The potential impact an income tax could have on business has turned into a pivotal issue for Initiative 1098.

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Martha Davis’ sign company in Seattle weathered the recession in good shape. Even so, she says her business could get a nice lift from one aspect of the income-tax initiative on the November ballot: a break in the business-and-occupation tax.

“We will probably save $2,500 a year,” said Davis, whose City Lights Sign has three full-time employees, adding that’s “a lot of money for me as a small business. I really need to upgrade my computer system and software I use. I really haven’t been able to do that, and that … would more than compensate me.”

Yet Bryan Mistele, president and CEO of INRIX, a traffic-information firm in Kirkland with 65 employees, calls Initiative 1098 “a nail in the coffin of Seattle’s tech community.”

Mistele says a state income tax would take a big bite out of money made from stock options, a key enticement for new hires at his startup company. It makes Washington “far less competitive and makes it a lot harder for us to attract talent,” he said.

The potential impact on business has turned into a pivotal issue for the measure, which seeks to upend Washington state tradition and start a state income tax.

Some see a break in the business-and-occupation (B&O) tax as a welcome benefit, while others fear an income tax would grab money they could use to reinvest in their business.

The effect of the initiative, which targets the state’s highest earners, would vary depending on income, deductions and how a business is structured. Several tax lawyers and experts interviewed for this story, including two attorneys from the same firm, offered conflicting opinions.

Even the rich themselves are at odds, with Microsoft co-founder Bill Gates and his father, William H. Gates Sr., supporting the measure while Microsoft CEO Steve Ballmer and Amazon.com founder and CEO Jeff Bezos oppose it.

By aiming the initiative at the wealthiest residents, supporters hope to turn around decades-long voter antipathy toward a state income tax.

I-1098 would create a 5 percent tax rate on annual income exceeding $200,000 for individuals and $400,000 for couples, and a 9 percent tax rate on income that tops $500,000 for individuals and $1 million for couples.

The measure includes some pot sweeteners: It would cut the state portion of everybody’s property taxes by 20 percent and exempt an additional 118,000 businesses from the B&O tax on gross receipts by increasing the state credit to $4,800.

That would mean, for example, that a small business like a mom-and-pop grocery would be completely exempt from the B&O tax if its annual gross income is $1 million or less. Until its gross receipts reached about $2 million, it would pay reduced B&O tax.

Opponents say I-1098 would hurt many businesses at the heart of the state’s economy that are too big to benefit from the B&O tax breaks, particularly companies structured so that profits are taxed as personal income. They contend that it would take away money firms could use to expand, and eliminate an incentive — no income tax — that startup companies need to attract highly skilled workers.

Plus, critics say, it’s a lousy time to create a new tax, with the economy in the dumps and businesses slow to hire.

I-1098 supporters disagree, saying the tax breaks would benefit many small businesses. They say the measure would not hurt the state’s economy, the wealthy can afford to pay the tax and the money is needed to help pay for education and health care, especially given several years of multibillion-dollar state budget shortfalls that have resulted in sharp cuts in spending.

The state estimates the tax would bring in more than $2 billion a year by 2013.

“What’s the trade-off?”

There’s no doubt I-1098 would be a dramatic change for Washington, where voters have rejected income-tax proposals four times in the past 70 years, most recently in 1975 by a 2-to-1 ratio.

“We’re talking about restructuring the system. Let’s change property taxes and business taxes and let’s increase the tax on the wealthy. That’s a real sore spot for a lot of people,” said Ann Murphy, a former IRS attorney who now teaches at Gonzaga University’s School of Law.

“The question, in my mind, for the voters is what’s the trade-off?” she said.

Major business groups including the Association of Washington Business, with more than 7,000 members; the Washington Roundtable, an association of corporate executives; and the National Federation of Independent Business oppose the income tax.

The Main Street Alliance of Washington, which represents around 2,000 small businesses, and the Greater Seattle Business Association, the gay-and-lesbian chamber of commerce, support the measure.

Opponents say I-1098 would penalize companies, such as limited-liability companies and S corporations, where the money the firms make is taxed as personal income on the owners’ federal tax returns. Companies structured as C corporations, including some of the state’s major employers, would not be affected by the initiative.

The state Department of Revenue doesn’t track the different types of corporations in Washington. However, state records show that of 470,000 active businesses in the state, about 22 percent (102,000 businesses) gross more than $200,000 annually. The department doesn’t know how many are C corporations, versus other kinds of companies.

The state estimates 38,400 filers would pay the income tax — 12,400 individual taxpayers and 26,000 joint, head-of-household and widower filers.

There are no estimates on how many of them own companies.

