The taxation of director fees under the Washington State business and occupation ("B&O") tax remains in a state of evolution. The Department of Revenue ("DOR") published a Special Notice[1] on June 22, 2010 and recently published a contract[2] that companies can accept with the DOR to remit the directors’ B&O tax obligations. Although the DOR has published the Special Notice, there remains many questions without clear answers.

Director fees have always been subject to the B&O tax; however, the DOR concedes that compliance over several years has been erratic. Consequently, the new statute requires directors who had been reporting the tax to continue reporting. Directors who had not been reporting director fees for B&O tax purposes are required to begin reporting July 1, 2010.

The specific B&O tax classification for director fees is the “service and other” category (hereafter “service”). The tax rate is 1.8% that is multiplied times the apportioned gross receipts. The permanent rate is 1.5% but that rate was temporarily increased to 1.8%. The temporary rate increase, assuming no legislative intrusion, has a sunset that will expire on July 1, 2013, returning to the permanent rate of 1.5%.

The First Question: Does the Director Have Substantial Nexus?

The first step in determining whether a director owes the tax is to determine if the director has substantial nexus with the State of Washington. The rules to determine nexus are more fully explained below, however, DOR is working on an online “nexus calculator” that it hopes to have available very soon. Without seeing the calculator, it is not possible to determine at this point if it is suitable for all fact patterns or only the simplest fact pattern.

Under the earlier physical nexus tests, Washington lacked the power to tax a taxpayer who did not have physical nexus. Under the new law, physical nexus is irrelevant for a non-resident. So, whether a non-resident director is physically present or not is no longer the starting point. The starting point is now whether the director has substantial nexus under the economic nexus tests.

Substantial nexus exists if:

1. The director is a Washington resident or is domiciled in Washington; or

2. The director is a nonresident who has:

· More than $50,000 of property in the state;

· More than $50,000 of payroll in the state;

· More than $250,000 of receipts from the state; or

· At least 25% of his or her total property, total payroll, or total receipts in this state.

These provisions, at first blush appear to be fairly simple to understand. However, the devil is in the details. First, the Special Notice does not indicate if “property” means all property (including tangible, intangible and real) owned by the director or only business property. The DOR is uncertain at this time. This may be relevant for a non-resident director, for example, if the director has a summer cabin in Washington. At this writing, the safest course is to assume that the DOR will decide that all property should be considered. As for intangible property (e.g., shares of stock in the company on which the director sits as a board member), the DOR will treat that as property located where the director resides or is domiciled.

Second, regarding the $250,000 of receipts, the Special Notice implies that only director fees are to be considered. However, the DOR has orally confirmed that such an inference would be wrong. All gross receipts should be considered (though certain deductions exist for wages, investment income and so on that can reduce the gross receipts to less than $250,000), not just receipts from director fees. (See below, regarding how much to report in Washington, to determine whether the gross receipt is from Washington.)

Third, it is clear from the Special Notice that the value of stock options should be included in gross receipts. However, only stock options that were granted after July 1, 2010 are included. Stock options that were granted before July 1, 2010 but exercised on July 1, 2010 or after are excluded. The Special Notice states that the reportable value of the stock option is the amount required to be reported on IRS Form 1099-MISC.

Fourth, the Special Notice does not address deferred compensation. The DOR is uncertain as to how deferred compensation will be treated, though it is possible that it will handle deferred in a similar manner as it did for stock options, exposing only deferred compensation earned on July 1, 2010 or after to receipts.

Fifth, because Special Notice mentions IRS Form 1099-MISC regarding stock options, one might be led to believe that whatever is reported on the 1099 is what one reports for B&O tax purposes. This would be a mistake. The amounts that are reportable not only include the director fee, stock options and deferred compensation, but it also includes reimbursed expenses (e.g., travel, hotels, meals and so forth), which are items not included in a 1099.

The Second Question: How Much Should Be Reported to Washington?

The next step is to determine how much of the director’s gross receipts is taxable in Washington. Unlike the sale of goods that relies upon the delivery location to allocate the receipts to a single state or Rule 194 that either (1) allocates gross receipts to where the taxpayer substantially performed the services or (2) apportions the gross receipts based upon the cost to generate the gross receipts, the new law relies on a single sales factor formula. The numerator is Washington gross receipts divided by total worldwide receipts.

Caution: Remember, the test is all gross receipts, not just gross receipts derived from sitting as director.

