By Joe Haberzetle, JD LLM and Jennifar Hill, JD LLM
In a previous article, we discussed how expense reimbursements could present a B&O tax trap for real property lessors. Since publishing the article, we have learned that the Washington Department of Revenue (DOR) is aggressively targeting property management fees and payroll reimbursements on audit. In certain cases, property managers have been assessed sales tax (as well as B&O tax) on management fees and payroll reimbursements the DOR recharacterizes as consideration for sales taxable services.
Payment structures for property management services run the gamut. For example, property managers may charge a flat fee or a percentage of rental income, or a cost-plus pricing model, or any combination of these. However, if a property manager pays wages and/or benefits to on-site employees, notwithstanding how management fees are structured, the DOR could recharacterize the payroll expense reimbursements as subject to B&O tax, and possibly sales tax. Moreover, if sales taxable services comprise more than 10% of a non-itemized management fee or non-itemized reimbursement, the DOR could potentially impose sales tax on the entire fee or reimbursement as a “bundled transaction.”
B&O Tax and Sales Tax on Management Fees and Payroll Reimbursements
Before June 1, 2010, payroll expense reimbursements for wages and benefits paid to leasing, maintenance and similar staff were specifically exempt from B&O tax when there was a written property management agreement and the property manager acted solely as the owner’s agent with respect to compensation, benefits and employment decisions. Since June 1, 2010, for-profit property managers have not been entitled to the exemption and generally must pay B&O tax on management fees. Payroll reimbursements are similarly taxable, unless strict rules for exclusion are met.
Receipt of reimbursements will generally trigger B&O tax unless the customer bears exclusive liability for payment of the expenses and the person receiving reimbursement and incurring the expense is acting solely as the customer’s agent. This rule is particularly difficult for the real estate industry since property lessors and managers often receive substantial expense reimbursements from tenants and property owners.
Management fees and payroll reimbursements are generally taxed at 1.5% under the “service and other” B&O tax classification. However, if employees of a property manager perform services that are subject to sales tax, reimbursements for those employees’ work could instead be subject to sales tax and retailing B&O tax.
Washington imposes sales tax on labor charges for maintenance, repair, construction and landscaping services. Thus, if employees of a property manager perform these services, the DOR could require the manager to collect and remit sales tax from the property owner on the resulting management fees or payroll reimbursements. If it is determined on audit that sales tax was not collected, the property manager could be held liable for it.
Avoiding explicit payroll reimbursements may help reduce the risk, but unfortunately does not solve the problem altogether. For example, in one decision the DOR determined that property management fees based on a percentage of rental collections were effectively used by the property manager to pay on-site employees and, consequently, the property manager was subject to B&O tax measured by the wages and benefits paid to the employees. In another decision, the DOR assessed sales tax and retailing B&O tax on a property manager when an employee on its payroll was borrowed by a related entity to perform construction services.
Common Paymaster B&O Tax Deduction
In many circumstances, using one entity to provide payroll services for numerous real estate projects can avoid the administrative nightmare that would ensue if each project had to have its own reporting accounts with the IRS, the Washington Employment Security Department and Department of Labor & Industries. Beginning October 1, 2013, the Washington legislature provided B&O tax relief in the form of a deduction for employee payroll reimbursements received from affiliated businesses by qualified employers of record, also known as “common paymasters.” To qualify for the deduction, reimbursements must be for:
- Customary amounts received for paying the employer obligations of a client;
- Services performed by employees that the taxpayer does not or cannot render;
- Services performed for which the taxpayer has no liability; and
- Employer obligations the taxpayer is not liable for, except as agent of the client.
This deduction is strictly construed, and if any one of the above requirements is not met, reimbursements are taxable. Also, the deduction is not available to taxpayers that share employees among entities; each employee must perform services exclusively for a single employer.
Qualifying for the paymaster deduction requires detailed planning, and the DOR has issued specific guidance explaining each of the above requirements. For example, each employee should agree in writing that the paymaster has no liability to the employee for employer obligations. Also, the language of any agreements between the paymaster and employer should provide that the paymaster has no obligation to provide labor or services to the employer. Beyond the contract, such terms must be adhered to in practice as well.
Although the requirements are stringent, qualifying for the paymaster deduction could provide significant state tax relief to property managers whose employees perform services for affiliated property owners. The paymaster deduction is not available on services provided to unrelated property owners.
If you are interested in more information about qualifying for the paymaster deduction or have other questions about the information in this article, please contact Clark Nuber or your state and local tax advisor.
Jennifar Hill is a manager in Clark Nuber’s state and local tax practice team.
© Clark Nuber PS, 2018. All Rights Reserved