05.04.2010
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Updates
On April 23, 2010, Governor Christine Gregoire signed into law Second Engrossed Substitute Senate Bill 6143, which extends Washington's business and occupation (B&O) tax to corporate directors beginning July 1, 2010. The B&O taxation of corporate directors is expected to raise approximately $2.1 million in taxes for fiscal year 2011—a modest sum considering the significant administrative costs and challenges associated with compliance with the tax.
The basic premise of the legislation is that corporate directors are engaged in business as independent contractors for the corporations on whose boards they serve. The legislature concluded that directors should be subject to B&O tax in the same manner as other independent contractors. To accomplish this goal and avoid confusion caused by years of understanding by taxpayers and the Washington Department of Revenue that directors were not considered to be engaging in business, the new tax bill explicitly extends the B&O tax to amounts received by an individual from a corporation for serving as a member of that corporation's board of directors.
The following Q&A provides highlights of the new tax bill and offers practical advice.
Question: Who is subject to extended B&O tax?
Generally, directors who receive compensation for serving on the board of directors of corporations that are based in or headquartered in Washington will be subject to the B&O tax. The combination of new nexus and apportionment provisions in the tax bill and long-standing B&O tax exemptions creates a few distinct fact patterns:
Employee Directors Are Likely Not Subject to B&O Tax. Although the legislation does not specifically address employees who serve as corporate directors, state B&O tax law retains an exemption from B&O tax for employee compensation. Thus, an employee who also serves as a corporate director should be taxable only to the extent his or her compensation is received from the corporation for service as a director. There is no basis in Washington law for the Department of Revenue to recharacterize employee compensation (normally included in a Form W-2) as compensation paid to an independent contractor for service as a corporate director (normally reported on a Form 1099). Because most employee directors receive compensation as an employee and not as an independent contractor, most employee directors will not be subject to B&O tax as a result of the new legislation.
Nonresident Directors May Have Sufficient Nexus for B&O Tax. Corporate directors may be subject to B&O tax even if they are not physically present in Washington. Under the nexus provisions of the new legislation, a director will have substantial nexus with Washington and be subject to the state's B&O tax if the director (a) is a resident of Washington; (b) owns more than $50,000 worth of property in Washington; (c) has more than $250,000 of total gross receipts attributable to Washington; or (d) has 25% or more of his or her total gross receipts from director compensation and other apportionable service activities attributable to Washington. As a practical matter, most nonresident directors serving on the board of a Washington-based corporation will have nexus by virtue of receiving 25% or more of their service income from Washington. However, it is possible in some narrow cases that a nonresident director might not have nexus (e.g., a nonresident director might serve as a director on the boards of other corporations based outside Washington or have gross receipts from other service activities conducted as an individual that dilute the percentage of gross receipts attributable to Washington below 25%).
Resident Directors Should Not Be Subject to B&O Tax on Compensation Paid by Corporations Based Outside Washington. Under the legislation's new apportionment provisions, corporate directors will generally be subject to Washington B&O tax only with respect to director compensation paid by Washington-based corporations. Directors should not be subject to B&O tax on compensation for service on the board of a corporation based outside Washington. A corporation's state of organization (e.g., Delaware) or the location of board meetings will likely not impact the taxability of director fees if the corporation has its headquarters in Washington.
Apportionment Provisions Generally Restrict B&O Tax to Compensation Paid by Washington-Based Corporations. The new apportionment provisions contain a hierarchy of rules designed to attribute service revenue to Washington. First, the director's compensation is assigned to the state where a corporation primarily receives the benefit of the director's service. The legislation gives no clear guidance on where the corporation primarily receives the benefit in the case of a multistate corporation. In many cases, the Department of Revenue and the director will have a reasonable argument that the benefit of a director's services is primarily received at the corporation's headquarters. In other cases, there may be no state in which the corporation primarily receives the benefit. In the latter case, the director's compensation will be assigned, under the following hierarchy, to the state: (a) from which the corporation requested the director's services, (b) to which the director sends billing statements or invoices to the corporation, (c) from which the corporation sends payments to the director, or (d) where the corporation is located, as evidenced by the director's business records. All or most of these alternatives would normally result in a director being subject to B&O tax on director fees received from a corporation based in Washington.
Question: What amounts are subject to B&O tax?
The B&O tax on corporate directors applies to all amounts the director receives from a corporation for serving as a member of that corporation's board of directors. The director's gross income subject to B&O tax includes all value paid or accrued for service as a director with no deductions for costs or expenses. Thus, directors will be subject to tax on cash compensation, noncash compensation including stock and stock options, and amounts paid as reimbursements for the director's expenses.
