On November 2012, Proposition E was passed in San Francisco by a landslide vote of 70.8%, which will gradually replace the annual San Francisco Business & Payroll Tax filing with a gross receipts tax. San Francisco is the only major city in California that levies its entire business tax on payroll expense, which critics have argued discourages businesses from adding new employees. Due to a variety of state and city exclusions, San Francisco's payroll tax only captures about ten percent of businesses in the city. Currently more than 30 cities in California have a gross receipts tax.
"Tax reform is not easy for voters to understand," said David Chiu, President of the San Francisco Board of Supervisors. "There's a lot of confusion that somehow we are creating a new tax ... We've had to engage in a real education effort to let people know we're phasing out essentially a job-killing, bad tax and phasing in a much more efficient, job-producing tax. It hasn't been easy." Mr. Chiu has a point: changes in tax law can bring uncertainty and always deserve careful scrutiny. This article will attempt to clarify the issues surrounding San Francisco's Proposition E.
So, what exactly is Proposition E? Proposition E is a gross receipts tax or "privilege tax" imposed upon persons engaging in business within the City for the privilege of engaging in a business or occupation in the City of San Francisco. Proposition E will gradually phase out or eliminate the annual San Francisco Business and Payroll Tax assessment over a 5-year span beginning in 2014 through 2018 in favor of a gross receipts tax. This will help start-ups ease the burden of trying to meet the San Francisco Payroll Tax obligation in the early years of their operations. This seems to be why many start-ups and tech companies have flocked to support Proposition E, including Zynga and OpenTable. One of the proponents' biggest arguments to support Proposition E is that tax policy has focused on penalizing job creation by taxing jobs instead of profits from companies. Critics of the reform counter by stating that placing a graduated tax on gross receipts will force businesses to relocate once they've grown large enough, driving tax revenue to cities outside of San Francisco.
What was the law before Proposition E passed? The old law required businesses to pay a flat 1.5% tax on payroll costs for all business activities attributable to the City of San Francisco. Small businesses with less than $250,000 in payroll costs were exempt from the tax. The City of San Francisco also required businesses to pay an annual registration fee ranging from $25 to $500.
From the 1970s through 2001, California's largest cities had used the payroll tax structure, under which businesses paid tax on payroll or gross receipts, whichever was higher. In March 2000, the California State Courts ruled this was unconstitutional , forcing the cities, including San Francisco, to choose one or the other. Companies sued San Francisco or filed tax claims over its two-tier tax system, which have amounted to approximately $80M in tax revenue losses and settlement payments to date. The San Francisco Board of Supervisors passed a measure to eliminate the gross receipts tax and chose a 1.5% flat tax on payroll costs that became effective May 2001.
Proposition E, or the "Gross Receipts Tax Ordinance," institutes a new gross receipts tax to replace the City's annual 1.5% payroll tax. Businesses with gross receipts of less than $1M annually will be exempt from the gross receipts tax. The $1M threshold will be adjusted based on the consumer price index (CPI) each year. The gross receipts tax will vary depending on the amount of annual gross receipts from the City. Article 12-A-1, Section 953.1 through Section 953.4 of the S.F. Business & Tax Regulations Code discusses the marginal gross receipts tax rates that will range from 0.075% to 0.65%. Also, the tax rate will fluctuate based on a business' industry classification. There are seven industries in total identified in the S.F. Bus. & Tax Reg. Code Section 953.1 through Section 953.7 as follows: "1) retail trade and wholesale trade 2) manufacturing, transportation and warehousing, information, biotechnology, and food services 3) accommodations, utilities, and arts, entertainment and recreation 4) private education and health services, administrative and support services, and miscellaneous business activities 5) construction 6) financial services, insurance and professional, scientific and technical services 7) real estate, rental and leasing services." For example, retailers and wholesalers with gross receipts of up to $2.5M will pay just a 0.1% rate, while the financial services sector will fall into the marginal 0.46% rate. This methodology reflects the reasoning that certain industries will have higher revenues and lower margins than others.
