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Jamie C. Yesnowitz
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On Feb. 24, 2020, the Washington Court of Appeals determined that the city of Seattle used an unlawful method to calculate the city’s Business and Occupation (B&O) tax liability of a broker-dealer taxpayer.1
Specifically, Seattle unfairly apportioned the tax by excluding amounts paid to independent contractors from the taxpayer’s payroll factor.
The taxpayer, KMS Financial Services, Inc. (KMS), a Seattle-based company engaged in the securities, insurance and investment advisory business, operates as a broker-dealer registered with the Securities and Exchange Commission (SEC). As is typical in this business, KMS acts primarily through registered representatives who provide a variety of investment related services. KMS earns income from clearing firms used to execute client trades. Generally, KMS receives a commission from the clearing firm for each trade and subsequently pays the associated registered representative a contracted amount of commission (generally, 85% to 90% of the amount it receives from the clearing firm).
Although KMS is based in Seattle, it generates most of its income through the sale of securities by the registered representatives located outside Seattle. Its registered representatives cultivate customers, process the opening of client accounts, provide investment advice, make securities recommendations and receive checks. KMS does not, except through these representatives, generate investment advice, make securities recommendations, or solicit the sale of securities or other financial products. By contract, KMS treats these representatives as independent contractors for federal income tax purposes. Pursuant to industry standards, a broker-dealer’s control and supervisory obligations are identical regardless of whether the registered representatives are independent contractors or employees for federal income tax purposes.2
During the period from January 2012 to March 2016, the tax period at issue, KMS directly employed approximately 50 individuals, most of whom worked in its Seattle headquarters performing various administrative functions. When calculating its payroll factor for purposes of computing Seattle B&O tax for the period, KMS included compensation paid to its registered representatives along with compensation paid to its employees. At the audit level, Seattle took the position that compensation paid to registered representatives should be excluded from the payroll factor calculation. This modification virtually tripled the amount of calculated tax due. KMS timely paid the Seattle assessment and filed for a refund in King County Superior Court, arguing that all of its registered representatives were deemed to be employees for securities law purposes includible in the payroll factor calculation. Both Seattle and KMS moved for summary judgment. After the Superior Court granted Seattle’s motion, KMS appealed to the Court of Appeals.
City of Seattle income tax apportionment provisions
Seattle’s B&O tax is generally imposed on all persons engaging in business activity within the city.3
In 2006, KMS successfully defeated an effort by Seattle to impose a B&O tax on KMS based on all commissions received in the KMS Seattle office, regardless of where the registered representative generating the commission was based.4
The Court held that the position violated the external consistency requirement contained in federal commerce clause jurisprudence.
In response to this decision, Washington imposed certain restrictions on its cities’ power to tax. Specifically, these provisions require that in order for a city to levy a tax: (i) the relevant taxable event must be identified; (ii) the taxable event must occur within the municipality’s territorial limits; and (iii) there must be a minimum connection between the municipality and the transaction it seeks to tax.5
For businesses earning income both within and outside of Seattle in 2008 and thereafter, to comply with this mandate, Washington cities, including Seattle, began to apportion service business income using a two-factor apportionment formula including a service income factor and a payroll factor.6
The average of the two factors is multiplied by the taxpayer’s total taxable income to derive the amount of income allocated to the taxpayer’s city activities.7
The payroll factor compares compensation paid to individuals and employees in the city to compensation paid to employees paid everywhere.8
By definition, compensation includes commissions paid to individuals
for personal services that are included in the individual’s federal gross income.9
Court of Appeals decision
The Court first considered whether Seattle used an unlawful apportionment method to calculate KMS’s B&O tax. To determine whether Seattle’s B&O tax was fairly apportioned as applied to KMS, the Court examined whether the tax satisfied the federal constitutional tests governing apportionment, specifically from the lens of external consistency.10
The Court ultimately rejected Seattle’s argument that compensation paid to KMS’s registered representatives must be excluded from the payroll factor because they are classified as independent contractors. Instead, it found that whether a taxpayer does business through independent contractors or employees is “without constitutional significance.”11
If the individuals did not work in Seattle, the city had no claim to a ‘fair share’ of the income they generated. Finding that Seattle failed to consider where and how KMS generated its income, the Court ruled that the tax was not externally consistent as applied to KMS.
KMS then argued that the Seattle Municipal Code provides for a remedy in instances in which the allocation and apportionment provisions of the city’s B&O tax do not fairly represent the extent of a taxpayer’s business activity. Specifically, Seattle is allowed to employ a different method in order to avoid a constitutional violation.12
In challenging Seattle’s assessment calculation, KMS offered that the tax could be fairly computed by including compensation paid to its registered representatives in calculating the overall compensation factor of Seattle’s apportionment formula, as it had done in preparing its originally filed returns.
In considering this treatment, the Court reviewed statutory language defining an individual as any individual who, under the usual common law rules applicable to determining the employer-employee relationship, has the status of an employee of that taxpayer.13
Supported by the evidence that the SEC and other related governing bodies consider a broker-dealer’s registered representatives to be its employees, since they are subject to the broker-dealer’s control, the Court found that they fell within Seattle’s statutory definition of individual. Thus, Seattle could logically consider the registered representatives to be employees for an alternative apportionment calculation of the B&O tax.
Therefore, although Seattle’s interpretation of its payroll factor as applied to KMS was unconstitutional, the defect could be remedied by applying the interpretation offered by KMS. The Court vacated the original order granting summary judgment to Seattle, and remanded the case to the trial court to grant KMS’s motion for summary judgment.
In finding that Seattle’s calculation of KMS’s tax liability was unconstitutional as applied, the Court essentially validated the original filing position reflected by KMS. By ruling on a constitutional issue on an as applied basis and finding that an existing statutory remedy could apply to resolve the case, the Court limited the scope of the decision to KMS. However, by acknowledging the unfair applicability of the general apportionment statute on KMS, the Court did open the door for other taxpayers to potentially set forth similar challenges. While the result remedies the apportionment challenge faced by a Seattle-based broker-dealer earning income through registered representatives located outside the city, other businesses situated within Seattle with large outsourced functions outside the city that generate income may want to evaluate the construction of their current Seattle payroll factor. Likewise, given that all the cities in Washington are required to utilize the same 2-factor apportionment method and definitions for the service and other activities classification, the issues raised by KMS could have wider application to other municipal B&O taxes beyond Seattle.
The decision also offers taxpayers an opportunity to reflect upon the distinctions between the B&O apportionment formula used by Washington and the cities. Washington adopted a single sales factor, market-based apportionment formula for state B&O tax purposes in 2010. The sales factor numerator includes gross receipts from apportionable Washington income, and the denominator includes gross receipts from apportionable worldwide income.14
Recent legislative changes require cities to adopt a market-based souring approach for the sales factor beginning in 2020,15
which would impact the method by which KMS and other service providers apportion their sales for purposes of the Seattle and other municipal B&O taxes. However, it does not appear that there is an imminent attempt to modify the overall municipal B&O tax apportionment formula to adopt a single sales factor in line with the state.
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