IN THE COURT OF APPEALS OF THE STATE OF WASHINGTON

CITY OF SEATTLE a municipal 

### ) No. 78946-5-I corporation, 

### )

Respondent, 

### )

) DIVISION ONE v. 

### ) KMS FINANCIAL SERVICES, INC., 

### ) PUBLISHED OPINION a Washington corporation, 

### ) ) Appellant. 

### ) FILED: February 24, 2020 __________________________________________________________________________________) MANN, A.C.J.

—This is a taxation case. The sole issue is whetherthe city of Seattle (City) used an unlawful method to calculate business and occupation (B&O) taxes owed by KMS Financial Services, Inc., between January 2012 and March 2016 (the audit period). The Commerce Clause ofthe United States Constitution requires state and local taxes be ‘fairly apportioned” so that the tax is imposed only on the portion of income reasonably attributed to the taxpayer’s instate activities. Washington law imposes a similar limitation on local government taxes. To complywith these requirements, the City’s B&O tax utilizes a two-factor apportionment method to calculate taxable revenue for service related businesses. One ofthose factors, the “payroll factor,” compares theNo. 78946-5-1/2

amount ofcompensation the taxpayer pays in Seattle to the compensation it pays outside the City. As a result, the more a taxpayer pays forwork performed outside the City, the less its income is apportioned to the City—which means a lower B&O tax. KMS is headquartered in Seattle, but generates most of its income through the sale ofsecurities by registered representatives located outside the City. In calculating the payroll factorfor its B&O tax, KMS included the compensation paid to its registered representatives. During an audit, Seattle determined that KMS’s registered representatives were not “employees” and therefore did not considertheir income in determining the payroll factor. The result roughlytripled KMS’s B&O tax liability. KMS sought review in the King County Superior Court. Aftercross-motionsfor summaryjudgment, the superiorcourt granted the City’s motion and dismissed KMS’s challenge. We agreewith KMS thatthe City’s B&O tax, as applied to KMS, is notfairly apportioned and is unconstitutional. In orderto avoid unconstitutionality, the Cityshould have instead treated KMS’s registered representatives as employeeswhich would have resulted in a valid, fairly apportioned tax. We vacate the trial court’s orderand remand forthe trial courtto grant KMS’s motion forsummaryjudgment.

A. KMS and Registered Representatives The parties stipulated to the undisputed, material facts.1 KMS is aWashington corporation, headquartered in Seattle. KMS engages in the securities, insurance, and investment advisory business. KMS is a broker-dealer underthe Securities Exchange Act of 1934 (1934 Act), and is registered with the Securities & Exchange Commission

1 See also KMS Financial Services, Inc. v. City of Seattle, 135 Wn. App. 489, 493-95, 146 P.3d 1195 (2006) (explaining further KMS’s use of registered representatives). 2No. 78946-5-1/3

(SEC), the Financial Industry RegulatoryAuthority (FINRA) and the state securities regulators ofall 50 states. Underfederal securities laws, a broker-dealers acts primarilythrough “registered representatives.” Registered representatives are individuals, often referred to as stockbrokers oraccount executives, who provide a variety of investment related services. Underthe 1934Act, all individuals in the business ofassisting others with securities trades are required to be registered representatives ofa registered broker dealer. KMS does not, exceptthrough its registered representatives, generate investment advice, make securities recommendations, orsolicitthe sale ofsecurities or otherfinancial products. As a broker-dealer, KMS must supervise its registered representatives, oversee their licensing status, and require them to complywith industry rules and standards of conduct and procedures set out in its policy manual. Forfederal income tax purposes, broker-dealerstypically structure their operation so thatthe registered representatives are eitherdeemed employees (Form W 2), or independent contractors (Form 1099). A broker-dealer’s control and supervisory obligations underthe 1934Act and by FINRAwith respectto the broker-dealer’s registered representatives are identical regardless ofwhetherthe registered representatives are deemed independent contractors oremployees forfederal income tax purposes. The National Association ofSecurities Dealers (NASD) Notice 86-65 provides that: Irrespective ofan individual’s location or compensation arrangements, all associated persons are considered to be employees ofthe firm with which
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theyare registered for purposes ofcompliance with NASD rules governing the conductof registered persons and the supervisory responsibilities of the member. The factthat an associated person conducts business at a separate location or is compensated as an independent contractordoes not alterthe obligations ofthe individual and the firm to complyfullywith all applicable regulatory requirements. [2] A SEC letterdated June 18, 1982, addresses the status of registered representatives as employees oftheirassociated broker-dealer. The letteraddressed whether independent contractors are subjectto the 1934Act. “The critical question is whethera so-called independent contractor’s activities are subject to control by a broker-dealerwithin the scope ofSection 3(a)(B) oftheAct.” The letterexplains that an independent contractorcan be subjectto the control ofan employer underagency law. “It has been a long-standing policy ofthe Commission that independent contractors whose selling activities were controlled bytheir broker-dealeremployers could be characterized as employees forthe purposes ofthe Act.” KMS’s revenue, through the sale ofsecurities, is generated by approximately 350

