Originally Published in the Daily Journal, February 14, 2019.

Is your “smart building” connected? Is your high-tech office, residential building or entertainment facility, with embedded sensors, wireless networks, remote monitoring devices and internet-capable security cameras, now just another “thing” connected to the global “Internet of Things”? Does embedding internet-connected devices within a building infrastructure impose enhanced “cybersecurity” requirements on developers, owners, architects, contractors or other building stakeholders? Do any of those stakeholders have affirmative obligations to mitigate the potential for breaches, hacks or misuse of embedded devices? While, perhaps, an odd question, the “connectedness” of buildings, cars, and other “objects” requires renewed consideration of security protocols and practices in light of evolving laws, changing commercial expectations and the potential implications for ubiquitous connected “things.”

California recently passed the first state law imposing security requirements on “connected devices.” The law, effective Jan. 1, 2020 (to be codified at Title 1.81.26 of Part 4 of Division 3 of the California Civil Code), requires manufacturers of internet-connected devices (with exceptions for federally regulated and health care-related devices) to equip them with “reasonable security features.” While ostensibly applying mainly to “off-the-shelf” wireless devices, like security cameras, thermostats and similar products with which consumers are fairly familiar, the definition of “connected devices” goes beyond the plain English. Under the new statute, “connected devices” also include any “other physical object” that is “capable of connecting to the Internet, directly or indirectly,” and that is assigned an IP address or Bluetooth address. What might that broader definition capture, with nearly every physical object today embedded with wirelessly enabled electronics that permit the exchange of data through the internet? Refrigerators, toasters, coffee makers, smoke detectors, vacuum cleaners, door locks, electricity meters, and, indeed, even formerly “static” buildings, cars and trains all come today with an embedded capability that enables them to interact with the internet. And, of course, the ability to connect with the internet offers hackers the opportunity to enter those objects, to control those objects, to lock-down those objects, to extract data from those objects and to move from connected object to connected object within a network. In April 2016, internet users in Europe and North America experienced that susceptibility when a distributed denial of service attack against Domain Name System provider Dyn, Inc., which manages web addresses and routes internet traffic, resulted in several hours of extensive network outages. The malware responsible for that attack infected the Dyn network, and overwhelmed its servers, by taking control of nearly 150,000 connected devices, including wireless security cameras, lightbulbs and baby monitors. Experts suggested that the attack had been initiated by a lone disgruntled gamer upset with the Sony PlayStation game network.

The international research and advisory firm Gartner, Inc. estimates that by 2020, there will be 25 billion or more connected devices. PricewaterhouseCoopers estimates that nearly $6 trillion will have been spent by businesses and consumers between 2014 and 2020 on hardware, software and connectivity solutions for the Internet of Things. IDC Corporation predicts that the Internet of Things marketplace — software, services, hardware and connectivity — will reach $1.7 trillion in 2021. By all measures, the number and types of connected devices will increase exponentially and proliferate even faster. The cost of electronics components will continue rapidly to decline and components will continue to get smaller. Wireless speeds and network coverage will continue to improve, with next generation “5G” wireless networks nearly ready for commercial deployment. The collection, transmittal, storage and analysis of terabytes and terabytes of data through internet-enabled objects will continue to accelerate. The new California law, whether, intentionally or otherwise, demands that a broader cross section of stakeholders assume responsibility for, or, at least, consider the implications of lax, or non-existent, security within connected devices and objects.

Who qualifies as a “manufacturer” of an internet-connected object under the new statute? It seems rather uncontroversial to suggest that a “car” is today a connected device and that the automobile manufacturer has likely assumed a responsibility, legal and otherwise, for the design, manufacture and security of its wirelessly enabled, and potentially “hackable,” transportation platform (that responsibility to the public stands independent of possible reimbursement claims the car manufacturer may have through customary third party indemnification arrangements with specific component manufacturers). Does a building owner, developer, architect or construction firm face similar questions regarding a networked facility that it has helped to create?

The statute applies to the “manufacturers” of “connected devices” and “connected objects” that are sold or offered for sale in California. If a building, entertainment facility or sports arena is wirelessly enabled with embedded sensors, cameras and other internet-capable objects that are designed with input from a developer or construction firm, and built to owner specifications, might that developer, owner or construction firm qualify as the “manufacturer” of a physical object — the building, the arena, a room, a space, an office — that exchanges data with the internet?

