Tech companies, real estate developers and others are managing San Francisco’s evolving tax code and city politics to grow in San Francisco

In recent years, San Francisco (the City) has overhauled its tax code. As a result, technology start-ups are deriving particular benefits. This overhaul culminated in the passage of referendum Proposition E, the Gross Receipts Tax (Prop E) in November 2012. San Francisco also has been focusing on the redevelopment of the blighted Mid-Market area. Development is speeding ahead as many companies move into the area to obtain the benefit of targeted tax savings. Recent laws and development led by the tech sector raise legal issues regarding local taxation, land use and entitlements, and labor, which companies and developers must navigate to develop in the Mid-Market area and throughout the City.

  1. The New Tax Landscape in San Francisco

San Francisco taxes companies based on the number of people they employ. This structure requires all businesses with payroll expenses over $150,000 to pay 1.5 percent of these expenses in taxes to the City.1 Payroll expenses are defined as “total compensation paid including salaries, wages, bonuses, commissions, property issued or transferred in exchange for the performance of services.”2 In 2011 and 2012, the City overhauled its tax code through ordinances and a referendum, using temporary tax exemptions to move towards taxation of gross receipts as opposed to payroll expenses. These potentially beneficial tax changes are one, among several factors, attracting technology companies to the City. The draw of a city lifestyle and the organization of San Francisco’s tech sector, provide other incentives for companies to make the move.

Central Market/Tenderloin Payroll Tax Exclusion (CMTPTE); Ordinance 68-11

In January 2011, social media giant Twitter was considering leaving San Francisco for the South Bay – the site of the former Walmart.com headquarters in Brisbane, California.3 In response, the San Francisco Board of Supervisors created a tax benefit to provide businesses with an exemption from additional payroll expense tax provided they “maintain[] a fixed place of business within the Central Market Street and Tenderloin Area for payroll expense attributable to that fixed location….”4 This tax savings, known as the Central Market/Tenderloin Payroll Tax Exclusion (CMTPTE), was based on a condition that Twitter (and companies that follow) move to a specific “blighted” section of the City along Market Street. This area is known as “Mid-Market” or “Central Market” and generally encompasses the area fronting Market Street, from Sixth Street to Eleventh Street, including 3.3 million square feet of office space within 73 buildings.5 (For a map of this area, please see Map of Payroll Expense Tax Exclusion in Central Market Street and Tenderloin Area Coverage Area.6) On April 19, 2011, the San Francisco Board of Supervisors passed the CMTPTE as Ordinance 68-11, by a vote of 8 to 3.7 Three days later, Twitter announced its lease of 215,000 square feet of office space at 1355 Market Street.8

Companies located in this Mid-Market area may take advantage of the CMTPTE for any six years during which they add jobs to their payroll during the eight-year period beginning in 2012 and ending in 2019.9 This is an exemption from tax additional to the business’ tax “Base Year.”10 This effectively exempts new hires after the “Base Year,” from San Francisco’s 1.5 percent payroll tax, while ensuring that “in no event shall the tax exclusion reduce a person’s tax liability to less than the person’s Base Year payroll tax expense liability.”11 For entities that maintained a fixed place of business in the Mid-Market area on the effective date of the ordinance (May 20, 2011), the “Base Year” is the 2010 tax year.12 For entities that do not meet this qualification, the “Base Year” is the first full tax year that entity maintains a fixed place of business in the Mid-Market area.13

City-Wide Stock Option Tax Exemption; Ordinance 87-11

Other technology companies expressed concerns about the tax levied on companies doing business in San Francisco and, in particular, the City’s payroll tax assessed on a company’s stock options.14 Consequently, on May 24, 2011, the San Francisco Board of Supervisors passed Ordinance 87-11, Excluding Stock-Based Compensation from Payroll Expense, Tax Years 2011 through 2017, by a vote of 8 to 3.15 Pursuant to Ordinance 87-11, when San Francisco companies go public they pay up to $750,000 in payroll expense tax on their stock options, but options after that are tax exempt.16 This stock option tax savings applies City-wide to any company that pays City payroll tax and “undertakes an initial public offering on a public stock exchange, or experiences a change in control prior to such initial public offering.”17