,1 registered representatives operating throughoutthe United States. By contract, KMS classifies its registered representatives as independent contractors. During the relevant period, KMS employed approximately 50 W-2 employees, most ofwhom worked in its Seattle headquarters. The registered representatives cultivate customers, process the opening ofclient accounts, provide investment advice, make securities recommendations, enterorders, and receive checks. The KMS W-2 employees handle administrative functions. KMS’sW-2 employees do not provide orgenerate investment advice, make securities recommendations, orsolicitthe sale ofsecurities and other financial products.

2 NASD was the predecessorto FINRA. Notice 86-65 continues to be in full force and effect. 4No. 78946-5-1/5

Atypical sale ofsecurities involves: the clienttells the registered representative to purchase orsell a security; the registered representative enters the client’s orderwith KMS’s primary clearing firm, Pershing LLC (Pershing); Pershing executes the trade and records it in the client’s account; the clientwrites a checkto KMS orto Pershing to pay forthe transaction; the registered representative forwards the checkto KMS, and a trade report is generated in KMS’s office; after settlement ofthe trade (usuallywithin three days), KMS receives a commission from Pershing and then pays the registered representative a commission based on its contractwith the registered representative; KMS pays the registered representative between 85 and 90 percent ofthe commission from Pershing, depending on its contractwith the registered representativewho generated the order. During the audit period, KMS paid its W-2 employees between approximately $2.6 million and $4 million annually, almost all ofwhich (approximately 95 percent) went to Seattle-based employees. Forthat same period, KMS paid its registered representatives between approximately $70 million and $79 million, the vast majority of (around 85%) which wentto representatives working outside of Seattle. B. Seattle’s B&O Tax Seattle imposes a B&O tax on all persons engaging in business activitywithin the City. Seattle imposes B&O tax on KMS’s ‘gross profits” underthe “service and other” activity classification rate. SMC 5.45.050(F); see KMS Financial Services, Inc. v. City of Seattle (KMS I), 135 Wn. App. 489, 496, 146 P.3d 1195 (2006). When a business
earns income both inside and outside ofSeattle, the portion ofthat business’s income attributable to Seattle must be determined. Beginning in 2008, all Washington cities