Connected physical objects are required to have “reasonable security features” that are “appropriate to the nature and function of the device,” appropriate to the “information” that the device may collect and transmit, and designed to protect the device from “unauthorized access.” “Appropriateness,” as a legal standard, should be expected to evolve and should remain a constant source of inquiry. Beyond an overarching set of security principles, the statute provides that preprogrammed passwords unique to a device or features that require a user to create a new means of authentication before the device is first accessed will constitute “reasonable security features.” But even if preprogrammed passwords or other authentication measures are implemented, the “appropriateness” of those measures to the nature and function of a particular device or object will remain subject to further consideration.

The California statute does not create a private right of action. It limits enforcement to the “Attorney General, a city attorney, a county counsel, or a district attorney.” But while enforcement may initially be restricted, the effects of the statute, especially as the first of its kind in the nation, will no doubt be broad and the bar it establishes for security practices involving connected “things” will no doubt rise. If it seems a stretch to cast a building developer, owner or construction firm the “manufacturer” of a “connected object,” the underlying legislative intent is clear — turning an intentional or unintentional “blind eye” toward cybersecurity protections for connected objects is unacceptable. Expectations have evolved; standards and practices will need to catch up.

The California statute, directly and indirectly, demands that anyone placing a connected object in the market for use by consumers or businesses undertake a critical security assessment of that “thing.” With a statutory security framework for connected devices taking hold in 2020, and a heightened societal awareness occurring in parallel, is it, or will it become, “negligent” to design or install an embedded sensor network without appropriate security features? Are there, or will there arise, express or implied warranties regarding the security of embedded devices and sensors or wireless networks within newly constructed facilities? How far and wide among the engineering and construction stakeholders associated with a new building or facility will those warranties and obligations extend? Do legacy construction and design contracts effectively address responsibility for connected security? Will questions of device security eventually inform issues of occupant safety and habitability when, for example, sensitive network data or personally identifiable information is stolen, when internet-ready cameras are turned by hackers into voyeuristic tools, when ambient sensors are used to disrupt building cooling and heating systems or when medical refrigerators are remotely disconnected causing essential medicines to spoil? Did the builder, owner, construction manager, facilities operator or other vendors properly consider appropriate security features to incorporate into their connected object during the design or “build” stage? Whether the new California statute is applicable on its face or not, and whether it affords a private claim or not, the statute, if nothing else, requires anyone creating or developing an internet-connected platform, or making available a connected object, to consider and think proactively about the features and measures necessary to ensure appropriate security for the platform and objects they intend to interact with the Internet of Things.

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Originally Published in the Daily Journal, February 7, 2019.

Digital technologies are disrupting the construction industry, which has been a notable laggard in technology adoption. For an industry that until recently has relied primarily on hardcopy versions of blueprints, excel spreadsheets to schedule subcontractors and track inventory, and old fashioned measuring tape to ensure the proper fit of building materials, the times “they are a changing’,” and quickly, as the song goes. And those changes demand new legal perspectives and more contemporary assessments of legacy agreements and contractual frameworks.

Sponsors and participants in new development projects have the opportunity to integrate new and emerging hardware and software technologies that will enhance productivity and increase visibility into the construction and development process, building performance and management, ongoing maintenance and future repair. Mobile applications can now deliver real-time, on-site access to digitized blue prints, punch lists, field progress reports and related data. Software platforms can enable online project bidding, vendor qualification, real-time inventory management and cost tracking. Building Information Modeling can provide 3-D digital representations of the physical and functional characteristics of facilities to architecture, engineering and construction professionals, eliminating future “guesses” about the location of mechanical, electrical and plumbing systems when maintenance is required. 3-D printing can allow onsite casting of concrete and steel objects, reducing transport and storage costs. Advanced building materials can enable the introduction of new building functionality and offer improvements in realizing sustainability objectives. Drone technology can permit remote inspection, measurement and monitoring of critical infrastructure assets, including dams, bridges and distant roadways. Embedded sensors can monitor and wirelessly report stress loads on building infrastructure. Modular construction and pre-fabrication techniques can compress project timelines, mitigate waste, reduce rework requirements and enhance coordination among subcontractors. Artificial intelligence and machine learning will offer further automation and potential efficiencies to industry participants.

