Proposition Q - Changes to the Payroll Tax

What it does

Many firms with one or more employees within the City and County of San Francisco are required to pay a payroll tax of 1.5 percent of their taxable payroll. Businesses with payroll of less $167,000 in a year are exempt from the tax.

Prop. Q would make two changes to the payroll tax. First, it would increase the small business exemption from $167,000 to $250,000 of annual payroll. In other words, businesses whose payroll is $250,000 or less would be exempt from the payroll tax. For all payroll amount greater than $250,000, a business would have to pay a tax of 1.5 percent to the City. To keep up with inflation, the small business exemption would be adjusted every two years, starting with the 2011 tax year, to reflect increases in the consumer price index during the preceding two years. Second, it would clarify how compensation to partners should be classified under the payroll tax. This means that compensation to partnerships for work done in San Francisco would be subject to the 1.5 percent payroll tax.

The current law is unclear about whether compensation for services paid to "pass through" entities — such as partners and owners of trusts, limited liability companies and Subchapter S corporations (where shareholders pay income, not corporate taxes, on earnings) — is considered "compensation paid to employees" and therefore subject to the payroll tax. As a result, the amount of payroll tax paid is up to the discretion of the partnership. For example, if a law firm earns $1 million per year, has $250,000 in expenses, pays $250,000 in salaries to its employees, and distributes $500,000 in profits to the partners, only the $250,000 paid to the employees is definitely subject to the payroll tax. However, some of the $500,000 paid to partners, is compensation but not currently subject to the payroll tax. The confusion lies in the fact that a distribution of income to a partner typically combines direct compensation for services rendered (i.e. salary for work done in San Francisco) plus that partner's return on his or her investment in the firm.

Under Prop. Q, the compensation for work done in San Francisco would be subject to the payroll tax, while the return on investment would not.

To comply with the measure, a partnership could choose to simply tell the City how much of its distributions to partners counts as payroll and therefore is subject to the payroll tax. If it chooses this approach, the partnership would make its own calculation but could be subject to an audit. However, if the partnership chose to not calculate how much it owed the City, then it would fall under Prop. Q's "safe harbor provision." Under this provision, the City would itself calculate payroll expenses for each owner, by combining the owner's salary as reported on the federal W2 form and 200 percent of the average annual compensation of the partnership's most highly paid employees who work in San Francisco — provided the partnership has at least four employees who work in the city. In no case would this result in a partner paying payroll taxes to the City on revenue that the federal government calculates as return on investment.

Why it is on the ballot

From 1970 until 2001, San Francisco businesses paid either the payroll tax or a gross-receipts tax, The gross-receipts tax was 0.15 percent of all revenues from goods sold or services performed in San Francisco. Each business was required to calculate its tax liability under both taxes, and then pay the higher of the two. In the late 1990s, a number of businesses sued the City, claiming the dual tax structure was unlawful because different companies were subject to different taxes — which violated the interstate commerce clause of the U.S. Constitution. In 2000, the City settled with the companies and San Francisco voters approved Proposition I, which eliminated the gross-receipts tax and established the payroll tax as the City's sole business tax.

Approximately 65,000 businesses are registered with the City, less than 10,000 of which are required to pay business taxes. The remaining businesses are small businesses, insurance companies, banks, biotech companies and cleantech companies, all of which are exempt from paying the tax. In 2007, the payroll tax generated approximately $360 million in revenues to the City.

Pros

Arguments in favor of Prop. Q:

• The current version of the payroll is inequitably applied, as some partnerships voluntarily pay it while others do not. By clarifying how to calculate compensation, this measure is an equitable application of the City's primary business tax.
• Expanding the small business exemption could encourage the retention and growth of small firms in San Francisco. This is an expensive city in which to operate, and the payroll tax is a disincentive to add employees in San Francisco.
• This measure was well drafted by including a safe harbor provision that allows firms to let the City calculate their tax liability while still allowing their partners a fair return on their investment.

Cons

Arguments against Prop. Q.:

• State and federal law prohibits the application of a local income tax. Because the proposed legislation taxes profits paid to partners — which effectively is their income — it acts like a local income tax, which is illegal.
• The proposed legislation requires businesses to determine how much of their income is salary and how much is profit. This requirement is overly burdensome and complex for business owners, particularly for small businesses.
• The small business exemption and safe-harbor provisions are not sufficiently aggressive. Even with these exemptions, the proposed legislation would create a disincentive for people to start or invest in small businesses or knowledge-services firms, such as law, accounting and private-equity firms, which often are formed as partnerships.
• San Francisco is very successful at attracting start-ups and small businesses. Our challenge is that we often lose them when they grow to 10 or 15 employees. By increasing the small-business exemption only to $250,000 in payroll, the measure tries to solve a problem we do not have.
• The City's payroll tax is one of the reasons job growth in San Francisco lags behind growth in other Bay Area counties. Instead of finding ways to apply this tax to more businesses, we should be looking at ways to reduce this tax and shift the tax burden to other activities that are actually harmful to the City — as opposed to job creation, which is something we want to encourage.

SPUR’s analysis

We recognize that the payroll tax is one of the least competitive aspects of San Francisco's business climate. Not only is the tax by far the highest among Bay Area cities, but it also is a tax that businesses easily can avoid — simply by moving to a different city. As such, it is likely one of the reasons San Francisco continues to experience slow job growth relative to other parts of the region. However, the payroll tax raises hundreds of millions of dollars for the City annually and is thus a significant source of General Fund revenue with few alternatives.

As a result, for the time being we are stuck with the payroll tax. Given this reality, we believe that we should have a business tax that is equitable and fair. San Francisco's current payroll tax system continues to cause confusion among partnerships, and some pay it voluntarily while others do not. Prop. Q includes language that clarifies the payroll tax for partnerships and thus levels the playing field across businesses. Further, Prop. Q also includes a common-sense provision to exempt additional small business and to index the payroll tax floor to inflation. While this measure is not a part of a needed comprehensive tax reform for San Francisco, it makes an important improvement to our current business tax.

SPUR recommends a "Yes" vote on Prop. Q.