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with a gross receipts B&O taxwere required to apportion service business income using
a two-factorapportionmentformula that averages a service income factorand a payroll factor. Seattle adopted the two-factorapportionment in SMC 5.48.081(F). The service income factorand payroll factors are reflected as a fraction. The fractions are added togetherand then divided bytwo. The resulting number is then multiplied bythe taxpayer’s total taxable income, without regard to its source, to derive the amount of income that can be allocated to the taxpayer’s Seattle activities. SMC 5.48.081. The parties do not dispute the method KMS used to calculate its service factor. The onlydispute is the calculation ofthe payroll factor. Underthe Seattle Municipal Code, the payroll factor is described as: 1. The payroll factor is a fraction, the numeratorofwhich is the total amount paid forcompensation in the city during the tax period bythe taxpayerand the denominatorofwhich is the total compensation paid everywhere during the tax period. Compensation is paid in the city if:
a. The individual oremployee is primarily assigned within the city; b. The individual is not primarily assigned to any place of business forthe tax period and the employee performs fifty percent (50%) or more of his or herservice forthe tax period in the city; or c. The individual is not primarily assigned to any place of business forthe tax period, the individual does not perform fifty percent (50%) or more of his or herservice in any city, and the employee resides in the city. SMC 5.45.081(F)(1). C. 2016 Audit During the January2012 through March 2016 audit period, KMS included the compensation it paid to its registered representatives when calculating the payroll factor. Because most ofthe compensation paid by KMS is in the form ofcommissions paid to its registered representatives, and most ofthe registered representatives work
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outside the City, the payroll factorcalculated by KMS was between 14% and 20%. After averaging this payroll factorwith the undisputed service income factor, KMA calculated, reported, and paid $187,998.34 in Seattle B&O taxduring the audit period. During the audit, the Citytookthe position that compensation paid to registered representatives should be excluded from both the numeratorand denominator in calculating the payroll factor. According to the City, compensation paid to KMS’s registered representatives should have been excluded because theywere not “employees.” Because nearly all of KMS’s W-2 employees work in Seattle, exclusion of the commissions paid to the registered representatives increased the payroll factor by almost 100%. By excluding compensation paid to the registered representatives, the average of KMS’s service income and payroll factors roughlytripled, therebytripling the amount oftax calculated due. As a result ofthe audit, the City assessed KMS with additional $460,972 of B&O tax, $20,501.78 of interest, and $23,048.64 in penalties, fora total of$504,532.22. KMS timely paid the additional assessment and then filed a complaintfora refund oftaxes paid in the King County Superior Court. Both parties moved for summaryjudgment. KMS argued that all registered representatives of broker-dealer
are deemed to be employees forsecurities law purposes because ofthe broker-dealer’s control and supervisory obligations. The City argued thatthe registered representative
are independent contractors, not employees, and therefore are not supposed to be counted in the payroll factor. The superiorcourtgranted the City’s motion forsummaryjudgment and denied KMS’s motion forsummaryjudgment. KMS appeals.

7No. 78946-5-1/8

Because this casewas resolved below on cross-motions forsummaryjudgment,
our review is de novo. Cmty. Telecable ofSeattle, Inc. v. City ofSeattle, Dep’t of Executive Admin, 164 Wn.2d 35, 41, 186 P.3d 1032 (2008). “Likewise, the proper construction ofa citytaxation ordinance is a legal question that is reviewed de novo on appeal, butthe ‘burden is on the taxpayerto prove that a tax paid by him or her is incorrect.” Avanade, Inc. v. City ofSeattle, 151 Wn. App. 290, 297, 211 P.3d 476 (2009) (quoting Ford Motor Co. v. City ofSeattle, Exec. Servs. Dep’t, 160 Wn.2d 32, 41, 156 P.3d 185 (2007)). The reviewing court “gives considerable deference to the construction of” the challenged ordinance “bythose officials charged with its enforcement.” Ford Motor Co., 160 Wn.2d at42 (citing Gen. Motors Corn. v. City of Seattle, 107 Wn. App. 42, 57, 25 P.3d 1022 (2001)). A. As we explained in KMS I: “Federal and state constitutional law limit a jurisdiction’s powerto tax activities occurring outside its boundaries. Because KMS’s registered representatives operated in Seattle, in otherWashington state locations, and in locations outside Washington state, the City’s tax must meet both state and federal constitutional requirements.” KMS I, 135 Wn. App. at 503. “The federal constitution’s commerce clause—preserving to Congress the authorityto regulate interstate commerce—may, by negative implication, rendera local tax regulation unconstitutional ifthe regulation has the effect of burdening interstate
commerce with the risk of multiple taxation.” Avanade, 151 Wn. App. at 301. To determine whethera taxviolates the commerce clause, the United States Supreme

