When American LegalNet Inc. got a surprise bill from the city of Los Angeles for $33,000 in back taxes and penalties for a three-year period – well above the $7,000 the company had paid for that span – executives learned it was the result of a city audit that had changed its tax classification.

So the Encino company hired a lawyer and went through a two-step appeals process in 2008 and 2009. That’s when the company got a second surprise.

“The whole appeal process is nothing more than a sham,” said Eli Eisenberg, American LegalNet’s acting chief financial officer.

The company said its arguments were firmly rejected.

“The most frustrating thing for me personally,” said Eisenberg, “is the fact that it became very clear to us during this process that we were dealing with people whose attitude was, ‘Our mind is made up. Don’t confuse me with the facts.’”

American LegalNet’s case is an example of the fallout from the city’s decision to reclassify as many as 91 businesses into a much more expensive tax category. Under 1997 rules adopted to lure multimedia and Internet companies to Los Angeles, companies in the city’s multimedia tax category got low tax rates. That category apparently was designed for Web designers and the like, and many companies that do business over the Internet, such as LegalZoom.com and Shopzilla.com, put themselves in that category.

But the city in recent years has reclassified some of those companies out of the multimedia category and into a much more expensive one, often the city’s most expensive. Then the city billed them at higher rates and assessed them for back taxes.

The problem now is that the appeals process, which had been a winding path to finesse the companies back into the low tax category or into some compromise category, apparently has become a one-way expressway into a high-tax category. Some have likened the appeals process to a “kangaroo court.” And some companies claim they may leave Los Angeles as a result.

Blythe Holden, general counsel for Shopzilla, a West L.A. Internet comparison-shopping company that is waiting for a ruling on its second appeal, said she felt that the company’s arguments weren’t heard.

“The feeling is you automatically lose,” Holden said. “We put a lot of effort into explaining to them what multimedia means and how we believe we fit within the definition.”

The first of the two-step appeal process is a hearing between the taxpayer and a senior tax auditor in the city’s Office of Finance. If the taxpayer remains unsatisfied, a second phase is scheduled before a review board, which is a three-member panel composed of a representative from the Controller’s Office, another from the Office of Finance and a member of the public who is supposed to represent the business community’s interest.

The Business Journal interviewed company executives, business owners and attorneys who have represented them in both phases of the hearings. Several said they believe the Office of Finance – which collects revenue from taxes, licenses, fees and permits – appears to have adopted a policy of reclassifying some businesses out of the multimedia category into the professional services category, the most expensive one, which includes lawyers and accountants. Then it refuses to consider arguments to the contrary.

Amended ordinance

Glendale lawyer Christopher Matarese, who represents taxpayers in city and state tax matters, said that in the past he was able to convince the Office of Finance that his multimedia clients should not be reclassified into a higher tax category. But in recent years, Matarese said the office won’t budge.

“Under the new regime, we wouldn’t have been able to win those cases,” Matarese said.

The former chief of the tax and permit division of the Office of Finance, Terrance Manocchio, said: “I allowed for a certain amount of discretion when I was chief.”

Back then, he tried to find a solution before the company appealed for a hearing, Manocchio said. “And right now, from what I understand, there are a lot of hearings, probably many more hearings than when I was chief. There is a lot of pressure there in trying to decide this issue.”

Manocchio, who now has his own business working on behalf of taxpayers in dealing with L.A. tax matters, retired from the city in June 2007.

Ed Cabrera, who became chief of the division after Manocchio retired, said in a statement: “There have been no policy changes implemented by the tax and permit division with regards to the multimedia business classification. Nor has there been any policy instituted to arbitrarily reclassify the business activities of the city’s taxpayers.”

However, he said the multimedia business ordinance that regulates the tax break was amended in January 2007, and that the ordinance is being applied consistently.

The amendment specifies that the tax break was intended for entertainment and media companies, and specifically excludes companies that just happen to use new media to sell products and services.

The public member of the three-member review board, Richard Groudan, said that the board’s priority was to be consistent. But he acknowledged that the board was more flexible in the past. The new rigidity could be a function of the amended multimedia ordinance.

“We are bound by the law, administrative rulings, case law and consistency among similar taxpayers,” he said. “We can’t set a precedent for a particular taxpayer and give them relief that other taxpayers haven’t gotten on a particular issue.”

Groudan, who has been on the board for more than six years, said he didn’t remember any case of the board placing a company back into the multimedia category on appeal.

The city has nine categories for business taxes. New-media companies are charged $1.01 per $1,000 in gross receipts, the lowest rate. But as the result of the audits and reclassifications, as many as 91 companies have been reclassified and are subject to the rate for professional services companies. At $5.07 per $1,000 in gross receipts, it is the highest rate. The category includes law and accounting firms, which tend to bill at much higher rates than multimedia companies.