The global construction industry accounted for about 13 percent of global GDP in 2013 and is expected to increase to nearly 15 percent of global GDP by 2020, representing trillions of dollars of investment. Despite the significant percentage of global GDP generated by the construction industry, the World Economic Forum reported that between 1964 and 2012, U.S. non-farm business labor productivity increased by 159 percent compared to a decrease in labor productivity of 19 percent in the construction industry over the same period. In 2015, the McKinsey Global Institute noted that the construction industry was second to last, above only “agriculture and hunting,” of the 24 industries it surveyed in the use and adoption of digital technologies. These statistics suggest not only the immediate need for the construction industry rapidly to accelerate its adoption and use of new (and, in many cases, now readily available) technologies, but confirm the tangible opportunities that exist within the sector to improve efficiencies, to improve safety and to increase return on investment.

While adoption of new technologies has been slow, the venture community has recently identified a significant opportunity within the construction sector. Investment in construction technology start-ups increased from about $4.5 million in 2008 to nearly $1.5 billion in 2018. Similarly, merger and acquisition activity has risen substantially. At the end of 2018, Autodesk Inc., a leading software services provider for the architecture, engineering and construction industries, spent more than $1.0 billion to acquire just two construction technology start-ups with relatively modest revenue streams. Venture investment, technology adoption and acquisition activity will continue to accelerate in 2019 and beyond. Increased digitization of project plans and construction-related information; increased availability and collection of construction-generated data; increased access to project analytics; increased industry transparency; increased use of advanced materials; and increased retention and dissemination of industry “know-how” — these and other advances made possible through the use of construction-focused technologies are fundamentally and forever changing expectations and outcomes for all stakeholders within one of the world’s oldest industries.

But, as those expectations and outcomes evolve, industry participants need to reconsider legacy contract terms, standards of performance and the implications for risk allocation. Contractors, vendors, architects, designers, financing sources and other constituencies must assess how, or whether, possible disruptions or failures of newly-adopted technologies have been effectively addressed in “off-the-shelf” forms of project agreements used for decades. They must evaluate how the use of these technologies may have influenced professional practices and how they are influencing expectations regarding the standards of professional conduct and care moving forward. Risk assessment and risk allocation, considered in the light of fundamental changes in business practices brought about by technology, must become an essential predicate to the design and planning stages of construction projects, and not simply an afterthought. Contractual pass-through provisions, like those routinely imposed by prime contractors on subcontractors, must be reevaluated to assess the varied effects that new technology solutions may have within the traditional construction ecosystem and on its participants.

What happens if a third-party software platform used to manage project scheduling, purchasing and inventory tracking suddenly crashes? Who is responsible if the platform stops working and construction comes to a halt, results in unforeseen delays or causes vendor payments to be missed? Who provides software platform support and to whom? What happens if blueprints that have been digitized become suddenly inaccessible or have inaccuracies? What happens if those digitized blueprints, or other digitized project information, is taken “hostage” through a ransomware attack and cannot be accessed for an extended period? Does construction stop? Do contractors need to obtain cyber insurance as the tools of their trade transition to the “cloud”? If project management software collects vendor data, where is that data stored and who “owns” the data? Since project “metadata” may offer valuable insights into regional purchasing trends and labor activity, among other things, who, if anyone, can mine and “monetize” that data during and after the project?

Technology adoption will also inevitably affect the post-construction phase. Connected devices are being embedded in new buildings to record performance loads and torque levels, to adjust room temperatures, to turn lights on and off based on the presence of tenants and even to change the tint of exterior windows as the day progresses. Embedded sensors are transitioning formerly static facilities into software platforms that will collect, analyze and store real-time data generated by both the building and its tenants. As sensor and similar technologies proliferate, owners, facilities managers, construction firms and other stakeholders must also consider the privacy, reliability, usability and related issues that will arise. Has patent indemnification coverage flowed through to protect a building owner sued for an alleged infringement tied to embedded sensors? If an in-building network is hacked, how is responsibility allocated among the manufacturers, installers, owners, managers and users of the network? To whom were relevant representations and warranties made with respect to the affected technologies? Were there third-party beneficiaries of licensed technologies employed in the construction process?