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Court has set out a four-factortest. “First, the tax must applyto an activitywith ‘substantial nexus’ to the taxing state. Second, it must be ‘fairly apportioned.’ Third, it must not discriminate against interstate commerce. And fourth, it must be fairly related to services or benefits provided bythe state.” KMS I, 135 Wn. App. at 504 (citing CompleteAuto Transit, Inc. v. Brady, 430 U.S. 274, 97 S. Ct. 1076, 51 L. Ed. 2d 326 (1977)). The second factor, fairapportionment, is at issue here. “A gross receipts tax is ‘simply a varietyoftax on income, which [is] required to be apportioned to reflectthe location ofthevarious interstate activities bywhich itwas earned.” KMS I, l35Wn. App. at 504 (quoting Ok. Tax Comm’n v. Jefferson Lines, Inc., 514 U.S. 175, 190, 115 S. Ct. 1331, 131 L. Ed. 2d 261 (1995). Aswe explained in KMS I:

The Constitution does not require a single apportionmentformula. Rather, “atax is fairly apportioned [if] it is internally and externally consistent.” Goldberg, 488 U.S. at 261. Internal consistency requires a taxto be “structured so that ifevery Statewere to impose an identical tax, no multiple taxation would result.” Goldberg, 488 U.S. at 261. “The external consistencytest asks whetherthe State has taxed onlythat portion ofthe revenues from the interstate activitywhich reasonably reflects the in-state component ofthe activity being taxed.” KMS I, 135 Wn. App. at 504 (quoting Goldberg v. Sweet, 488 U.S. 252, 261-62, 109 S. Ct. 582, 102 L. Ed. 2d 607 (1989)). The tax must actually reflect a reasonable sense of how income is generated. KMS I, 135 Wn. App. at 505. In KMS I, we reviewed a similar effort bythe Cityto impose a B&O tax on KMS. At that point in time, KMS had approximately 300 registered representatives working in approximately210 business locations in nine western states, including Washington. KMS I, 135 Wn. App. at494. During the period January 1999 through March 2003, the City assessed the B&O tax on all commissions received in the KMS Seattle office, no 9No. 78946-5-1110

matterwhere the registered representative who generated the commission was based. The City maintained that because the Seattle office was KMS’s sole office, KMS was notentitled to apportionment underthe City’s tax code. KMS I, 135 Wn. App. at494. We held that “attributing the entire proceeds of KMS’s registered representatives to KMS’s Seattle office because that is KMS’s sole office violates the external consistency requirement offederal commerce clausejurisprudence.” KMS I, 135 Wn. App. at 509. Adopting the rationale ofa Pennsylvania court, we reasoned thatthis was so because taxing the entire gross proceeds ofan out-of-citytransaction, based solely
on the factthatthe transaction occurred in a state in which the taxpayerdid not have an office, resulted in a taxthat “was ‘out ofall appropriate proportion to’ and had no ‘rational relationship’ with” the taxpayer’s business activities within Seattle. KMS I, 135 Wn. App. at 506-08 (quoting Northwood Constr. Co. v. Twp. of Upper Moreland, 579 Pa. 463, 486, 856 A.2d 789 (2004)). Similarto federal law, Washington imposes a three-parttest on a city’s powerto tax: (1) the relevanttaxable event must be identified; (2) the taxable event must occur

- within the municipality’s territorial limits; and (3) there must be a minimum connection between the municipality and the transaction it seeks to tax. KMS I, 135 Wn. App. at 510 (citing Dravo Corp. v. City ofTacoma, 80 Wn.2d 590, 594-95, 496 P.2d 504 (1972)). With respectto the application ofstate lawto the City’s imposition of its B&O tax
on KMS based solely on its office being in Seattle, in KMS I, we concluded: thatthe City cannottax income generated by securities transactions within Washington state but outside Seattle city limits when the incident of taxation is the privilege ofdoing business in the City. Whetheror not KMS maintains an “office” as defined bythe City’s tax ordinance is not a 10No. 78946-5-Ill 1

