Double duty: How startups and small businesses could be hit twice under Seattle’s new income tax

In certain circumstances, business revenue would be subject to the Business and Occupation (B&O) tax and Seattle’s new income tax. (GeekWire Photo / Brian Westbrook)

Revenue generated by some of Seattle’s tech startups and small businesses will be taxed twice if the city’s new income tax clears the courts.

Councilmember Lisa Herbold is pushing for a Seattle income tax. (Seattle City Council Photo)

In July, the Seattle City Council approved a proposal to levy a 2.25 percent tax on any income that is higher than $250,000 for individuals and $500,000 for joint filers. If a Seattleite earned $300,000, for example, the city would collect 2.25 percent of $50,000, amounting to $1,125 in taxes.

Business owners in Seattle operating “pass-through” entities like LLCs, S Corporations, and partnerships — in which the business income is attributable to the owner — will also have to pay the tax if the business generates more than $250,000 in net income for each owner, after operating expenses and losses are deducted. Separately, the city of Seattle also charges Business & Occupation (B&O) tax on gross receipts.

That means, in certain circumstances, some business revenue could be subject to both the B&O tax and the income tax. It’s a reality that could have big implications for the Seattle startup scene, which includes many businesses under those designations. An amendment added by two City Councilmembers promises to reduce the regressive nature of the B&O tax, but without specifics, some business owners and legal experts are skeptical.

How much are small businesses on the hook for?

What would the tax scenario actually look like for pass-through entities and people who own them? Consider the following example from Bob Mahon, chair of the state and local tax practice at Seattle law firm Perkins Coie:

Jane owns a retail business (Jane LLC) in Seattle with $4,000,000 in annual gross receipts and $1,000,000 in net income. Jane LLC would pay $8,760 in Seattle B&O tax (0.219% x $4,000,000). If Jane is a Seattle resident, she would also pay $16,875 in income tax (2.25% x ($1,000,000 – $250,000)).

Councilmember Lisa Herbold championed the income tax proposal and she says one of its goals is to reduce the regressive nature of the city’s B&O tax. “Regressive” refers to a tax that, in effect, takes a larger portion of income from low-income earners than from high-income earners. Herbold and Councilmember Lorena González added an amendment to the ordinance that adds B&O to the list of regressive taxes that income tax revenue could alleviate.

“If we’re stating that we have a commitment to addressing the regressivity in our existing tax structure, we all know that that means property tax,” Herbold told GeekWire in an interview. “We all know that that means sales tax. But not everybody knows that that also means our B&O tax structure. So that’s what that amendment was about. It’s about calling out that that business tax, which you don’t necessarily think of as being regressive, is also regressive.”

Bob Mahon heads Perkins Coie’s state and local tax practice. (Perkins Coie Photo)

Mahon says that, despite that intention, the policy would, in reality, result in double taxes for some businesses.

“I think they will see the B&O tax stay in place,” he said. “They’re not going to get any relief, is my expectation for B&O tax, and I expect that the income tax, if it is affirmed, will be a second burden on many small businesses. The question is are you a small business person that happens to reside inside Seattle or are you a small business person that resides outside of Seattle?”

Mahon is also worried about competitive challenges for businesses whose owners live within Seattle city limits. Startups that are subject to the income tax will face greater financial burdens than chains setting up outposts in Seattle or companies that operate in the city but have founders who live in neighboring communities, he says.

Will the income tax relieve the B&O burden?

Longtime Seattle-based journalist Mike Lewis is an owner of an LLC, The Streamline Tavern, in the Queen Anne neighborhood. He says he’s almost always supported tax increases but that the City Council is asking business owners to take a big leap of faith to trust that they will see relief from the B&O tax if the income tax is implemented.

“It’s not a fair decision to ask people to make, that we will pass something now on the promise that we will improve it later,” he said.

Washington state doesn’t currently have an income tax. The Seattle City Council unanimously approved the income tax plan, estimating that it will bring in an additional $140 million each year. The revenue would go toward the city’s housing affordability agenda and carbon reduction goals, and supplant federal funds if they are cut. The revenue is also intended to alleviate the burden of Washington’s property and sales taxes, which are often called the most regressive in the country.

Herbold says that Washington’s tax structure is suffering from a “crisis in adequacy,” noting that the state and local effective tax rate fell from 11.4 percent to 9.4 percent between 1995 and 2014. That decline is occurring concurrently with a population boom driven by job growth in tech and other industries.

Herbold provided the chart above, which shows Washington state’s declining effective tax rate based on U.S. Bureau and Census data.

“No other state in the nation has experienced a greater decline over this period,” she said. “I can’t think of another thing that illustrates the crisis that we have in this state more than that factoid.”

Where do we go from here?

Herbold and Councilmember Kshama Sawant drafted the bill knowing that it would most likely be challenged in court. Washington state law says, “a county, city, or city-county shall not levy a tax on net income” and one lawsuit has already been filed over the policy.

Molly Moon Neitzel.

The income tax proposal received broad support from Seattleites during public hearings leading up to the Council vote. Supporters filled the Council chambers arguing that the tax is necessary to deal with the city’s affordability crisis, transportation needs, and other problems.

“Seattle needs to be committed to solving these issues in a way that is equitable,” said Molly Moon Neitzel, owner and namesake of the iconic Seattle ice cream shops, during a hearing. “I absolutely support the Seattle income tax initiative because it’s what’s best for our community and what’s best for my business.”

On the flip side, critics claim that it is too burdensome for the city to build income tax infrastructure rather than piggybacking on existing state systems as other cities often do. Others say that piecemeal income taxes levied by cities create bureaucratic issues.

Lewis worries about the cumulative effects of increases in property taxes, minimum wage requirements, and other expenses for Seattle businesses.

“It’s not like these things are in a vacuum,” he said. “At least for some people, they’re all chipping away at your ability to do business in the city.”

Matt McIlwain pledges to fight Seattle’s income tax. (Madrona Photo)

With these concerns in mind, Madrona Venture Group Director Matt McIlwain founded a non-profit, called the Opportunity for All Coalition, to fund legal challenges to the income tax.

“Entrepreneurs and their companies create jobs, build innovative products and add more resources to our communities … in defeating the city income tax, we can help maintain a system of opportunity creation for the next generation of innovators and workers,” he told GeekWire in an email.

The income tax is expected to see a series of legal challenges in the coming weeks. They may be consolidated into one suit, asking the court to interpret Washington state law and determine whether local jurisdictions can levy income taxes going forward.