Mayor Cherelle L. Parker’s administration defends move to eliminate tax break that helps small businesses

Top aides to Mayor Cherelle L. Parker on Thursday defended the administration’s plan to eliminate a popular business tax break that is facing a legal challenge, saying the city would be unlikely to prevail in court if it defended the policy and could face significant financial consequences if it loses.

“The mayor made the hard but prudent decision to discontinue the [tax break], rather than placing the city into a devastating financial position,” City Solicitor Renee Garcia said at a City Hall news conference meant to combat “misinformation” about Parker’s decision. “While we realize this news is unwelcome, the city will continue with financial assistance and business support programs that remain compliant under tax law.”

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The tax break, which took effect a decade ago, excludes companies’ first $100,000 in revenue from being taxed under Philadelphia’s business income and receipts tax, or BIRT. That effectively allows companies that make less than that amount in a calendar year to pay no taxes at all, and it lowers tax bills for all firms.

Parker’s move to preemptively eliminate the tax break, known as the BIRT exclusion, before a judge rules on its constitutionality has met resistance from progressives, small-business owners, and some tax experts. It has also prompted a strange dynamic in which city officials are arguing with one another in public over whether an existing city law is worth defending in court — something that presumably would be more difficult now that the mayor has made her doubts known.

All sides agree, however, that the existing tax break policy has been a boon for Philadelphia’s smallest businesses. It also has helped make the tax more progressive, meaning larger or more profitable firms pay a greater share than those scraping by.

Parker has affirmed that she supports the policy in principle. But she announced in March that the administration is reluctantly seeking City Council approval to eliminate the $100,000 exclusion in response to a lawsuit challenging its legality.

Massachusetts-based Zoll Medical Corp., a medical device manufacturer that does business in Philadelphia, last year sued the city over its BIRT bill and argued in part that the $100,000 exclusion violates the Pennsylvania constitution’s uniformity clause, which requires taxes to be applied to all taxpayers evenly.

Garcia said Thursday that the city soon expects to reach a settlement with Zoll.

If Council eliminates the exclusion, an estimated 54,000 Philadelphia small businesses — and another 21,000 firms based outside Philly that do business in the city — would have to pay the tax next year after being effectively exempt this year, Revenue Commissioner Kathleen McColgan said.

The elimination of the tax break would boost revenue by $30 million, Finance Director Rob Dubow said, and Parker has proposed spending that money on services and outreach to companies affected by the change.

Parker’s handling of the Zoll case has proven unpopular in several camps, from progressives who see the move as a ploy to build support for eliminating the business tax, to tax attorneys who think the lawsuit challenging the exclusion is weak.

“Instead of fighting for small businesses in court, the administration chose to give up,” Councilmembers Kendra Brooks and Nicolas O’Rourke of the progressive Working Families Party said in a joint statement. “Their fears are overblown, and we do not understand why they would choose to undermine their legal case publicly.”

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Stewart M. Weintraub, a tax attorney who worked in the administrations of former mayors Frank L. Rizzo and William J. Green III, said he doubts Zoll would be able to prove it has legal standing to challenge the tax break’s constitutionality, given that it does not cause any harm to the company.

Even if Zoll had standing, he said, the city might prevail by arguing that the exclusion complies with the uniformity clause because it allows all businesses to deduct $100,000 in income when calculating their BIRT bills — not just small businesses.

“I believe the lawsuit is wrong,” said Weintraub, who sat on the city’s 2003 Tax Reform Commission. “I think the $100,000 exclusion is absolutely legal.”

Garcia, however, has noted that the Pennsylvania Supreme Court in 2017 struck down a provision of a state business tax that was structured similarly to the BIRT exclusion. In that case, Nextel Communications v. the Commonwealth of Pennsylvania, the justices ruled that even if all taxpayers are ostensibly subject to the same tax rate, a policy that results in companies of different sizes having different “effective tax rates” — a measure of what taxpayers actually end up paying compared to their overall income — violates the uniformity clause.

With the BIRT exclusion, for instance, companies that make $99,999 per year have an effective rate of 0%, while large companies with millions in sales per year have much higher effective tax rates because reducing their taxable income by $100,000 does little to affect their tax bills.

“The courts have been very clear on how tax uniformity applies: If you create a threshold and tax people above it but not below it, you are violating the constitution,” Garcia said. “It does not matter that everybody gets the exemption. What matters is the effective tax rate.”

Even some critics of Parker’s approach admit that it would be an open question as to whether the city could win if it tried to defend the policy in court. But given the likely harm to small businesses if the policy is repealed, many are urging the administration to fight for the tax break until the courts rule it unconstitutional — a line of attack that has prompted a second layer of debate over what the city stands to lose by prolonging its fight.

The BIRT tax is projected to bring in $725 million in the next budget, which begins July 1, and is projected to total $6.7 billion. The city would be financially hobbled if courts were to rule it could not collect BIRT because the exclusion is unconstitutional, and Dubow said Thursday the administration would have to consider tax increases and service cuts to make up the shortfall.

“We cannot predict what a court would order in that instance, but a decision requiring a retroactive remedy could have serious consequences for the city, including sanctions or reimbursement of hundreds of millions of dollars per tax year,” Garcia said.

Parker’s critics, however, note that the court in Nextel didn’t rule that the entire state business tax was unconstitutional, and instead “severed” the illegal provision while allowing the state to continue collecting the tax. It also did not force the state to make retroactive payments or tax refunds for years in which it was enforcing the problematic provision.

If the Zoll case made it to the Supreme Court, they argue, the city may have little to lose.

“Our state Supreme Court ... would be highly reluctant to require the City to make such payments, particularly as it would yield an absurd and untenable result contrary to public policy and the equities of possibly bankrupting the City for attempting to lawfully collect revenue,” Jonathan Stein, a former executive director of Community Legal Services, wrote in a legal memo on Parker’s decision. “The City has virtually nothing to gain by dropping the exemption prematurely and voluntarily.”

But Garcia said the city cannot assume it will be treated the same because the Zoll suit was filed after the court settled the legal question at hand through the Nextel case. In other words, Philly won’t be able to argue officials didn’t know the exclusion was likely unconstitutional, and the justices may therefore take a less favorable view of the city.

Despite those concerns, it’s far from clear that the majority-Democratic state Supreme Court would precipitate a financial calamity in Pennsylvania’s biggest city. Parker, however, didn’t want to risk the worst-case scenario.

“We did not think about the risk we could take,” Dubow said.

The BIRT includes two separate taxes. Companies must pay 5.81% of their net income or profits, and they must also pay 0.1415% of their gross receipts or total revenue, even if they made no profits that year.

For several years, local business groups and some City Council members have been pushing to dramatically reduce or eliminate the BIRT, which they contend makes the city less competitive for employers.

That effort culminated in Council President Kenyatta Johnson convening a new Tax Reform Commission, which earlier this year proposed phasing the tax out over eight to 12 years. The Zoll case has thrown a curveball into those efforts, but Parker is nonetheless proposing a modest $9.2 million cut to the business tax for next year by lowering the net income rate to 5.71% and the gross receipts rate to 0.141%.

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“This is unfortunate because this exclusion saved thousands of neighborhood-based businesses from even having to file a BIRT return with the city,” Parker said in her budget address to Council last month. “But we are not going to turn our backs on these businesses.”