Study: The Los Angeles Business Tax Structure Lacks Equity and Competitiveness

By Dave Naney

Item: A financial services firm with 400 employees and gross receipts of $24 million a year would pay total taxes and fees of $160,275 in Los Angeles, but the same business would pay only $45,268 on the average in competing cities.

Item: A high-tech business with 325 employees and $33.5 million in gross receipts would pay $57,081 in Los Angeles taxes and fees. In competitor cities, the tariff is only $20,983 on the average.

Item: Four of 10 Los Angeles businesses do not pay business license taxes. Why? Because the ordinance is extremely complicated, making it onerous to taxpayers and difficult for tax collectors to audit.

Those are findings of a recently released competitiveness study which says the Los Angeles business tax structure is antiquated and unwieldy - and the rates are too high. In short, the L.A. business tax puts the city in a competitive disadvantage.

What should be done? Here are interim recommendations:

• Increase enforcement on companies doing business in the city, including an amnesty program upon completion of a publicity campaign.
• Minimize the uncertainty of development fees.
• Shift more tax burden to non-residents, such as an increase in the hotel occupancy tax.

About the study

In its aim to improve the city's business tax climate, the city of Los Angeles commissioned a team of consultants to study the city's current business tax structure and to propose recommendations for changes to the overall tax structure. The first phase of the study - "Competitiveness of City Taxes and Fees" - analyzed the city's taxes and fees compared to other cities which compete with Los Angeles for certain key industries. The consulting team consisted of UT Strategies, Inc., Landmark Partners, Arthur Andersen LLP and the Milken Institute for Jobs and Capital Formation.

The study compared Los Angeles with 16 competitor cities in and outside of California to determine what impact taxes and fees have on business location decisions. The competitor cities are: Burbank, Culver City, Glendale, Irvine, Las Vegas, Long Beach, Ontario, Phoenix, Salt Lake City, San Francisco, San Jose, Santa Monica, Seattle, Simi Valley, Torrance and Vernon. In evaluating the competitiveness of the Los Angeles tax structure, the study included review of the Los Angeles business tax ordinance. The study focused on illustrating the complex nature of the tax code and quantifying its inequities.

Initial findings

• In situations where businesses have a choice between Los Angeles and another city, other things being equal, the study suggests that Los Angeles' high tax burden discourages choosing Los Angeles.
• The results of the competitor city survey and a review of the Los Angeles ordinance revealed that the tax burden on most industry sectors is higher in Los Angeles than the competitor cities. The magnitude of the tax differential depends on the particular industry and the competitor city. For example, in certain industry sectors, such as multimedia and professional services, business taxes and utility taxes in Los Angeles are higher than all of the selected competitor cities. Since the report was drafted, the city has reduced the multimedia tax rate from $5.91 to $1.18 per $1,000 of gross receipts.
• The city's business tax is a tax on "gross receipts" regardless of whether a company is profitable. This type of tax can be particularly onerous for start-up businesses.
• A critical issue facing businesses that plan to build new facilities in Los Angeles is the development fee process. In those areas of the city that are not "Specific Plan" areas, the development fee is determined on a case-by-case basis and is not finalized until completion of the project. The uncertainty of this cost presents a major concern for any new development.
• In terms of distribution of taxes between the residential and business communities, the study estimated that residents pay approximately 50 percent of all of the taxes and fees collected by the city, while businesses pay 46 percent and tourists or outsiders pay 4 percent.

   

Current tax structure

The Los Angeles business tax is not well understood by taxpayers. In the following paragraphs, we will discuss the general issues associated with the ordinance and its complexity.

The city imposes a business tax on businesses either located in or doing business within the city. Every business that has nexus with the city should be paying the tax. The city's business tax is imposed on most businesses based on gross receipts. However, there are certain business activities that are subject to a payroll expense tax in lieu of the gross receipts tax.

The applicable tax rate, which ranges from $1.18 to $5.91 per $1,000 of gross receipts, varies in accordance with each of 52 classifications identified in the ordinance. Consequently, a company engaging in various lines of businesses will most probably fall within more than one classification under the ordinance. It is the burden of the taxpayer to determine which classifications apply, which tax rate to apply and which apportionment formula to use. In addition, there is no cap on the total tax liability by classification, except for the cap contained in two tax classifications. Consequently, the more gross receipts a business generates, the more tax it will pay whether or not that business is making a profit.

Another key component to determining the tax burden of a taxpayer is the issue of apportionment of gross receipts. The theory of apportionment of gross receipts requires a taxpayer based outside the city of Los Angeles to pay tax on a portion of the gross receipts generated within the city. In- city businesses must also apportion gross receipts for in-city operations and out-of-city operations.