One should be careful when accounting for "gross receipts" as defined under the new law. For example, Article 12-A-1, Section 952.3(d)of the S.F. Business & Tax Regulations Code states that "gross receipts also shall not include any allocations of income or gain, or distributions (such as dividends, interest and other returns on capital) from an entity treated as a pass-through entity for federal income tax purposes, provided such allocations or distributions are derived exclusively from an investment in such entity, and not from any other property sold to, or services provided to, such entity." Also, Section 952.3(g) states that "no person shall be deemed to be engaging in business within the City if its activities in the City consist solely of one or more of the following:, 1) contracting with, acting through or using the services of an investment advisor or affiliated member which is not a related entity 2) maintaining documents or formation, incorporation, or registration within San Francisco 3) being an owner, member, or other entity participant in an entity within San Francisco that is simply a pass-through entity for federal income tax purposes 4) or having trustees or directors who meet or reside within San Francisco." Notably, simply being an owner, member, or other participant in an entity engaging in business within the City which is a pass-through entity for federal income tax purposes would not in it of itself subject you to the new gross receipts tax. As a result of these nuances individuals and businesses may wish to consult with a tax accountant familiar with the new law and discuss whether they are "engaged in business within the City" and if their specific earned income falls under the "gross receipts" definition.
The San Francisco gross receipts tax will become operative on January 1, 2014, and will be phased in. The existing payroll tax will be phased out, incrementally over a five-year period from 2014 through 2018 to allow businesses time to adjust to the change. Each year the City will reduce the payroll tax and increase the gross receipts tax based on a formula in the legislation that would equally offset the reduction to payroll tax revenue.
The final gross receipts tax rates will depend on if the City of San Francisco achieves certain targets from the revenue received via the implementation of the new tax. The payroll tax will be reduced or eliminated depending on if those monetary targets are met. Two possible scenarios are listed as follows:
- Gross Tax Revenue > Payroll Tax Revenue - If the gross receipts tax revenue exceeds the revenue the City would have received under the tax on payroll costs, then the tax on payroll costs will be eliminated, and the final gross receipts tax rate will be reduced.
- Gross Tax Revenue < Payroll Tax Revenue - If the
gross receipts tax revenue never equals the revenue the City would
have received under the tax on payroll costs, then the tax on
payroll costs will be reduced but not eliminated.
In scenario #2, businesses would pay taxes on payroll costs and gross receipts.
Proposition E has also increased the annual registration fees for businesses in San Francisco. These new fees range from $75 for smaller businesses to $35,000 for businesses with more than $200M in annual gross receipts.
The higher registration fees are expected to produce a net revenue increase of approximately $28.5M beginning in fiscal year ending 2014. The revenue from the gross receipts tax is expected to equal the amount that would have been collected under the old system, as well as cover any administrative fees required to transition to the new system.
Prop. E also established penalties for failure to properly register a business.
The tax and fees from the new system are expected to generate approximately $450M in the fiscal year ending 2014, which will be contributed to San Francisco's General Fund. According to the controller's office, this makes it the City's second largest contribution to the general fund, behind only property taxes.
The city's chief economist, Ted Egan, projected that the change would create a net increase of about 2,000 jobs over the next 20 years.
Not everyone will benefit from the new tax law. Companies likely to see their tax increase in the coming years include those in industries such as financial services and commercial real estate, due to the high revenue-producing nature of these industries. Another industry group likely to be detrimentally affected by the change would be those involved in real estate and leasing services, and the activity of providing related services (i.e. rental management companies). Apartment and property owners as well as those in the business to provide related services will now be taxed on 0.285% of gross revenue between $0 and $5,000,000, and 0.3% tax on gross revenue above $5,000,000. Gross receipts from real estate and rental/leasing services located within the City are subject to this tax, but properties located or used outside the City are exempt. Sole-proprietors and smaller business owners in the business of renting and leasing properties will likely be minimally impacted by these changes. However, those business owners who had proportionately more gross revenue in comparison to payroll expenses will be the most detrimentally affected by this outcome. Now that the change is based on gross receipts within the City, this may cause a disincentive for larger property owners to continue or even begin business within San Francisco.
On the other hand, companies that rely on hiring a large workforce, such as restaurants, tech companies, and manufacturers, will most certainly benefit from the change. The reason is due to the fact that these companies tend to have a much larger workforce, which correlates to higher payroll costs which is what the old tax was based on. Concerned taxpayers must continue to pay attention to how proposition E will affect their specific industry sector. Will it be more equitable than the previous system, and will it truly realize proponents' intentions of producing more jobs in the coming years? These answers are yet to come. We do know that it is important that all San Francisco businesses become more familiar with the new law and we recommend that businesses contact their CPA to clarify any questions they may have.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.