determining factor in the state Jawtest ofthe limits ofa municipality’s taxing power. The City mustfairly apportion KMS’s gross receipts based on where the income-generating activity occurred. The assessment did notfairly apportion KMS’s gross receipts. KMS I, 135 Wn. App. at 512. B. KMS first argues thatthe City’s B&O tax is unconstitutional as applied because it
was notfairly apportioned. This is so, KMS contends, because the City ignored that most of KMS’s taxable income is generated by registered representatives thatwork out ofthe city and state. We agree. An “as applied” constitutional challenge to statute is “characterized bya party’s allegation that application ofthe statute in the specific context ofthe party’s actions or intended actions is unconstitutional.” City of Redmond v. Moore, 151 Wn.2d 664, 668- 69, 91 P.3d 875 (2004). This does nottotally invalidate that statute, only its future application in a similarcontext. ~I. Atax assessed on gross income, such as the City’s B&O tax, must be fairly apportioned to reflect “the location ofthe various interstate activities bywhich itwas earned.” KMS I, 135 Wn. App. at 504. In orderto insure compliance with this mandate, in 2008 (after KMS I), the legislature enacted RCW 35.102.130, requiring all Washington cities with a B&O taxto use a two-factorapportionmentformula based on service income and payroll. Wedbush Sec., Inc. v. City of Seattle, 189 Wn. App. 360, 364, 358 P.3d 422 (2015). The City incorporated the requirements of RCW 35.102.130 in SMC5.45.081. Wedbush, 189 Wn. App. at 364, n.3. Under RCW35.102.130(3)(a) and SMC 5.45.081 (F)(1), the payroll factortakes into accountthe location ofthe ofthe employees and individuals that generate the income.
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The City’s payroll factordoes this by comparing the compensation paid to individuals and employees “in the city”to compensation paid to individuals ‘paid everywhere.” SMC 5.45.081(F)(1). Compensation is defined to include “commissions paid to individuals for personal services that are orwould be included in the individual’s gross income underthe federal Internal Revenue Code.” SMC 5.45.081 (G)(2). In reporting its B&O tax liability, KMS included the commissions paid to its registered representatives in the payroll factor because most of KMS’s taxable income was generated through the sale ofsecurities and services bythe registered representatives

.~ The City’s argumentthat compensation paid to KMS’s registered representatives must be excluded from the payroll factor because they are classified as independent contractors instead ofemployees necessarily fails. Whethera taxpayer does business through independent contractors oremployees is “without constitutional significance.” Scripto Inc. v Carson, 362 U.S. 207, 211-12, 80S. Ct. 619,4 L. Ed. 2d 660 (1960). Moreover, the point offair apportionment is to ensure that a city onlytaxes income attributable and proportional to a taxpayer’s income-generating activity in the city. KMS I, 135 Wn. App. at 506-09, 512; Avanade, 151 Wn. App. at 304. It does not matter whether income is generated by independent contractors oremployees working outside the city. Eitherway, they are notworking ~i the city; the city has no claim to a “fair share” ofthe income they generate.

~ It is undisputed that KMS’s registered representatives must report commissions as gross income in their individual federal tax returns. SeeWatson v. Commissioner, T.C. Memo. 2007-146 (U.S. Tax Ct. 2007), aff’d, 277 Fed. App’x 450 (5th Cir. 2008). 12No. 78946-5-1113

While the law has changed, the City’s argument here suffers the same defect it did in KMS I. The Cityagain ignores where KMS’s registered agents work and generate income in calculating the payroll factor. In calculating the payroll factor Seattle allocates
morethan 95% of KMS’s compensation to the city because this is where KMS’s W-2 employees work. In essence, the City attributes most of KMS’s income to the work of approximately 50 employees based in the citywhen it is undisputed thatthe bulk of KMS’s income comesfrom the work ofthe 300-plus registered representatives based outside the city. Because the Cityfailed to considerwhere and how KMS generated its income, the tax is not externally consistentas applied to KMS. Therefore, the B&O tax is not fairly apportioned to KMS. Becausethe tax is notfairly apportioned, it is unconstitutional as applied to KMS. C. As a matterofconstitutional avoidance, ifa statute is susceptible to morethan
one interpretation, courts should construe it “to avoid constitutional doubt.” Utterv. Bldg. Indus. Ass’n ofWash., 182 Wn.2d 398, 434-35, 341 P.3d 953 (2015). KMS argues thatthe Seattle Municipal Code provides a safety net: that ifthe allocation and apportionment provisions ofthe B&O tax do notfairly representthe extent ofthe taxpayer’s business activity, the City may employ another method to allocate the taxpayer’s income and thereby avoid a constitutional violation. We agree. In RCW 35.102.130, the Legislature specifically provided at catchall to the apportionmentformula. When Seattle adopted the RCW in SMC 5.45.08, it also adopted this relevant portion:

