San Francisco Gross Receipts Tax – Frequently Asked Questions from the Real Estate Industry

This alert addresses the following FAQ:

FAQ 1: Persons Subject to Tax

FAQ 2: Operating Income and Expenses

Described below are some of the transactions involved in a typical commercial real estate investment, including the acquisition, ownership structure, operation, and management of commercial real properties, and profit distributions and dispositions relating thereto. This description forms the basis for the FAQ and the discussion of the GRT impact on the owners, investors, management companies, agents and brokers involved.

Base Case Scenario (see Appendix for schematic)

Acquisition and Ownership Structure

West Corp and East Corp (collectively, “Parents”) are unaffiliated corporations that invest in real property throughout the world. They have agreed to acquire together from an unrelated party two operating commercial real estate properties, one located in San Francisco and the other located outside San Francisco.

To that end, Parents, through their respective wholly owned limited liability companies, West LLC and East LLC (collectively, “Members”), will form a limited liability company called Venture LLC, and will each hold (through the Members) a 45-percent managing membership interest in Venture LLC. The remaining 10-percent membership interest will be held by outside investors as non-managing members. For federal income tax purposes, Members will each be disregarded from their respective Parents, and Venture LLC will be a partnership.

Venture LLC will be the sole member of two limited liability companies known as SF Prop LLC and Non-SF Prop LLC (collectively, “Owners”), each of which will be disregarded for federal income tax purposes. SF Prop LLC will directly acquire and own real property located in San Francisco, and Non-SF Prop LLC will directly acquire and own real property located outside of San Francisco.

Operation and Management

Owners will each enter into listing agreements with an exclusive listing broker (the “Listing Broker”) to fill property vacancies in exchange for a commission based on a percentage of rent paid by the tenant under the lease. In addition, Owner and/or Listing Broker will enter into contracts or other understandings with brokers representing prospective tenants (each a “Procuring Broker”), wherein the Procuring Brokers will be paid a commission if a lease is signed with the applicable tenant. The Listing Broker has no offices in San Francisco, but has employees regularly in San Francisco to market properties located there. None of the Procuring Brokers have offices in San Francisco, but they are regularly present in San Francisco to show properties to potential tenants.

Owners will each enter into separate property management agreements with Management Corp—a wholly owned subsidiary of West Corp. Under the management agreements, Management Corp will collect rental income, coordinate payment of operating expenses, maintain insurance policies, and engage third-party contractors to provide general property maintenance and repairs. Management Corp will deposit rent checks into separate operating bank accounts established by the Owners, and will draw upon those accounts to remit payment for the above expenses on behalf of the Owners. Owners will pay Management Corp a monthly management fee equal to three percent of the gross rents from the managed properties. Management Corp will perform these property management functions from its office in San Francisco.

Distributions and Disposition 

Owners will periodically distribute to Venture LLC income generated from the properties in excess of amounts reasonably required to maintain the properties. In turn, Venture LLC will distribute this income to Members and the outside investors in proportion to their respective membership interests, and Members will each distribute their shares of this income to Parents. After several years of owning interests in the properties, Parents will dispose of those interests at a substantial gain.

FAQ 1 – Persons Subject to Tax

The GRT is generally imposed on a broad array of business entities engaging in business in San Francisco, including entities that are not subject to federal income tax, but instead are treated as “flow-through” entities (e.g., entities taxed as partnerships). A business may not realize it is “engaging in business” in San Francisco, as the threshold for doing so is very low. For example, section 952.3(h) of the San Francisco Business and Tax Regulations Code (“Code”) provides that simply using San Francisco streets for business purposes for seven or more days during a year is sufficient to meet this threshold. Nevertheless, Code section 952.3(g) provides several exceptions which taxpayers should be aware of. For example, Code section 952.3(g)(3) provides that a person is not considered to be engaging in business in San Francisco solely as a result of being an owner of a pass-through entity that is engaged in business in San Francisco.

FAQ 1a – Who in the ownership chain is subject to the GRT?

Under Code section 6.2-12(c), SF Prop LLC is engaging in business in San Francisco as a result of its direct ownership and rental of real property located in San Francisco. However, it will not be subject to the GRT. Although the GRT is imposed on a broad array of legal entities, the San Francisco Treasurer and Tax Collector (“Tax Collector”) has stated in Regulation 2014-2 that single-owner entities that are disregarded for federal income tax purposes (such as SF Prop LLC) will likewise be disregarded for the GRT. Thus, according to Regulation 2014-2, the San Francisco activities of SF Prop LLC will be attributed to Venture LLC, and subject Venture LLC to the GRT as a result.

As noted above, Code section 952.3(g)(3) expressly provides that an ownership interest in a pass-through entity that engages in business in San Francisco is alone insufficient to create a GRT filing requirement for owners of the pass-through entity. Accordingly, Parents should not be subject to the GRT solely as a result of their indirect ownership interests (through the Members) in Venture LLC. However, if either Parent (or their respective disregarded Members) is otherwise directly engaged in business in San Francisco (e.g., if either have an office or employees, agent, or representative present in San Francisco for more than 7 days of the year), they could be subject to the GRT as a result.

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