Phase in of the Gross Receipts Tax; Prop E

On November 6, 2012, San Francisco voters passed referendum Proposition E, the Gross Receipts Tax (Prop E) by 71 percent.18 Prop E is a major overhaul of San Francisco’s tax structure wherein the City will phase in a gross receipts tax over a five-year period beginning in 2014.19

Gross receipts are defined as “the total amounts received or accrued by a person from whatever source derived, including, but not limited to, amounts derived from sales, services, dealings in property, interest, rent, royalties, dividends, licensing fees, other fees, commissions and distributed amounts from other business entities.”20 Following a predetermined formula, the City’s payroll expense tax will be reduced in tandem with the raise in gross receipts tax and, if the gross receipts tax generates more revenue than the payroll expense tax would have, San Francisco will transition away from payroll expense tax completely.21

The gross receipts tax is industry dependent, meaning there are different tax rates for different industries (e.g., manufacturing, retail, construction, financial services, real estate) which will be tiered based upon a company’s annual gross receipts.22 Commentators have noted that Prop E “benefits low-revenue, high-headcount companies like startups” and that companies in industries such as finance, insurance and real estate could see their local taxes increase up to 30 percent, while taxes would not increase for most scientific and technical companies.23

Prop E preserved the tax savings granted by the 2011 ordinance which created the CMTPTE, guaranteeing that beneficiaries of the CMTPTE will not pay more under the new tax scheme than they would have paid had Prop E not been enacted, for the duration of the CMTPTE, which expires in 2019.24

Prop E also creates a “Payroll Expense Tax Exclusion Credit” for those companies benefiting from other tax savings, including the Enterprise Zone Tax Credit, the Biotechnology Exclusion and/or the Clean Technology Business Exclusion.25 Prop E does not alter the stock option tax savings in effect until 2017 under Ordinance 87-11.

  1. Challenges Facing Businesses Operating in the Mid-Market Area: Land Use, Entitlement, and Labor Issues

Companies and prospective developers considering opportunities in the Mid-Market area face potential challenges. Interested parties must be familiar with the requirements of the CMTPTE, including the requirement to negotiate Community Benefit Agreements, and relevant land use and labor issues.

Navigating the CMTPTE

The Office of Economic and Workforce Development (OEWD) and the Office of the Treasurer and Tax Collector are the two major government entities responsible for ensuring that the CMTPTE is appropriately implemented and that the eligibility criteria are observed.26 Companies wishing to qualify for the CMTPTE must submit an application to OEWD, the entity responsible for ensuring that businesses meet the eligibility criteria.27 Interested companies must complete a two-page application, file a payroll expense tax return, and file an annual Affidavit of Renewal which details the total number of individuals hired during the year, the number of individuals who were referred by the San Francisco Workforce Development System during the year, and the duration of employment for each individual hired during the year.28 Companies must also enroll in the First Source Hiring Program (a program to connect economically disadvantaged San Francisco residents with entry-level jobs).29 Although Mid-Market developers (as opposed to lessees) have applied for the tax savings, their applications have not thus far been granted; the City has resisted their applications on the grounds that they do not meet the condition of having a fixed place of business in the Mid-Market area.30

Community Benefit Agreements are required of any company with annual payroll expenses over $1 million that wishes to apply for the CMTPTE.31 To qualify for this tax savings, companies initially were expected to donate 30 percent of what they saved in taxes to the community.32 This 30 percent donation figure is unofficial — it is not part of the tax code and appears to be based on negotiations prior to the passage of the CMTPTE.33 While the Community Benefit Agreements contain key features that encompass a number of beneficial programs for the City, the actual amount of the donations varies based on the aspirational nature of many of the “key features” of the Community Benefit Agreements (which do not require strict adherence but instead generally provide that “[c]ompletion of at least 80% of items in the CBA [Community Benefit Agreement] will be deemed as successful, provided that a good faith effort was made to achieve all items).”34

Of the start-up companies that have moved to the Mid-Market area, the following companies have signed Community Benefit Agreements with San Francisco: Zendesk, Yammer (a subsidiary of Microsoft), Zoosk, One Kings Lane, and 21 Tech.35 For 2013 alone, based on its Community Benefit Agreement, news sources report that Twitter will “spend at least $200,000 this year at local businesses and offer at least $60,000 in grants to area nonprofits,” and has plans to donate $50,000 worth of computers to schools and $60,000 of promotional tweeting to nonprofits.36 Other aspects of the Community Benefit Agreements are, however, much less specific, such as: “encourage employees to volunteer” and “make employees aware of the Department of Public Works’ Community Clean Team event.”37