As digital technologies take hold within the construction industry, prudence requires a reassessment of legacy agreements and legal arrangements. Contracts that fail to account for the use, integration and permanence of advanced technologies, or that fail to reflect the terms, conditions, conventions and practices of the technology sector, are likely to result in undesirable or unanticipated allocations of project risk. The issues associated with increased adoption of construction-related technologies are not unique. Rather, they require the rethinking of traditional business methods and practices among industry participants through the lens of a technology user. And, they raise the need for heightened sensitivity, and indeed awareness, to the implications of technology adoption, to the terms on which technologies are purchased, licensed and used, to the ways in which technologies are integrated into industry processes and to the varied effects that these technologies may have, directly or indirectly, on construction industry stakeholders.

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By Fred Alvarez and Laura Seegal. Originally Published in the Daily Journal, February 6, 2019.

It’s time to take another hard look at whether it’s worth it for employers to ask their departing employees not to recruit anyone away after they leave. Nobody wants their former employees to raid the ranks of their current employees, but they don’t want to be forced to defend an unfair competition lawsuit in California either. By the same token, nobody tempted to recruit their former colleagues wants to be sued for breach of contract or to have their new employer sued for interference with contractual relations. The need to balance those risks is becoming ever more acute.

Up until the 2008 California Supreme Court decision in Edwards v. Arthur Andersen LLP, 44 Cal. 4th 937, California employers routinely and comfortably relied on the 1985 Court of Appeal decision in Loral Corp v. Moyes, 174 Cal. App. 3d 268, to justify including employee nonsolicitation clauses in employment and severance agreements. (Applying a rule of reason analysis, the Loral court enforced an employee nonsolicitation covenant because it did not significantly restrain trade so as to run afoul of California Business and Professions Code Section 16600.) Those provisions typically prevent employees who have left their employment from recruiting current employees of their former employer to work elsewhere.

In Edwards, the court invalidated a noncompetition agreement that contained both noncompete and customer nonsolicitation clauses on the basis that Business and Professions Code Section 16600 unambiguously prohibits all restraints on trade, without regard to reasonableness. Though the agreement at issue in Edwards also contained an employee noncompetition clause, the plaintiff had not specifically challenged it. Therefore, despite the California Supreme Court’s sweeping rationale in Edwards, many employer-side attorneys continued to “whistle past the graveyard” on employee nonsolicitation clauses. Similarly, many employee-side attorneys had to urge caution to their clients who had signed nonsolicits but were anxious to bring former colleagues to their new ventures. Moreover, until recently no definitive Court of Appeal decision existed to compete with Loral. For these reasons, many employers routinely continue to include employee nonsolicitation clauses, just as they did before Edwards. Two recent developments have made reliance on Edwards’ silence as to employee nonsolicits a little more treacherous for employers — and a little less scary for ex-employees.

At least one Court of Appeal case, and some commentators, have assumed or even suggested that the Edwards rationale would logically encompass employee nonsolicitation clauses. Yet, the decision of the 4th District Court of Appeal in AMN Healthcare, Inc. v. Aya Healthcare Servs., Inc., 28 Cal. App. 5th 923 (2018), brought the fight directly to Loral. In AMN, the Court of Appeal ruled that an employer could not enforce its employee nonsolicit against former company recruiters, after finding that the clause would effectively prevent the recruiters from performing their jobs in violation of Section 16600. The AMN court went to some lengths to illustrate that the analysis and rationale in Loral were not compatible with the Supreme Court’s approach to Section 16600 in Edwards. It then boldly concluded that “We thus doubt the continuing viability of [Loral] post-Edwards.”

Employer attorneys looking to continue relying on Loral have harbored some hope that the particular facts in AMN — recruiters who could no longer practice their profession of recruiting — would help keep Loral on some solid ground despite its negative treatment in AMN. That hope was confronted with a dose of harsh reality in the recent decision of Barker v. Insight Glob., LLC, No. 16-CV-07186-BLF (N.D. Cal. Jan. 11, 2019). In Barker, Northern District Judge Beth Freeman, applying California law, reversed a decision she had made several months earlier in which she relied on Loral to dismiss a frontal attack on an employee nonsolicit. According to Judge Freeman, AMN was “a change in law warranting a fresh look and changed outcome” that now justified her denial of summary judgment in favor of an employer who sought to enforce an employee nonsolicit. In reaching this decision, Judge Freeman made two key points: (1) The particular facts in AMN — recruiters who could no longer recruit — did not limit AMN’s holding that Loral was no longer viable, and (2) the analysis in AMN was more persuasive than that in Loral.