In recent years, a significant percentage of state and local tax litigation stems from the apportionment issue. A long line of federal, state and local cases have held the apportionment of gross receipts to be constitutionally mandated under the Commerce Clause of the U.S. Constitution. The city has responded to constitutional limitations by setting up apportionment rules for various tax classifications. Unlike other state or local taxing agencies, which generally have one apportionment methodology for all taxpayers, Los Angeles has different apportionment methodologies for differing tax classifications. For instance, if a taxpayer has a location within the city which provides some retail sales and also provides taxable services, the taxpayer will use two different methodologies for apportioning its gross receipts. If the taxpayer has a retail location in the city and one outside the city, and makes sales from both locations into the city, the taxpayer will use two different apportionment formulae to determine its taxable gross receipts. Likewise, if a taxpayer reports under two different classifications, it must use a different apportionment formula for each classification.

The complicated nature of the city's business tax ordinance and the various apportionment rules result in low compliance, under-reporting and over-reporting of gross receipts. It is estimated that the compliance rate in Los Angeles could be as low as 60 percent. In other words, 40 percent of businesses pay no taxes. Since the city's auditors have to spend a significant amount of time on each audit, the number of audits that can be completed each year is minimal, resulting in low enforcement. The Internal Revenue Service-defined optimal audit rate is 7 percent of tax revenue while the audit rate in Los Angeles is only 3 percent of tax revenue.

The Los Angeles gross receipts tax is one of the most litigated local taxes in the nation. There are a number of cases that have limited the city's power to tax and which have challenged the city's allocation and apportionment methodologies. The most recent of these limiting cases is the General Motors case, whereby the city was restricted in its taxation of manufacturing companies due to a discriminatory effect on manufacturers with out-of-city activities (General Motors v. City of Los Angeles (1995) 35 Cal.App.4th 1736). Many of these cases have resulted in administrative changes to the business tax ordinance or rulings by the City Clerk's Office that attempt to comply with the court decisions. These necessary modifications have added to the confusion faced by both the city and taxpayers because only the affected sections of the law have been modified.

Unlike the Internal Revenue Code, which is modified somewhat every two years, the Los Angeles business tax ordinance has never had a wholesale rewrite or revision. The Los Angeles ordinance was drafted many years ago and is in need of such a revision even if no changes are made to the taxing structure. The ordinance has experienced a number of modifications principally as a result of court decisions; however, the ordinance has not kept up with the huge technological and workforce changes experienced by the city and is in need of revision and simplification.

What's next?

The second phase of the study commissioned by the city will develop a fiscal policy model that will allow the city to estimate the effects on revenue and job creation associated with various proposed tax changes. The results of phase two are expected by July 1997. They are expected to provide the data for analyzing impacts of a suggested simplified tax code, possibly with new apportionment rules and equalization of rates between categories of taxpayer; continued upgrading of the city's audit department, and consideration of replacing the gross receipts tax with a different form of tax, such as payroll, income or flat tax.

Reaction: Findings are no Surprise

For years, says Mayor Richard Riordan, the city of Los Angeles took on the charactor of a "drunken sailor" by raising business taxes and fees without considering the consequences.

The mayor commented in reaction to interim findings from the "Competitiveness of City Taxes and Fees" study, commissioned by the Mayor's Office. He told the Daily News of Los Angeles that an overhaul of the business tax structure is needed to prevent the city from continuing to rob from its future.

"What the city did for years was raise fees and raise taxes. They ran around like a drunken sailor not looking two, three, 10 years ahead," the mayor said. "I don't think we have a choice."

It will always be a challenge to balance the city budget, Mr. Riordan said. "The problem is if you continue to raise revenues for the city in ways that discourage business and jobs, you may have a short-term benefit, but you will be losing the tax base for the future."

Gary Mendoza, deputy mayor for economic development, told Cal-Tax: "The study reaffirms what we have been saying for a long time: the tax system is not competitive, it is outdated, and it is complicated. We want these issues to be fully debated by the City Council to see what changes can be made to make the structure more competitive and compatible. There are opportunities to fix the tax system. We think we can broaden the base, reduce the rates and not blow a hole in the city's budget."

Robert Cendejas, president of the Los Angeles Taxpayers' Association, which has a task force drafting potential ideas for simplifying the system, said: "The question is, can we all work together to modify this system or adopt a new system? Our goal is to maintain businesses for the good of all. Without businesses and job growth, we are on a downward spiral. We want to work with the city to develop ideas. We all have a vested interest in the future of Los Angeles."

Jack Kyser, chief economist for the Economic Development Corporation, told the Daily News that the study "is no surprise. If you talk to people around the business community, in all types of businesses, what you sense is a great frustration. What you run into is the city of Los Angeles acts like it's an island and doesn't think it has to worry. That's not the case."