The new law allocates gross receipts to a particular state in a particular order. That order is as follows:

1. The receipt is allocated to the state where the customer benefits from the taxpayer’s service.

2. If the customer benefits from the service in more than one state, then the receipt is allocated to the state where the customer primarily benefits from the taxpayer’s service.

3. The receipt is allocated to the state from which the customer ordered the service.

4. The receipt is allocated to the state to where the taxpayer sends billing statements or invoices.

5. The receipt is allocated to the state from where the customer sends payment for the services.

6. The receipt is allocated to the state where the customer’s address is located

a. As shown in the taxpayer’s business records or

b. Obtained by the taxpayer during negotiation for the services.

7. The receipt is allocated to the commercial domicile of the taxpayer.

Thus, if one cannot allocate receipts based on #1, then the taxpayer must use #2 and so forth until one reaches #7. The DOR has said a company located in Washington benefits from the directors work in Washington even if the board meetings might be held out of state or the nature of the meeting is to discuss corporate activities to take place outside of Washington. So, director fees paid by a company with its headquarters in Washington would be allocated to Washington. Of course, if the company is headquartered in another state, then the director fees would not be allocated to Washington.

With respect to #2, the statute uses the term “primarily benefits.” This, according to the DOR, means more than 50%. Further, it is not enough that more than 50% of the benefit is outside of Washington. The way that the legislature wrote the statute, the DOR says that this means that more than 50% of the benefit must be in a particular state, not just outside of Washington.

To compound the complexity, there is no “one size fits all” approach as each director’s situation is probably different. Each director must review his/her gross receipts, and then allocate each gross receipt paid by a customer under these rules to Washington or to some other state. In other words, it is not enough to analyze the director fee, but the taxpayer must analyze each source of income that is classified as a service. This tedious process is necessary to determine if the taxpayer has received gross receipts … in the aggregate … of more than $250,000 from Washington sources for nexus purposes. To illustrate the complicated nature of these rules, an example would be helpful. Assume that the director is a lawyer that operates as a sole proprietor. The director/lawyer has clients in three states. Not only would the director/lawyer need to allocate the director fee based on the rules above to determine nexus and how much to report to Washington but that director/lawyer would also need to do the same analysis for every legal client.

Also, the legislation included a “throw out” rule. If, after sorting the gross receipts between Washington and other states, the gross receipt has been allocated to a state where the taxpayer is not taxable (e.g., lacks nexus), then the gross receipt is “thrown out” of the denominator. Further, if the gross receipt has been allocated to a state that does not impose a business activities tax (e.g., Nevada), then such gross receipt is also thrown out of the denominator. The effect of the throw out rule is to increase the Washington percentage as denominator gets smaller. A “business activities” tax includes net income and gross income or receipts taxes. It does not include sales, use or similar transaction taxes, imposed on the sale or acquisition of goods or services.

The Third Question: How Does the Director Register to Pay the Tax?

If the director has nexus and has apportioned gross receipts to Washington, then the director needs to register with Washington. The director can register by filing a Master Business Application form or filing online with the Department of Licensing.[3] Once the director registers with the Department of Licensing, then the director will be issued a uniform business identifier (UBI) number. This is like a social security number or employer identification number for federal purposes; it is what the state uses to keep track of taxpayers in Washington. So, on each tax return, the director will need to use his/her UBI number. The DOR will determine the director’s reporting frequency.

The Fourth Question: How Does the Director Pay the Tax?

When the director files the return, the tax must be remitted at that time. Washington allows for small business tax credits. The credit begins at $70 per month and decreases as reportable gross receipts increases, finally disappearing when the tax reaches $141. For a taxpayer reporting service income on a monthly basis, the $70 credit, which is the same as $3,889 of gross receipts. For a quarterly filer, the $210 ($70 times 3 months) credit, which is the same as $11,667 of gross receipts. For an annual filer, the $840 ($70 times 12 months) credit, which is the same as $46,667 of gross receipts. Keep in mind that the credit is tied to the reporting period. Thus, if a director exceeds the $70 credit for January, then the director must pay the applicable B&O in excess of $70 even though no tax would be due if the director filed on an annual basis. For more discussion of this issue, see

To help streamline the payment of director fees, the DOR will enter into agreements with companies to allow them to remit the tax for their directors. See footnote 2. Under this agreement, the company can agree to cover all directors or only some directors. The agreement requires quarterly reporting unless DOR determines that a different frequency is more appropriate.