There is no doubt that the AMN decision arose from facts that placed the employee nonsolicit in a particularly harsh light, and that Barker is merely one federal judge’s opinion about a long-standing proposition in California nonsolicit law. Yet, employers who continue to use employee nonsolicits would be well-advised to take heed. Of course, it is also true that until the California Supreme Court definitively overrules Loral, a good faith basis will continue to exist to support the routine usage of employee nonsolicits. On the other hand, with two courts now clearly rejecting the approach and making explicit the contention that Loral’s rationale does not survive Edwards, the risks of business as usual are more tangible than ever.

Employers should now anticipate that more employee-side attorneys will look critically at routinely imposed employee nonsolicits and that they will make litigation calculations about whether they are willing to undertake a direct challenge to those clauses based on California’s Unfair Competition law and other theories under California law. Indeed, the challenge in Barker was brought as a purported class action on behalf of all employees who had ever signed or been presented with an employee nonsolicit. Correspondingly, employers will need to assess whether these clauses are truly worth the risk that more courts will follow what could become an anti-employee nonsolicit parade following the AMN and Barker cases.

Click here to download a PDF of this article.

In August 2018, the U.S. Department of the Treasury issued final Regulations concerning the qualifications, designation, authority, and resignation of the required Partnership Representative under the new Centralized Partnership Audit Regime.[1] The rules are effective for tax years beginning after December 31, 2017 and apply to all partnerships and LLCs taxed as partnerships, although certain partnerships and LLCs may elect out of the regime to continue to be audited under the former rules. The option to elect out of the regime is limited to partnerships having 100 or fewer partners with individuals or corporate partners only (any partnership or LLC with a trust or a disregarded entity as a partner/member cannot elect out). Partnerships and LLC’s taxed as partnerships both will be referred to in this letter as “partnerships.”

Under the new partnership audit regime, the IRS can make an audit change to a partnership’s tax return and assess the tax against the partnership instead of the partners. This could result in the partnership paying additional tax for a prior year adjustment even though there are different partners or different ownership interests in the current year than in the year that was audited. As discussed, partnerships need to amend their agreements to address this and other partnership audit issues.

In addition, the new regime replaces the former “Tax Matters Partner” with a “Partnership Representative” (“PR”), but provides much greater authority for the role of the PR. Importantly, the PR has the sole and binding authority over all matters of the partnership before the IRS in audits under the Bipartisan Budget Act of 2015 (BBA). The partnership must designate the PR each year on its filed tax return for all tax years beginning after 2017. For a calendar year Partnership/LLC this would be its 2018 tax return, so this issue needs prompt attention.

Authority of the Partnership Representative in Centralized Partnership Audit Regime

The PR has the “sole authority to act on behalf of” the partnership. Other than the PR or designated individual for a PR that is an entity, no partner or other person may participate in administrative proceedings without permission by the IRS.[2] However, the rules are not intended to prohibit partnerships from using state law to limit the authority of the PR. Therefore, partnerships and LLCs should review and amend agreements carefully to tailor the duties and authority of the PR.

Designation and Eligibility of the Partnership Representative

Every partnership must designate a PR for each separate taxable year. There may only be one designated PR for a partnership taxable year at any time, and the designation will remain in effect for that year until terminated by resignation, revocation, or a determination by the IRS that a designation is not in effect. If a partnership fails to designate a PR, then the IRS will designate one for the partnership.[3] When designating a PR for the partnership, the IRS may designate anyone except an IRS employee, unless the IRS employee is a partner in the partnership or was a partner in the partnership for the year under audit.[4]

The PR need not be a partner or member of the entity. Any person or entity who meets the requirements in the Regulations may serve as the PR, even the partnership itself. If an individual is designated as PR, the person must have a “substantial presence” in the United States, which exists if (1) the person makes itself available to meet in person with the IRS, and (2) the person has a United States taxpayer identification number, a street address located in the United States, and a telephone number with a United States area code. If an entity is designated as the PR, there must be a “designated individual” appointed to act for the partnership at the time of designation, and the individual must meet the substantial presence requirements for an individual PR.[5]

Resignation, Revocation, or Determination by the IRS that a Designation is Not in Effect

Resignation. A PR or designated individual of an entity PR may resign by notifying the partnership and the IRS in writing of the resignation, but may not appoint a successor PR or designated individual.