Method of Reporting Stock Options Is Unclear. The major unsettled issue in the new B&O tax on directors is the timing and measurement of compensation from stock options. From an administrative perspective, the Department of Revenue and many directors may prefer to measure compensation from stock options in the year a director exercises his or her options, based on the difference between the fair market value of the stock on the date of exercise and the exercise price of the option. The advantages of this approach would be: (a) valuation issues are straight-forward and would track the director's income as reported on a Form 1099; (b) the director would have the liquidity to pay the B&O tax (although liquidity issues are likely minor because of the low B&O tax rate); and (c) the Department of Revenue could easily audit and verify the compensation without significant administrative resources. Basing director compensation on the excess of fair market value at exercise over the price paid is also consistent with the Department of Revenue's treatment of stock options granted to employees in the context of the research and development credit. For purposes of the state R&D tax credit, R&D expenditures include stock options granted to employees to the extent an employer reports them on an employee's Form W-2 and takes them as a deduction for federal income tax purposes. By analogy, the Department of Revenue might reasonably treat stock options as gross income to directors to the extent and in the year the corporation takes the amounts as a deduction and reports them to the director on a Form 1099.
However, there are several potential disadvantages to measuring a director's compensation from stock options for B&O tax purposes based on the excess of fair market value at exercise over the price paid. First, because the new B&O tax is effective beginning July 1, 2010, this approach could potentially trigger B&O tax on stock options granted for service as a director before the effective date of the tax based solely on an exercise date after the effective date. Second, in many cases, measuring B&O tax based on the spread at exercise does not accurately reflect all value paid or accrued for service as a director and instead captures value more fairly attributable to nontaxable investment gain. Consequently, although difficult to value, directors might reasonably take the position that B&O tax should be based on the value of the stock options at the time they are granted. Thus, under this position, stock options granted before July 1, 2010 would not be subject to B&O tax even if exercised after July 1, 2010.
We expect that the Department of Revenue will address the stock option issues in rulemaking or some other form of public guidance. We further expect that the Department of Revenue will be open to taxpayer input on the proper measurement and timing of B&O tax on stock option and other noncash compensation.
Question: What is the B&O tax rate on corporate directors?
Under the new tax legislation, the B&O tax rate for director compensation will be 1.8% of gross income, under the "service and other" classification. The rate is scheduled to decline to 1.5% after June 20, 2013.
Question: Are any credits available to reduce the B&O tax on corporate directors?
Potentially. Because directors are "engaging in business" under the new tax law, they may be entitled to a small business B&O tax credit to eliminate or reduce their B&O tax. The new tax legislation doubles the current B&O tax credit for service businesses to $840 per year ($70 per month). The credit eliminates the B&O tax for directors whose total Washington service revenue is less than $46,667 per year. The credit reduces, but does not eliminate, B&O tax for directors whose Washington service revenue is between $46,667 and $93,333 per year. A director who receives Washington service revenue in excess of $93,333 per year is not eligible for a credit on that amount. To illustrate, a director who earns $40,000 per year for serving on the board of Company A and has no other service revenue would have no B&O tax liability as a result of the small business B&O tax credit. A director who earns $40,000 per year for serving on the board of Company A and $60,000 per year for serving on the board of Company B (that is, $100,000 in total service revenue) would not be entitled to a small business B&O tax credit.
Question: What is the effective date of the new B&O tax on corporate directors?
The B&O tax on corporate directors is effective beginning July 1, 2010.
Question: Can corporate directors who paid B&O tax prior to the effective date obtain a refund?
Probably not. The new tax legislation specifically provides that the changes to the taxation of corporate directors do not authorize refunds of B&O tax validly collected before July 1, 2010 on amounts received by a director as compensation for serving as a member of a corporation's board of directors. Although this provision is clearly intended to prevent refunds, a corporate director may have a refund claim based on the position that B&O tax on director compensation was not "validly collected" for periods prior to July 1, 2010 because a director's service on a board of directors was not considered "engaging in business" prior to the new tax legislation. The disparate treatment of directors could also give rise to equal protection and other constitutional concerns.
Question: Is there a requirement for corporate directors to pay city B&O tax or obtain a city business license?
The new legislation does not specifically address city licensing or B&O taxes, which are imposed and administered separately by individual cities in Washington. There is at least some risk that cities that impose B&O taxes will interpret their own B&O taxes to reach corporate directors. It is possible that city B&O taxes could be imposed retroactively to tax periods before July 1, 2010.
Question: Will nonresident directors receive a credit against their home state income tax for the new B&O tax on corporate directors?
Generally not. Most states provide a credit against a resident's home state income tax for net income taxes paid to other states. The Washington B&O tax will not qualify for the credit in most states because it is a gross receipts tax rather than a net income tax. For example, a California resident may claim a credit against his or her California income tax for any net income tax paid to Oregon but cannot claim a credit for B&O tax paid to Washington.
Although a credit will not generally be available, directors may be able to deduct the B&O tax as a business expense in computing their home state income tax.
Additional Information
This Update is only intended to provide a summary of the Second Engrossed Substitute Senate Bill 6143. You can find discussions of other recent cases, laws, regulations and rule proposals of interest to public companies on our Website.
