City of Seattle v. KMS Fin. Servs., Inc.

12 Wash.App.2d 491

459 P.3d 359

CITY OF SEATTLE a municipal corporation, Respondent,

v.KMS FINANCIAL SERVICES, INC., a Washington corporation, Appellant.

No. 78946-5-I

Court of Appeals of Washington, Division 1.

FILED: February 24, 2020

Scott M. Edwards, Ryan P. McBride, Daniel A. Kittle, Lane Powell PC, 1420 5th Ave. Ste. 4200, Seattle, WA, 98101-2375, for Appellant.

Jennifer K. Ryan Gilman, City of Seattle Law Dept., 701 5th Ave. Ste. 2050, Columbia Ctr., Seattle, WA, 98104-7095, for Respondent.

PUBLISHED OPINION

Mann, A.C.J. ¶1 This is a taxation case. The sole issue is whether the city of Seattle (City) used an unlawful method to calculate business and occupation (B&O) taxes owed by KMS Financial Services, Inc., between January 2012 and March 2016 (the audit period).

¶2 The Commerce Clause of the United States Constitution requires state and local taxes be "fairly apportioned" so that the tax is imposed only on the portion of income reasonably attributed to the taxpayer’s instate activities. Washington law imposes a similar limitation on local government taxes. To comply with these requirements, the City’s B&O tax utilizes a two-factor apportionment method to calculate taxable revenue for service related businesses. One of those factors, the "payroll factor," compares the amount of compensation the taxpayer pays in Seattle to the compensation it pays outside the City. As a result, the more a taxpayer pays for work performed outside the City, the less its income is apportioned to the City—which means a lower B&O tax.

¶3 KMS is headquartered in Seattle, but generates most of its income through the sale of securities by registered representatives located outside the City. In calculating the payroll factor for its B&O tax, KMS included the compensation paid to its registered representatives. During an audit, Seattle determined that KMS’s registered representatives were not "employees" and therefore did not consider their income in determining the payroll factor. The result roughly tripled KMS’s B&O tax liability.

¶4 KMS sought review in the King County Superior Court. After cross-motions for summary judgment, the superior court granted the City’s motion and dismissed KMS’s challenge. We agree with KMS that the City’s B&O tax, as applied to KMS, is not fairly apportioned and is unconstitutional. In order to avoid unconstitutionality, the City should have instead treated KMS’s registered representatives as employees which would have resulted in a valid, fairly apportioned tax. We vacate the trial court’s order and remand for the trial court to grant KMS’s motion for summary judgment.

I.

A. KMS and Registered Representatives

¶5 The parties stipulated to the undisputed, material facts.¹ KMS is a Washington corporation, headquartered in Seattle. KMS engages in the securities, insurance, and investment advisory business. KMS is a broker-dealer under the Securities Exchange Act of 1934 (1934 Act), and is registered with the Securities & Exchange Commission (SEC), the Financial Industry Regulatory Authority (FINRA) and the state securities regulators of all 50 states.

¶6 Under federal securities laws, a broker-dealer acts primarily through "registered representatives." Registered representatives are individuals, often referred to as stockbrokers or account executives, who provide a variety of investment related services. Under the 1934 Act, all individuals in the business of assisting others with securities trades are required to be registered representatives of a registered broker-dealer. KMS does not, except through its registered representatives, generate investment advice, make securities recommendations, or solicit the sale of securities or other financial products.

¶7 As a broker-dealer, KMS must supervise its registered representatives, oversee their licensing status, and require them to comply with industry rules and standards of conduct and procedures set out in its policy manual.

¶8 For federal income tax purposes, broker-dealers typically structure their operation so that the registered representatives are either deemed employees (Form W-2), or independent contractors (Form 1099). A broker-dealer’s control and supervisory obligations under the 1934 Act and by FINRA with respect to the broker-dealer’s registered representatives are identical regardless of whether the registered representatives are deemed independent contractors or employees for federal income tax purposes.

