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State May Lose Fees Paid by Businesses

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Times Staff Writer

A legal glitch in the state’s tax code could cost California $1.5 billion in corporate tax payments, further draining a state budget that is projected to be billions in the red next year.

The state is in a quandary over taxes it demanded from companies that did no business in California. The collections affected a small fraction of the state’s limited liability corporations, but one of them asked a trial court to declare the entire fee unconstitutional, and it did.

The case is on appeal now. If the decision stands, the state could be forced to return fees it has received from limited liability corporations since 2001 as well as be prohibited from collecting them in the coming budget year.

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The effect on the state’s finances would be severe. California is already facing a $5-billion budget gap for the coming fiscal year. The loss of this revenue would cause the gap to grow 30%.

And the refunds would mean handsome checks for thousands of companies -- the kind of tax break corporate lobbyists have been trying to land for years without success. They have complicated legislative efforts to address the parts of the tax code that the courts are now considering.

Under pressure from business groups, the governor vetoed a bill late last month that attempted to make changes that would satisfy the courts.

“These business groups are seeing a chink in the armor,” said Phil Jelsma, a tax attorney with corporate clients who has advised the state on the fee issue. “They see an opportunity to knock this tax out.”

The bill passed by the Legislature (AB 1614) would have refunded $250 million in tax payments over the next three years. In a rare reversal of roles, it was Democrats who championed the refunds and Republicans and business groups that opposed them. But the bill’s failure threatens to cost the state significantly more.

The state Franchise Tax Board estimated the immediate return of some $1.1 billion in fees that it has collected since 2001, and the forfeit of at least $400 million more in annual tax revenue, starting in the upcoming budget year.

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Schwarzenegger said in his short veto message that as long as the matter is in the courts, it is “premature to take legislative action.” A spokesman for the state Department of Finance said that the state has lost other costly cases at the trial court level only to win on appeal.

In letters to the governor leading up to his veto, some business groups made clear their belief that the tax was as good as gone and the Legislature’s attempt to retroactively fix the problems identified by the courts was unconstitutional.

“Such an action would undermine the integrity of the legislative process,” wrote Larry McCarthy, president of the California Taxpayers Assn. “All legislators and their constituents have a compelling interest in ensuring this does not occur.”

The fee was originally established to allow other types of partnerships to convert to limited liability corporations without costing the state revenue. The dispute has angered some activists, who accuse business groups of exploiting an opportunity to back out of fees they agreed to pay long ago.

“They trumped up all these bogus reasons” to reject the legislative refund proposal, said Lenny Goldberg, executive director of the California Tax Reform Assn. “The bottom line is they don’t want to pay a fee that they agreed to.”

The state Franchise Tax Board -- California’s version of the IRS -- is appealing a March ruling by San Francisco Superior Court Judge Donald S. Mitchell. At issue in that case is $27,458 in tax payments by explosives company Northwest Energetics, based in Washington state. The company had no business connection to California other than filing incorporation papers with the secretary of state.

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Mitchell ruled that the fees paid had no relation to the state’s cost of regulating and serving limited liability corporations, and thus could not legally be charged to businesses with no operations or sales in California.

If the issue is not resolved in the state’s favor, it could have a major effect on budget negotiations, which begin in earnest when the governor presents his spending blueprint in January. The $1.5 billion the state stands to lose is roughly half the amount it is spending on the University of California system this year.

Considering the stakes, Assembly Budget Committee Chairman John Laird (D-Santa Cruz) said he is puzzled by the administration’s wait-and-see approach.

“I was really disappointed by the governor’s veto,” Laird said. “Now I’m just hoping that they have a backup strategy and it just isn’t evident to me what that is.”

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evan.halper@latimes.com

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