Citizens’ Advisory Committee for the Central Market Tenderloin Area

On June 14, 2011, the San Francisco Board of Supervisors unanimously passed Ordinance 103-11, adding San Francisco Business and Tax Regulations Code § 906.3-1 and creating an advisory committee to assist the City Administrator with Community Benefits Agreements, as required by the CMTPTE.38 The Citizen’s Advisory Committee for the Central Market & Tenderloin Area (CAC) is comprised of 11 members who are appointed by the San Francisco Board of Supervisors to recommend policies and programs to benefit the Central Market & Tenderloin Area.39 The 11 CAC members, who represent a variety of socio-economic backgrounds and expertise, negotiate and monitor adherence to the Community Benefit Agreements, focusing on an enumerated list of community priorities.40 CAC works collaboratively with developers and the City.41 A prerequisite for qualification for the CMTPTE is that companies “[f]ile an annual Payroll Expense Tax Return with the Tax Collector regardless of the amount of tax liability, if any, shown on the return after claiming the exclusion….”42 Companies are not, however, required to disclose the amount of their tax savings to the general public, and at least one request from a public attendee at a CAC meeting to disclose this amount has apparently gone unanswered.43

Land Use Considerations

The Mid-Market area is zoned primarily commercial, with some public zoning around the Civic Center and some downtown residential zoning, mostly in the Tenderloin.44 The area is covered under the General Plan’s Downtown Area Plan, with the exception of the Civic Center, which has its own Area Plan.45 As development continues in the Mid-Market area, developers will need to navigate the California Environmental Quality Act (CEQA) process by qualifying for exemptions, obtaining Negative Declarations, or working through the Environmental Impact Report (EIR) process. In March 2013 alone, exclusions or categorical exemptions were issued for no fewer than 10 projects in the Mid-Market area.46 Historic properties also create potential issues for developers in the Mid-Market area. After San Francisco’s 1906 earthquake, Mid-Market developed into a thriving theater arts and shopping district, and thus there are buildings in the area that are potentially historic.47

Hiring

Part of the application process for the CMTPTE is participation in the First Source Hiring Program, which is referenced in each company’s Community Benefit Agreement.48 This program requires “the identification of entry level positions in order to properly allocate training resources, and the availability of the first opportunity for graduates of those training programs to be considered for employment.”49 The program has been criticized as requiring only good-faith efforts, and not quantifiable metrics or hiring mandates.50

One focus of the CMTPTE has been job creation. When Twitter decided to stay in San Francisco, it planned to add at least 2,000 jobs to its existing 400.51 Tech industry advocates argue that Twitter’s decision to remain in the City and the arrival of so many other tech companies benefits the City through lower than average unemployment and an increase in tech jobs.52 Housing advocates argue, however, that the extra jobs created by the tech industry are “opportunities to service those tech workers” in jobs that will not support a family in the changing rental market.53

Developers for residential or commercial projects in the City are required to comply with both the First Source Hiring Program and a construction-specific local hire law.54 Local unions have complained that Mid-Market area developers pay less than union-level wages for City-funded projects, leading to protests.55 Community activists argue that this development cannot be touted as creating jobs that will grow a stable middle class, unless Mid-Market developers are required to pay the prevailing San Francisco wage. Currently, most developments are not funded by the City and as a result developers are not legally bound to pay union-level wages.56

  1. Additional Considerations: The Promise and Potential Pitfalls of the Reinvigorated Mid-Market

Both the City government and an organized tech community have focused on improving the Mid-Market area. These developments have tapped into a growing desire among high income earners for urban living and help draw companies to San Francisco generally, and to the Mid-Market area specifically. As with any redevelopment, however, this transition is not without its issues.