¶9 The National Association of Securities Dealers (NASD) Notice 86-65 provides that:

Irrespective of an individual’s location or compensation arrangements, all associated persons are considered to be employees of the firm with which they are registered for purposes of compliance with NASD rules governing the conduct of registered persons and the supervisory responsibilities of the member. The fact that an associated person conducts business at a separate location or is compensated as an independent contractor does not alter the obligations of the individual and the firm to comply fully with all applicable regulatory requirements.^{[2 ]}

¶10 A SEC letter dated June 18, 1982, addresses the status of registered representatives as employees of their associated broker-dealer. The letter addressed whether independent contractors are subject to the 1934 Act. "The critical question is whether a so-called independent contractor’s activities are subject to control by a broker-dealer within the scope of Section 3(a)(B) of the Act." The letter explains that an independent contractor can be subject to the control of an employer under agency law. "It has been a long-standing policy of the Commission that independent contractors whose selling activities were controlled by their broker-dealer employers could be characterized as employees for the purposes of the Act."

¶11 KMS’s revenue, through the sale of securities, is generated by approximately 350 registered representatives operating throughout the United States. By contract, KMS classifies its registered representatives as independent contractors. During the relevant period, KMS employed approximately 50 W-2 employees, most of whom worked in its Seattle headquarters. The registered representatives cultivate customers, process the opening of client accounts, provide investment advice, make securities recommendations, enter orders, and receive checks. The KMS W-2 employees handle administrative functions. KMS’s W-2 employees do not provide or generate investment advice, make securities recommendations, or solicit the sale of securities and other financial products.

¶12 A typical sale of securities involves: the client tells the registered representative to purchase or sell a security; the registered representative enters the client’s order with KMS’s primary clearing firm, Pershing LLC (Pershing); Pershing executes the trade and records it in the client’s account; the client writes a check to KMS or to Pershing to pay for the transaction; the registered representative forwards the check to KMS, and a trade report is generated in KMS’s office; after settlement of the trade (usually within three days), KMS receives a commission from Pershing and then pays the registered representative a commission based on its contract with the registered representative; KMS pays the registered representative between 85 and 90 percent of the commission from Pershing, depending on its contract with the registered representative who generated the order.

¶13 During the audit period, KMS paid its W-2 employees between approximately $2.6 million and $4 million annually, almost all of which (approximately 95 percent) went to Seattle-based employees. For that same period, KMS paid its registered representatives between approximately $70 million and $79 million, the vast majority of (around 85%) which went to representatives working outside of Seattle.

B. Seattle’s B&O Tax

¶14 Seattle imposes a B&O tax on all persons engaging in business activity within the City. Seattle imposes B&O tax on KMS’s "gross profits" under the "service and other" activity classification rate. SMC 5.45.050(F); see KMS Financial Services, Inc. v. City of Seattle (KMS I), 135 Wash. App. 489, 496, 146 P.3d 1195 (2006). When a business earns income both inside and outside of Seattle, the portion of that business’s income attributable to Seattle must be determined. Beginning in 2008, all Washington cities with a gross receipts B&O tax were required to apportion service business income using a two-factor apportionment formula that averages a service income factor and a payroll factor. Seattle adopted the two-factor apportionment in SMC 5.48.081(F). The service income factor and payroll factors are reflected as a fraction. The fractions are added together and then divided by two. The resulting number is then multiplied by the taxpayer’s total taxable income, without regard to its source, to derive the amount of income that can be allocated to the taxpayer’s Seattle activities. SMC 5.48.081.

¶15 The parties do not dispute the method KMS used to calculate its service factor. The only dispute is the calculation of the payroll factor. Under the Seattle Municipal Code, the payroll factor is described as:

1. The payroll factor is a fraction, the numerator of which is the total amount paid for compensation in the city during the tax period by the taxpayer and the denominator of which is the total compensation paid everywhere during the tax period. Compensation is paid in the city if:

a. The individual or employee is primarily assigned within the city;

b. The individual is not primarily assigned to any place of business for the tax period and the employee performs fifty percent (50%) or more of his or her service for the tax period in the city; or c. The individual is not primarily assigned to any place of business for the tax period, the individual does not perform fifty percent (50%) or more of his or her service in any city, and the employee resides in the city.

SMC 5.45.081(F)(1).

...