Caution: As will become evident from the following discussion, the agreement may put substantial burden on corporate resources, especially if the company has a large number of board members. Further, if the directors rely on the company to remit tax on their behalf, it may be necessary for them to provide a lot of confidential financial information that they may not want to share with the company.

If the company decides to enter into an agreement with the DOR, then the company will need to take follow these steps:

1. Is the director a resident or nonresident? If the person is a nonresident, then the company must determine if that person has substantial nexus. (A resident director has substantial nexus by his/her residency.) To make this determination, it will need the director to provide the following information:

a. Whether he/she has more than $50,000 of property (tangible, intangible or real) in the state;

b. Whether he/she has more than $50,000 of payroll in the state (i.e., has employees in the state);

c. Whether he/she has more than $250,000 of receipts from the state; or

d. At least 25% of his or her total property, total payroll, or total receipts in this state, requiring the director to provide the company with financial data from all activity in order to determine if the 25% combined economic factors exist to establish substantial nexus.

Caution: Recall that receipts includes stock options that are paid as director fee compensation. If the option was granted before July 1, 2010, then the amounts are not included. If the options were granted after June 30, 2010, then the amounts are included. The DOR has not determined how deferred compensation will be treated but indications as of August 10, 2010 are that it will probably treat it in the same way as stock options.

Caution: Also recall that 1099s are not sufficient because reimbursed expenses are also part of receipts and 1099s do not include reimbursed expenses. Thus, do not rely on 1099s.

If there is no economic nexus, then the nonresident director is not subject to the B&O tax and the company does not need to report and pay B&O tax for that director.

Caution: Keep in mind that the law does not entitle the company to take a snap shot and apply it for the entire period. If the director’s activities change, and substantial nexus is created, then the tax will be owed after nexus is created. For this reason, the payment agreement should not include directors who lack nexus even if they have no liability, unless the company will periodically conduct due diligence to determine if the facts and circumstances has changed. (This recommendation is for maintaining a good relationship between the director and the company . There is no penalty to pay to the DOR if a mistake is made if it turns out that the director is taxable. If it turns out that the director eventually established substantial nexus, the company reports this director as not taxable and the DOR later determines that the director is taxable and assesses the tax, then that director might blame the company for the tax liability, interest and penalties.)

2. If economic nexus exists for a nonresident director, then for that nonresident director and for a resident director, the company must determine how much of the director’s income is taxable in Washington. The company determines this by applying the apportionment rules to every source of service income that the director receives even if not earned in Washington. The allocation rules to determine what income should be in the numerator are set forth above in the nexus discussion. These rules must be applied to each source of gross receipts derived from service activities.

Caution: Do not forget about the “throw out” rule. If any of the receipts are sourced to states that do not impose a business activities tax, then that amount is deducted from the denominator, increasing the Washington percentage. This means that the company will need to analyze all the states where the receipt is allocated, and determine if the director is taxable in those states.

3. Next, once the director’s income has been apportioned, then the company must compute the tax on the taxable amount. Each director is entitled to a small business tax credit of $70 per month, $210 per quarter or $840 per year.

Caution: Unless the reporting is done on an annual basis, this computation must be done for each reporting frequency for each director to be sure that the facts have not changed that might alter the amount of gross receipts that should be apportioned to Washington.

After taking these steps, the company will have sufficient information to remit the tax for the directors. The DOR will issue a separate tax reporting account to each company, allowing such reporting to be done separately from the combined excise tax return the company files for its business activities.

If the company elects to report on behalf of some or all of the directors, then it must file listings of the covered directors. Within 60 days of signing the agreement, the company must provide the DOR with a list of the directors on whose behalf the company intends to pay the tax. At the close of the calendar (by January 31 of the next calendar year), it must file a listing of the directors on whose behalf the company did remit tax. The company may be required to provide additional information to the DOR regarding the amounts remitted the DOR.

If the company elects to report under the agreement, each director will not be required to register as long as the director engages in no other business activity that requires registration. The company is not personally liable for the directors’ tax obligations (e.g., the director failed to provide the money to the company to pay the tax, which could occur with stock options). However, if the company actually collected the tax money from the director but failed to remit it, then it will be personally liable to the extent of the tax collected. The director remains personally liable for the tax unless it can show to DOR’s satisfaction that he/she paid the company the amount of the B&O tax due.

Caution: It will be important for the company to provide each director with an accounting of the tax computed, collected from the director and remitted to the state.