As a result of what they perceive as shocking tax bills and an unfair change in mood if not policy, some business owners are threatening to move to other cities such as Burbank, Glendale or Santa Monica to avoid the higher taxes.

“The existing process is a black eye to the city of Los Angeles,” said Gary Toebben, chief executive of the Los Angeles Area Chamber of Commerce. “Let’s increase revenue of the city by creating more jobs and businesses, not by going back to businesses and changing their category.”

Mayor Antonio Villaraigosa and City Councilmen Bill Rosendahl, Eric Garcetti and Greig Smith have been trying to compromise by creating an advantageous classification for companies that use the Internet as a primary means to provide services.

In a Jan. 5 letter, City Controller Wendy Greuel urged action on the matter quickly. She said the lack of the category is “driving businesses away because our code has not adapted to today’s business models.”

However, critics of the reclassifications have pointed out that if the tax pushes the businesses out of Los Angeles, that may result in an even bigger loss of city tax revenue.

Shopzilla’s lease on its headquarters at Olympic Boulevard and Bundy Drive is set to end in June. Shopzilla executives have said that they would move to neighboring Santa Monica, where the company would be classified as a service company and taxed lower than its contested rate in Los Angeles.

Unappealing prospects

American LegalNet signed a five-year lease in 2009, so it can’t leave anytime soon despite its big back-tax bill.

The company, which operates a database of legal forms and case law for legal professionals, in 2008 appealed an audit by the Office of Finance that reclassified the company into the professional services category.

American LegalNet had its first appeal hearing in May 2008. The company argued that it sells legal forms via the Internet, so if the city wouldn’t accept the low-tax multimedia classification, it should be placed in the retail category, resulting in charges of $1.27 per $1,000 in gross receipts. Executives believed that proposal would be a reasonable comprise.

In July 2008, the Office of Finance ruled in a six-sentence analysis that American LegalNet “sells no product” and upheld the audit.

American LegalNet then made its second appeal. The company brought its case to the three-member board of review in April. In December, the company was notified that the board kept the company in the highest tax category.

Ariela Bicer, the company’s controller, said American LegalNet’s arguments were ignored.

“There was a feeling that we were talking to deaf ears,” Bicer said. “It was a waste of our time and money to pay an attorney because they didn’t listen.”

American LegalNet is considering a lawsuit against the city over what it contends is an unfair reclassification.

LegalZoom.com Inc., a Hollywood-based Web site for legal documents and related services, is another company that has been through the wringer of the appeal process. Its case went for a first appeal in 2009. Before company executives even argued their position, they had an idea of what was coming.

Leron Gubler, chief executive of the Hollywood Chamber of Commerce who has been working with LegalZoom on its tax problem, said the word was out among knowledgeable sources.

“We were told to expect them to reject the appeal at the hearing examiner level, and that we would have to go on to the next step,” Gubler said. “People knowledgeable with the process said almost automatically you get rejected at that level. That’s how the process works, and then you have to appeal to the panel of three.”

LegalZoom’s problem is that its lease is up for renewal and executives were hoping for a quick decision. As a result, the company was able to negotiate a temporary compromise with Gubler’s help: The company will pay a blended rate for its back taxes, and its 2009 and 2010 business taxes.

Meanwhile, the audits and resulting reclassifications have had an impact beyond Internet and multimedia companies.

In one of the most high-profile cases, Creators Syndicate Inc., which sells syndicated columns and cartoons for publication by newspapers, magazines, books and newsletters, had won a 1994 ruling by the board of review that placed it in the retail category.

However, the company was reclassified as a professional services provider after a 2005 audit and placed in a higher tax bracket. As a result, the company was billed $105,000 in back taxes, penalties and interest.

Creators Syndicate appealed the reclassification and filed a first appeal in 2008 and a second appeal in 2009. Both appeals were rejected.

Richard Newcombe, founder and chief executive of Creators Syndicate, compared the appeal process to a “kangaroo court” and said the board was an extension of the Office of Finance.

“It is no longer an independent board,” Newcombe said.

Creators Syndicate paid the $105,000 in back taxes to stop interest and penalties from accruing, and then filed suit against the city in July claiming that there was no justification for the reclassification.

Chamber Chief Executive Toebben said the appeals process is just one more hurdle for L.A. business growth.

“It is both frustrating and it’s expensive,” Toebben said. “And it’s time and money that they would much rather be using to grow their business and to create more jobs for the city of Los Angeles.”