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Ifthe allocation and apportionment provisions ofthis subsection do not fairly represent the extent ofthe taxpayer’s business activity in the city or cities in which the taxpayerdoes business, the taxpayer may petition foror the tax administrators mayjointly require, in respectto all or any part of the taxpayer’s business activity, that one ofthe following methods be used jointly bythe cities to allocate orapportion gross income, if reasonable: (i) Separate accounting; (ii) The use ofa single factor; (iii) The inclusion ofone or more additional factors thatwill fairly representthe taxpayer’s business activity in the city; or (iv) The employment ofany other method to effectuate an equitable allocation and apportionment ofthe taxpayer’s income. RCW35.1 02.130(3)(c); SMC 5.45.081 (F)(3). Here, when KMS challenged the City’s tax apportionment, KMS argued that “Seattle’s B&O tax can be fairly apportioned by including compensation paid to KMS’s registered representatives in calculating the compensation factorofSeattle’s apportionmentformula, as KMS did when preparing and filing its Seattle taxes.”4 KMS has provided foran additional method bywhich the City could have apportioned the tax so thatthe taxwould fairly represent KMS’s activity in the city. As discussed above, the City’s application was notfairly apportioned to KMS and did not fairly represent how KMS conducts its business in Seattle. The catchall created bythe Legislature gives the City authorityto use a different method to apportion the taxwithout adhering to the two-factorformula in a waythat is fair. Because the Legislature provided a catchall in the RCW, the Cityshould have employed a different method to reach afairly apportioned tax.

~The City does not claim that KMS did not challenge the apportionment and provide an additional method ofcalculating the B&O tax. 14No. 78946-5-1115
D.

KMS argues thata plain language reading ofSMC allows forthe Cityto consider the registered representatives as employees foran alternative apportionment calculation. We agree. The relevant definition ofthe code are: 3. “Individual” means any individual who, underthe usual common law rules applicable in determining the employer-employee relationship, has the status of an employee ofthattaxpayer. SMC 5.45.081(G). The common law ‘rightto control” testfordetermining whether a worker is an employee oran independent contractor is derived from the common law oftorts. Anfinson v. FedEx Ground Package Sys., Inc., 159 Wn. App. 35, 53, 244 P.3d 32, 41 (2010), aWd, 174Wn.2d 851, 281 P.3d 289 (2012). The rightto control another’s conduct is often the most decisive factor in determining ifan agency relationship exists. Masseyv. Tube Art Display, Inc., l5Wn. App. 782, 787, 551 P.2d 1387 (1976). Fortort purposes, the principle does not need to show complete control, rather, substantial evidence ofcontrol is sufficient. Massey, 15 Wn. App. at 787.~ Hôre, it is undisputed that both the SEC and FINRA consider a broker-dealer’s registered representatives to be its employees because they are, by law, subjectto the broker-dealer’s control—even ifthey are classified as independent contractors. Additionally, KMS’s registered representatives fall within the definition of individual underSMC 5.45.081 (G). An individual is considered an employee underthe

~The city cites to Seattle Rule 5-039, which distinguishes employees from persons engaging in business. The rule provides a list offactors to determine ifa person is an employee. The rule also states that “while no one factordefinitely determines employee status, the most important consideration is the employers rightto control the employee.” 15No. 78946-5-1/16

common law rules ifthe employerexercises control overthe individual. Underfederal law, ‘as a broker-dealer, KMS must supervise its registered representatives, oversee their licensing status, and require them to complywith industry rules and standards of conduct and procedures set out in its policy manual.” Therefore, the City could logically considerthe registered representatives to be employeesforan alternative apportionment calculation ofthe B&O tax. We conclude thatthe City’s interpretation of its payroll factoras applied to KMS fails to fairly apportion the City’s B&O tax and is unconstitutional as applied to KMS. The constitutional defect can be avoided, however, by applying the interpretation offered by KMS and including its registered representatives in the payroll factorfor calculating its B&O obligation. We vacate the ordergranting summaryjudgmentto the City and remand with instruction forthe trial courtto grant KMS’s motion forsummaryjudgment.

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WE CONCUR: 

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