Focus on Mid-Market

Various improvement programs under the umbrella of the public/private Central Market Partnership (CMP), launched in January 2010 by the Office of Economic and Workforce Development, impact the Mid-Market area.57 Components of the CMP include: creating the November 2011 Central Market Economic Strategy policy document, attracting businesses and arts organizations to the area, creating a loan fund to support businesses that will strengthen the community, and the repaving of Market Street under the Better Market Street Initiative.58

The Tech Community Gets Organized

Since 2011, the following companies have moved or expanded to San Francisco: Amazon.com; LinkedIn; Yelp; Salesforce.com; Riverbed; Airbnb; Yammer; Tagged; Macys.com; Pac-12 Enterprises; Kabam; Funzio; 6waves; StumbleUpon; FiveStars; Zynga; Pulse; Appirio; FinancialForce; EVault; Moshi; Reclip; CallSocket; Pinterest, and Lithium Technologies .59 Several major technology funders have also opened offices in the City. Benchmark Capital, which invested in Twitter in 2009, leased office space in the Mid-Market area of San Francisco during the summer of 2012.60 Kleiner Perkins Caufield & Byers, a venture-capital group, also recently opened an office in the City.61 Additionally, venture-capital funding of San Francisco-based companies increased about 41 percent from 2011-2012.62

The San Francisco Citizens Initiative for Technology and Innovation (sf.citi), a group whose mission is to leverage the power of the technology community around civic action in San Francisco, is closely aligned with the City’s tech sector.63 Among sf.citi’s initiatives are: creating jobs and promoting San Francisco’s Tech Sector (sf.citi served as a well-connected proponent of Prop E); educating San Franciscans; and public safety (including applications to assist both MUNI and SFPD employees).64 The draw of city living and the convergence of like-minded start-ups and tech companies are bringing employees and companies to San Francisco. Surprisingly, several start-ups cite the lower rent for office space, as compared to cities on the Peninsula such as Palo Alto, as a reason to relocate to San Francisco.65

Rent Increases; Housing Shortage

The influx of new companies and young professionals with high salaries has driven rents higher – even in the formerly depressed Mid-Market area.66 Residents are concerned about the rising cost and general lack of available housing. Long-term residential and small business tenants are worried that rent increases will drive them out of their neighborhoods.67 In 2011, in the Downtown City planning district which encompasses the Mid-Market area, “a total of 20 new units were constructed, but the demolition of 52 units and merger of 1 unit produced a net areawide reduction of 31 units.”68 New housing, however, is being developed. Mid-Market housing developments in progress include Crescent Heights’ 754-unit project at 1401 Market St. (called “NEMA” based on “New Market”), Trinity Properties’ 418-unit tower at 1169 Market St., Avalon Bay’s 260-unit at 55 Ninth St (called “AVA”), and Raintree Partners’ 973 Market Street (the “Wilson Building”).69 Also many projects that were entitled before the economic downturn are getting back on track.70

Rent increases have had little demonstrable effect on low-income residents, whose ability to remain in the area is protected by “[v]ocal advocates, along with rent control and safeguards against converting single-room occupancy hotels to market-rate housing.”71 Among the safeguards are San Francisco’s Area Plans (components of the General Plan) for both the Downtown and Civic Center planning districts, which protect housing located in areas zoned for commercial use.72 The Mayor’s Office of Housing (which now administers housing programs formerly administered under the San Francisco Redevelopment Agency) has a Citywide Tax Increment Housing Program requiring that at least 15 percent of new units within redevelopment project areas be affordable housing.73 Mayor Lee has pointed to the Housing Trust (passed as Proposition C, Housing Trust Fund, or “Prop C,” on the November 2012 ballot) as a way to expand modestly priced housing in San Francisco by authorizing the development of up to 30,000 affordable rental units in the City.74 The measure was structured to make use of some of the revenue from the former San Francisco Redevelopment Agency that was previously allocated to affordable housing. Prop C requires private residential developers to contribute to the fund and/or provide on-site affordable housing.75

  1. Summary and Practical Advice

Clearly, companies can benefit from San Francisco’s various tax incentives. Navigating the challenges and potential pitfalls of expanding a company’s presence in the City and the Mid-Market area will require knowledge of, and expertise with, the new legal framework presented by the various enactments since 2011. An understanding of how these new laws intersect with, and alter preexisting obligations, will be crucial. An integrated approach to tax, land use, and labor planning would serve companies well, and help ensure an optimal and strategic approach to these opportunities.