When it comes to businesses, who pays taxes depends on a number of factors.

Here’s one very simplified example: An S corporation with 10 shareholders makes $1 million in profits. If each shareholder got a $100,000 distribution and had no other income that put him above the I-1098 threshold, he would not pay an income tax.

If the same company had only one owner who took all the profits as income and filed an individual return, that person would pay $60,000 in state income taxes.

I-1098 opponents complain that if the owner decided to reinvest the $1 million to expand or improve the business, the initiative would still tax the entire amount as income and reduce the amount of money that could be used to grow the company.

George Bartell, CEO of Bartell Drug, makes a similar case, saying that an income tax, combined with the existing B&O tax and potential increases in federal taxes, would hit hard. His company has 59 stores and 1,700 employees in Washington.

“Basically, we’d just not be able to invest enough in the business,” Bartell said. “We’d have to postpone. We’d probably have to try to cut labor. We’d probably have to defer maintenance to some extent and not be able to improve and renovate stores as we would like.”

Supporters maintain that businesses, which reinvest profits, would be able to deduct those expenses and reduce their taxes. And they note that 43 other states already have personal income taxes and that companies such as Bartell’s face a similar situation in those states.

How much is too much?

Clearly, many companies would pay increased taxes. Whether they’d pay too much may depend on your point of view.

Bill Clapp, chairman of the Matthew G. Norton Co., an S corporation that develops and manages warehouses, said he supports I-1098 even though his company would be affected by the tax.

“This is tough times right now and it’s going to get tougher,” he said. “We’ve got to step up. … You can’t ask people who are really struggling right now to do a lot.”

Clapp said he thinks many businesses oppose the initiative because they have little faith in state government and believe lawmakers are not making good decisions spending the money they already have.

“People are really just very frustrated with government,” he said. “I’ve asked some of them: ‘Is your theory to just starve the beast?’ and some of them said ‘yes.’

“I don’t want to be the one who walks into a classroom and says, ‘Hey, bad news, guys. We’ve decided to take it out on you so we can teach the people in Olympia a lesson.’ “

Davis, the City Lights Sign owner, said her company does not make enough money to pay more taxes under I-1098, but maintains she’d support the measure even if it meant a bigger tax bill.

The state’s B&O taxes “are grossly unfair,” as are the high sales taxes, Davis said.

“It’s just something I believe needs to happen at some point in time,” Davis said. “It’s not something anybody wants to do, but it’s something that’s needed.”

As it is, the measure would only help her 23-year-old business, she said, noting that most of the small-businesses owners she’s talked to “have said they’re not going to have to pay that tax.”

INRIX in Kirkland would not pay an income tax as a company because of its tax structure. But that’s not the issue, said Mistele, the company’s CEO.

For startup companies like his, stock options attract highly skilled workers who may spend years working for limited pay in order to cash in when a company goes public, he said.

“People who join us, knowing that they could go public within two years, is the number one factor people come to this company.”

Mistele said that “most times what happens is people exercise their stock within one year. … They’re not rich. These are people who make less than $100,000 a year. But for one year this state is going to call them rich and confiscate” a significant chunk of their stock options.

Michele Radosevich, a Seattle attorney and partner at Davis, Wright, Tremaine, who supports I-1098, notes that companies like INRIX face the same issue in every state with an income tax. Washington is one of the few states that does not have such a tax.

“A state income tax does not seem to have made the Silicon Valley or Route 128 outside Boston less competitive,” Radosevich said in an e-mail.

Joe Wallin, an I-1098 opponent, who also is a partner at Davis, Wright, Tremaine, said he questions why Washington would want to be like other states. “This is one of Washington state’s great competitive advantages,” he said. “Why would we give away a competitive advantage to become equal?”

Andrew Garber: 360-236-8266 or agarber@seattletimes.com

Would I-1098 taxes be deductible?

The income-tax initiative on the Nov. 2 ballot refers to the proposed income tax as an “excise tax.” Opponents of the measure say the language matters and that taxpayers and business owners may not be able to deduct the state tax on their federal tax returns.

“Because of the way the law is drafted, there is considerable uncertainty,” said Joe Wallin, an attorney with the Seattle law firm Davis, Wright, Tremaine. “In my world, if the government can use a law against you, it will.”

The initiative calls it an excise tax to conform with existing law and to avoid problems with the state constitution, according to I-1098 supporters.

Ann Murphy, a former IRS attorney now teaching at Gonzaga University’s School of Law, said the IRS doesn’t care what it’s called. “You can call it the tree tax and they don’t care. If it walks, talks and taxes like an income tax, it’s an income tax. That’s how they’ll treat it, and so it would be deductible.”