PwC alternatives alert, February 26, 2010

Proposition Q's effect on payroll expense tax in San Francisco

Some statutory amendments may catch taxpayers unaware this filing season. The amendments, which expand the San Francisco payroll expense tax base to include all compensation for services provided by owners of pass-through entities, are currently the subject of a court challenge that may provide taxpayers a basis to file protective refund claims. To understand the full effect of the amendments and the potential impact of federal legislation that would modify the definition of compensation, read on.

Background

The City of San Francisco imposes an annual 1.5 percent payroll expense tax on persons and associations. It is attributable to all business conducted in the city. Provisions allow for the apportionment of payroll expense, such as when an individual performs work both within and outside the city. Generally, payroll expense is apportioned based on the percentage of hours worked in the city compared with total hours worked.

"Payroll expense" is defined broadly and includes compensation (e.g., salaries, wages, commissions) paid to an individual who performs work in the city. However, it might surprise some taxpayers that the city's definition of "payroll expense" includes the value of stock options and employer contributions to 401(k) plans. The tax, which is calculated based on the preceding year's compensation, is due the last day of February, unless that day falls on a weekend. Because February 28, 2010, is a Sunday, the 2009 San Francisco Payroll Expense Tax Statement and tax are due March 1, 2010. The 2009 statement must be filed with the 2010/2011 Business Registration Renewal.

Proposition Q and what it means for 2009 returns. Prior to Proposition Q (enacted November 4, 2008), the law was unclear as to whether compensation for services related to “pass through” entities such as partnerships and limited liability companies was considered “compensation paid to employees” and, therefore, subject to tax. Given the uncertainty, the city was generally unsuccessful in its attempts to expand the tax base to tax a partner's distributive share of income, including guaranteed payments. As a result, the city taxed only the W-2 wages paid to employees.

Proposition Q includes in the tax base pass-through compensation for services paid to owners, which is defined as the aggregate compensation paid by the entity for personal services rendered by its owners, excluding returns on capital investment. As amended, the definition of "payroll expense" includes:

Compensation paid to an individual shareholder of a professional corporation or LLC
Compensation for services to owners of a pass-through entity
"…If more than one shareholder of a professional corporation or member of an LLC during any tax year performs services in whole or part, in San Francisco,… the total compensation paid including salaries, wages, bonuses commissions, property issued or transferred in exchange for the performance of services,… in addition to any compensation for services to owners of pass-through entities and any other form of compensation for services to all shareholders of a professional corporation or LLC member."
City guidance provides that the payroll base of pass-through entities should include distributions to an owner for services performed, exclusive of any return on capital investment or profit interest.

Proposition Q provides the following two alternative methods to calculate the amount of pass-through compensation for services tax an entity or owner must pay:

No Safe Harbor - Calculate the amount of compensation paid to each owner of a pass-through entity. This approach would be based on a facts and circumstances analysis in which a pass-through entity would be required to demonstrate distributions received by the owner as compensation for services rendered versus distributions that represent return of capital or profit interest return.
Safe Harbor - If a taxpayer has at least four W-2 employees based in San Francisco, the amount of payroll included for each individual owner of a pass-through entity may be calculated by adding to his or her base salary an amount equal to 200 percent of the average annual compensation paid to the W-2 employees of the pass-through entity whose compensation is in the top 25 percent of that entity's employees based in San Francisco.

State court challenge to Proposition Q. A challenge to Proposition Q was filed with the California Superior Court, and the city and county of San Francisco. Chiatello v. City and County of San Francisco, et al. No. CGC-08-483632, (Sup. Ct. S.F. April 30, 2009). The challenge alleges the city is implementing and administering Proposition Q in an invalid and illegal manner and expanding a tax on payroll for the first time to profit earned by a pass-through. As applied, the challenge alleges, such application would be illegal and invalid because (1) Proposition Q was presented to voters as a mere clarification of the existing tax and its language does not support the city’s interpretation, (2) taxation of partnership profit, or income, is squarely barred by California Revenue and Tax Code Section 17041.5, which prohibits local income taxes; (3) Proposition Q did not receive the required voter approval under Proposition 218 because the text of its key provision was presented to voters as existing law and the voters approved only modest changes thereto, and (4) when presented to the voters, Proposition Q also increased the payroll tax exemption for small businesses, thereby misleading voters as to the actual impact and intent of the initiative, and violating San Francisco’s single subject rule for legislation. The case, which is on appeal with the San Francisco Superior Court, was initially denied based on the grounds that Chiatello lacked legal standing to sue San Francisco until the payroll tax related to the new rules imposed by Proposition Q was paid and administrative remedies had been sought.

Proposition Q's impact on the asset management industry. The San Francisco Office of the Treasurer and Tax Collector website previously provided the following guidance with respect to the calculation of the payroll expenses for a partnership:

Payroll Expense Partnership Calculation: Pursuant to Business and Tax Regulations Code Section 903.1, a payment to an owner of a partnership for work performed or services rendered in whole or in part in the city is considered a distribution by way of salary. Such a distribution is subject to the payroll expense tax if the payment made to the owner is determined without regard to the income of the partnership and the payment is treated as an income tax deduction for the partnership.

Based on the above language, it would seem to suggest that the city may interpret Proposition Q as imposing tax on all manner of income received by a partnership. This would include guaranteed payments, management fees, and incentive allocation income. Although the above guidance is informal and does not have the force of an adopted city ordinance, regulation, or notice, it does provide insight into the city's view as to the broad application of Proposition Q. Because this guidance was removed from the city's website and had not been replaced as of the publication date of this article, it is unclear whether the city will target only "self employment," such as guaranteed payments or management fees. Moreover, the fund's current structure could further expose the fund to San Francisco payroll tax, especially where the management fee income is received by the fund manager who also receives the incentive allocation income.

PwC observes: Although it appears that certain management fees paid to a general partner would now fall within the broad sweep of Proposition Q's "payroll expense," the amount paid as "carried interest" is likely not subject to the expanded payroll tax base without federal legislation changing the character of such income. "Carried interest" distributions, classified as "profit interest" distributions, are by their nature excluded from the payroll tax base. However, if proposed federal legislation modifies the definition of self-employment income to include the incentive allocation income, the city's ability to sweep such income into its payroll base increases. Fund managers are advised to review their current business structure to determine the impact of such interpretations on their annual San Francisco payroll tax.

For additional information, please contact your PwC engagement partner.