The good and the bad for Washington companies

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Washington’s unique tax structure puts it at both the top and bottom of various studies that attempt to rank states’ business climates. Some reports, including one prepared by Forbes magazine, rank Washington very high, in large part because the state does not have a personal income tax. The absence of a state personal income tax has been a major recruiting tool for Washington businesses conducting national searches for skilled employees and executives. Success in recruiting highly educated workers to relocate from elsewhere is, in turn, a factor in Washington’s high ranking for the educational attainment of its workforce.

Other reports, including one prepared by Ernst & Young for the Council on State Taxation, rank Washington near the bottom quintile for business climate. Washington fares poorly in these studies because of the heavy tax burden the state imposes on its businesses. The business and occupation tax, commonly referred to as the B&O tax, combined with the state’s heavy reliance on sales taxes, results in more than half of all tax revenues collected by state and local governments being paid by Washington businesses. The tax burden on Washington businesses is well above the national average; according to the 2011 Ernst & Young study, only 12 states impose a heavier tax burden on their businesses than Washington. Reducing the tax burden on Washington businesses can put people back to work and grow state revenues as the economy recovers.

Washington’s B&O tax is imposed on “the act or privilege of engaging in business” in Washington. The tax rate depends on the type of business activity. There are more than 50 different B&O tax classifications. State B&O tax rates vary between .0138 percent for classifications such as “processing perishable food products” and up to 3.3 percent for “disposing of low-level waste.” The successive taxation of business activities results in a pyramid of B&O tax costs — the revenue from a single transaction may be subject to more than one B&O tax. B&O tax compliance is further complicated by the fact that 39 cities also have a local B&O tax. Local B&O tax systems differ from the state structure and from each other.

Washington is also more dependent on its sales tax than all but a handful of states. Its over-reliance on its sales tax has been a contributing factor to the state’s current fiscal crisis. For example, although the construction industry accounts for roughly 5 percent of economic activity in Washington, because construction is subject to sales tax, it has historically accounted for about 10 percent of state tax revenues. Consequently, the downturn in construction has had an outsized impact on deteriorating tax revenues. At the same time, the state tax treatment of construction is highly complicated, with the same activity taxed differently, depending on factors such as whether the project is deemed custom or speculative building, whether the owner or the contractor is deemed the “consumer” and whether the project is private or public.

The business climate in the state, including its tax structure, will continue to affect businesses’ decisions whether to expand into Washington, whether to leave Washington, and in some instances whether to even remain in business. In June, the Department of Revenue issued a report identifying a number of tax simplification measures focused on small businesses. The top recommendation was centralized administration of both state and local B&O taxes. The department found that by “centralizing administration of state and local B&O tax reporting, Washington can relieve a significant burden for small business owners — freeing them to get back to the work of running their businesses.”

Scott M. Edwards is a shareholder at Lane Powell, where he focuses his practice on all aspects of state and local tax including tax planning, audit defense, refund claims, administrative proceedings and litigation. He is a frequent author and speaker on state and local tax issues, and has been an adjunct professor in taxation at the University of Washington School of Law since 2000. He can be reached at edwardss@lanepowell.com or 206.223.7010

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Legal Briefs: Private Foundations

Legal Briefs: Private Foundations

Taking them beyond checkbook philanthropy.
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Today, we are seeing more sophisticated inquiries by founders of private foundations in line with the discussions surrounding social impact investing. For many years, high-net-worth individuals have used the same formula to set up private foundations. An individual or married couple — the donors — establish an entity whose assets are to be used for general charitable purposes, qualifying it as a tax-exempt foundation. The donors transfer assets — often appreciated stock — to the foundation. This stock is then sold, allowing the donors to avoid income tax on the gain. The donors retain distribution oversight by serving on the foundation’s board. The foundation essentially becomes their philanthropic checkbook.
 
Tax-exempt organizations must be organized and operated for an exempt purpose. A private foundation is an organization that qualifies for tax-exempt status under Internal Revenue Code (“Code”) §501(c)(3) but does not qualify as a public charity under §509(a). The rules and regulations applying to private foundations are much stricter than those that apply to public charities.
 
As private foundations, the “checkbook foundations” are subject to various excise tax rules, including Code §4942, which requires private nonoperating foundations to make certain minimum annual distributions for charitable purposes. The amount required to be distributed is measured by a percentage of the private foundation’s investment assets. Generally, the annual minimum distributable amount is equal to 5 percent of the aggregate fair market value of all of the foundation’s assets, reduced by certain adjustments. Private foundations that fail to meet this requirement are subject to an excise tax on the undistributed income.
 
Today’s donors question why they would want to drain their foundation’s funds, which seems to be the policy goal of the 5 percent distribution requirement. What about lending funds to a charitable organization recipient or investing directly in the underlying charitable cause?
 
 
 
Program-related investments (PRIs) have been used for many years. Generally, a private foundation that makes investments jeopardizing its ability to carry out its exempt functions is subject to an excise tax under Code §4944. However, PRIs are an exception to that rule. Under the regulations, an investment qualifies as a PRI if: (a) its primary purpose is to accomplish the foundation’s exempt purpose(s); (b) the production of income or appreciation of property is not a significant purpose of the investment; and (c) none of the purposes described in Code §170(c)(2)(D) (i.e., carrying on propaganda or otherwise attempting to influence legislation) are a purpose of the investment. 
 
Examples in the final regulations issued earlier this year illustrate a variety of PRI investment terms and structures, including equity investments, loans, loans with equity components and guarantee arrangements. Smaller foundations take comfort that the big name foundations were using PRIs long before the regulations were final. Since 2009, the Bill & Melinda Gates Foundation has complemented its grants budget with a substantial allocation for PRIs.
 
Foundations are also pushing the boundaries of permissible investments in the area of mission related investments (MRIs). MRIs are financial investments that further the foundation’s exempt purpose. Unlike PRIs, MRIs are included in the foundation’s investment assets and are not qualifying distributions for purposes of the 5 percent distribution requirement under Code §4942. In addition, MRIs must satisfy applicable prudent investment standards, although the IRS confirmed in Notice 2015-62 that foundation managers may consider the relationship of a proposed investment to the foundation’s charitable purpose when determining whether an investment is prudent.
 
Careful consideration of the foundation’s charitable purpose, investment policy, and proper use of PRIs and MRIs allow today’s foundations to take their philanthropy far beyond the checkbook-only days.