Originally published on Forbes.com.

It takes a special kind of person to see the humor in the lawsuit of Coblentz, Patch, Duffy & Bass LLP against the City and County of San Francisco.  I’m that type of person.  I’ll save the hilarity for the end.  CPDB is a significant San Francisco law firm.  I count just short of 80 attorneys.  According to their website they really like San Francisco

We are a San Francisco Bay Area law firm, not just a firm with a San Francisco office. For generations, our attorneys have been deeply involved in, and engaged with, the life and the progress of our City and the greater Bay Area.

What’s not to like? San Francisco was the setting for one of the best TV shows of the seventies.  Remember Karl Malden in Streets of San Francisco.

Well that 1.5% payroll tax that the city has is something for a good sized firm to not like.  On the other hand, I suppose it has the virtue of simplicity.  Just look at the transmittal form for your W-2s and multiply the total by 1.5%.  Nothing is that simple though.  What happened in San Francisco was that it dawned on somebody that there were many highly compensated people working in San Francisco who do not show up on payrolls.  Among them are the partners in professional practices.

There Are Partners And There Are Partners

So are the partners in a professional practice workers getting paid for what they do or business owners sharing in the profits of a business?  My personal insight on that issue comes from working in and owning a small sliver of a regional accounting firm. Actually I was the last founding partner of the firm still around when it sold its practice to a not quite Big Four firm.  From what I can gather the dynamics are similar in many law firms.

It is complicated by a further concept that many firms have – income partners. When you see a public accounting firm patting itself on its back about how woman friendly is it will often mention the percentage of women that are partners. Apparently the rule is that you can start calling yourself woman friendly when you hit what I call the United States Senate threshold – around 20%. Nobody ever seems to ask how many of those women are income partners. Income partners usually get a K-1 and may have the professional authority of partners, but they are not partners in an economic sense. The, if you can excuse the expression, real partners are the equity partners. It is a really big deal, but not something you see mentioned in tax litigation very often.

So if you ask an equity partner if he or, less likely, she is getting paid for working or, you know, being an equity partner, the answer to that question will vary based on a variety of circumstances and the context in which the question is asked. Is the question coming from an impertinent uppity worker bee or a fellow equity partner who works four times as many hours as the partner being quizzed? When asked about the system by which the equity partners divide the spoils, the response will likely be one that demonstrates why that particularly equity partners share is meager, even if it is among the larger shares. Equity partner compensation is governed by Rule 97 of the Ferengi Rules of Acquisition – “Enough is never enough”.

Proposition Q

In 2008 the voters of San Francisco approved Proposition Q which extended the payroll tax to “certain partnerships and other businesses”.  The proposition recognized the difficulty in distinguishing between whether partners were getting paid for working in the business or sharing in the business profits.  A safe harbor measure allowed partnerships to elect to treat a portion of partner income as compensation subject to the city payroll tax.  The safe harbor was 200% of the compensation of the top quartile of employees.  Talk about an incentive to make the top paid managers in an accounting firm income partners.  I’ve been trying to figure out how to model that against different types of partnerships, but I have not come up with enough data.  I suspect the safe harbor would not be of much help to accounting firms, but the income spread tends to be more radical in law firms.

The Lawsuit

CPDB filed the lawsuit to recover a potion of the payroll tax paid on the compensation of its equity partners – $194,903.  That’s just shy of $13 million in compensation they were splitting up if I did the math right.  The argument is that that equity partner compensation should only be subject to the payroll tax to the extent that it is guaranteed.   Essentially, CPDB was trying to smuggle federal income tax principles into the city’s payroll tax computations.

The Internal Revenue Code defines guaranteed payments as amounts paid to partners that do not hinge on partnership profits.  Such payments are deductible to the partnership and included in the partner’s income.  When it comes to equity partners, that can be a meaningless distinction.  One way to split things is to have fixed draws and then some sort of convoluted formula to split up the balance possibly involving the arbitrary rulings of a dictator of greater or lesser benevolence, who usually is just a bit of a sociopath.  On pirate ships he is called the captain.  The modern term is managing partner. What happens if you don’t make draw?  After having a couple of people walk the plank so such a travesty does not happen in the future, the pain has to be spread one way or another.  Ultimately there have to be some partners who have none of their compensation guaranteed, should the sky fall in.

The court did not agree with the notion that federal and state income tax concepts of “guaranteed payment” were of any relevance in determine San Francisco’s payroll tax:

We have no quarrel with plaintiff’s arguments or the authorities on which it relies concerning the calculation of an equity partner’s individual income tax liability for profit distributions paid by the law firm. The problem with plaintiff’s argument is that Proposition Q is not concerned with an equity partner’s individual income tax liability for profit distributions. As we now discuss, the tax ordinance more broadly seeks to tax “compensation for services” reflected in the calculation of the partnership’s profit distributions…..

Accordingly, we conclude some portion of plaintiff’s profit distributions do include an equity partner’s “compensation for services,” as that term is used in Proposition Q, which sum is to be included in the calculation of the payroll expense tax base.

There were also some objections to how Proposition Q was passed, but there was no luck for CPDB on those points either.

Oh What A Tangled Web We Weave

I did not find much commentary on the most recent decision.  An article by Adele Nicholas in California Lawyer – A Taxing Fight for Partners written during the early stages of the case pointed out the conflicting impulse that this case implicates.

While a 1.5 percent tax on partner payouts doesn’t represent a huge portion of firms’ total tax liability, there is more at stake. Under California partnership law, any profit an equity partner earns on business conducted for the partnership belongs to the firm, not the individual lawyer. So if a lawyer leaves a firm and takes along a book of business, money earned on ongoing matters must be returned to the original partnership, even if it splits or goes bankrupt. Prop. Q, then, puts partners in a tough position. To keep their city tax liability low, it behooves them to characterize most of their income as partnership profits. But to protect their own interest in earnings in the event of a firm split or bankruptcy, it’s better to have characterized more of their income as compensation for services.

“That’s why this is a big issue,” says Edwin Reeser, former managing partner of SNR Denton’s Los Angeles office. “If a lawyer establishes a record of low compensation and high profit, it could be a ‘gotcha’ if the firm goes bankrupt. And that’s on people’s minds after Thelen and Heller Ehrman.

Source of the 200% Safe Harbor

I don’t know where the city came up with that 200% safe harbor.  One possible source were the articles of Captain Edward Low

The Captain is to have two full Shares; the Quartermaster is to have one Share and one Half; The Doctor, Mate, Gunner and Boatswain, one Share and one Quarter.

Doing little side jobs could be hazardous in those days.

If any Gold, Jewels, Silver, &c. be found on Board of any Prize or Prizes to the value of a Piece of Eight, & the finder do not deliver it to the Quarter Master in the space of 24 hours he shall suffer what Punishment the Captain and the Majority of the Company shall think fit.

Anybody who is interested in my movement to make September 19th Managing Partners Day in addition to Talk Like a Pirate Day can comment below.