered.