Press Room: Tax Release

May 12, 2011

Welcome to the Twitter Zone

San Francisco Passes a New Payroll Tax Exemption

At the end of April, the San Francisco Board of Supervisors voted to approve the Mid-Market Payroll Tax Exclusion. This legislation provides a tax incentive for moving into San Francisco's Mid-Market/Tenderloin neighborhood—an area west of downtown with urban challenges the city has targeted for revitalization. The legislation was a response to Twitter’s announcement that it was evaluating whether to stay in San Francisco or relocate outside of the city to escape the payroll expense tax, which could be substantial depending upon the scope of “payroll” subject to the tax. San Francisco is the only city in California that levies this type of tax.

The Payroll Expense Tax and the Issue with Stock Options
The tax is imposed on all companies with payroll in excess of $250,000, and is calculated at 1.5% of a company’s payroll expense, including salaries, wages and similar forms of compensation paid for services performed in San Francisco. Specifically, the tax includes the compensation element from stock option transactions whether paid to an employee or, starting in 2008, to non-employees.

Stock options are at the heart of the issue for start-ups and technology companies. Many of the compensation structures for these types of enterprises are tied to options that may increase significantly in value as the company grows and/or achieves profitability. Cash-strapped companies may issue this type of remuneration to outside consultants and professional service providers as an incentive to provide services and share in the upside in lieu of cash fees.

There are generally two types of stock options: Incentive Stock Options (ISOs) and Non-Qualified Stock Options (NQSOs). For NQSOs (generally awarded to rank-and-file employees and non-employees), compensation is triggered on the date an option is exercised and is calculated as the difference between the market value of the stock on the date of exercise and the “strike” price (the price the employee must pay to exercise as determined by the option grant). Internal Revenue Service (IRS) and California rules require that this "bargain element" be reported as W-2 compensation for employees or on Form 1099 for non-employees. ISOs—which receive beneficial treatment but must meet stricter IRS and California rules in order to retain their ISO treatment—do not generally trigger compensation when they are exercised. Compensation is triggered only if there is a “disqualifying disposition” of the stock acquired through the ISO exercise, which occurs when the stock is sold or disposed of within one year from the date of exercise or two years from the date of grant. When a "disqualifying disposition" of an ISO share occurs, the "bargain element" is treated as compensation. When a company goes public, the amount of compensation from NQSO exercises and ISO disqualifying dispositions can be eye-popping.

There is some uncertainty regarding how the City would treat stock option exercises that are not treated as compensation to an employee for income tax purposes. While gains from equities not treated as compensation for income tax purposes would appear to fall outside of the City’s payroll tax base, the law appears to cast a wide net. Understandably, Twitter had much to gain from the passage of the Mid-Market Payroll Tax Exclusion.

The Mid-Market/Tenderloin Exemption
The new legislation excludes new payroll from the tax for a six year period. Twitter, and other companies that locate in the zone, will still pay a tax based on a base year payroll expense prior to the exemption’s passage. The exclusion is principally targeted toward companies that may have a profile like Twitter—those expecting a significant increase in compensation either because of anticipated hiring or the potential for significant stock option compensation.

New Changes on the Horizon?
The payroll expense tax is evolving as San Francisco attempts to attract business to the city while managing a budget deficit. There are current exemptions for clean technology and biotechnology businesses. The city has also maintained a tax incentive for hiring certain types of employees within an enterprise zone. On the flip side, the city extended the tax to certain business owners that earn “pass-through compensation” from the profits of the business.

For stock options, the city is currently entertaining changes to the payroll expense tax that may provide exclusions for certain forms of equity compensation. There are many factors that may come into play: Would these exclusions be for all companies regardless of size? Would the entire city enjoy the exemption or would businesses located in certain areas be excluded from the incentive? Would all industries qualify? In a new twist, the city is also considering a proposal to repeal the payroll expense tax altogether in favor of a gross receipts tax (similar to the tax currently imposed by Los Angeles).

We will likely see more changes in the coming months. For now, we have the “Twitter Zone” - a patchwork of other limited incentives and a tax landscape that is as shifty as the ground upon which San Francisco sits.