Revocation. The partnership may revoke a PR designation for a tax year for any reason by notifying the PR and the IRS in accordance with applicable forms and instructions, but the partnership must designate a successor PR. However, the flexibility for revoking a PR designation is limited where the PR has been designated by the IRS.

IRS Determination that a Designation is Not in Effect.  The has the authority to determine that a PR designation is not in effect in situations including: the IRS becoming aware that the PR or designated individual does not have a substantial presence in the U.S., the partnership failing to appoint a designated individual of an entity PR, the partnership failing to make a valid designation of a PR, and the PR or designated individual resigning. Until a termination, resignation, or revocation is in effect, the PR’s authority to bind the partnership remains unaffected.[6] Therefore, a partnership will want be sure that the particular requirements for a valid resignation are followed.

Push-Out Elections

Partnerships and LLCs may make a “push-out” election to transfer the liability for underpayments from the partnership itself to those who were partners during the year being audited. The economic effect of this election may be material in situations where the ownership of the partnership may change from year to year.

Amendments to Consider in Partnership and LLC Agreements

Partnerships and LLCs taxed as partnerships should consider amending agreements to account for how the new rules might affect the liability of partners in the audit year and the prior year, and due to the amount of power vested in the PR, should specifically address the obligations and limitations on the PR’s authority. Amendments to agreements will vary, but items that should be considered include:

• The conditions for making the opt-out election (the election to opt out of the new regime) and push-out election (the election to cause audit adjustments to be allocated to those who were partners in the year under audit), and maintaining eligibility for making these elections;
• Indemnification by former partners if partners become liable for any tax, penalties, or interest that effectively pertain to a former partner with respect to a prior year;
• The manner and method of appointing and removing the PR;
• The PR’s fiduciary duties to the other partners, if any;
• The PR’s duties to notify and keep informed the partnership and the partners of any matters relating to its authority under the new rules;
• Extending the PR’s duties beyond the year of designation until the statute of limitations for such year has run; and
• Limiting the PR’s authority, such as by requiring cooperation with the partners prior to any settlement with the IRS.

This is not an exhaustive list, and new amendments will vary based on the needs of each partnership or LLC. Partnerships and LLCs should carefully review and amend their agreements to address the new audit procedures.

For more information, contact Coblentz Tax Partner Jeff Bernstein at jbernstein@coblentzlaw.com.

 

[1] See Treas. Reg. §§ 301.6223-1 and 301.6332-2.

[2] Treas. Reg. § 301.6223-2(d).

[3] Treas. Reg. § 301.6223-1(c) and (f).

[4] Treas. Reg. § 301.6223-1(f)(5).

[5] Treas. Reg. § 301.6223-1(b).

[6] Treas. Reg. § 301.6223-1(d) – (f).

The state of California is keeping a watchful eye on the potential land use, environmental, and social consequences of automated vehicle deployment. On November 16, 2018, the Governor’s Office of Planning and Research announced the release of “Automated Vehicle Principles for Healthy and Sustainable Communities.” This document involved staff collaboration among state agencies, including the Office of Planning and Research, the Air Resources Board, and Caltrans.

The Automated Vehicle Principles set out several broad guiding considerations that seek to align automated vehicle deployment with other environmental and public policy objectives. The Principles address topics such as encouraging shared use and car-pooling, utilizing low-emission vehicles, promoting efficiency in vehicle size, undertaking efficient land use planning, and addressing transportation equity. These considerations are largely reflective of the research of programs like UC Davis’s 3Revolutions.

While the Automated Vehicle Principles do not impose specific standards and are more likely to serve as a general policy statement for future agency efforts, the statement is nevertheless significant. The Automated Vehicle Principles acknowledge the potential benefits to automated vehicle deployment but warn that the potential consequences could be severe if automated vehicles are deployed without careful consideration of the environmental, land use, and social impacts of the new technologies.

For example, if automated vehicles are deployed as personally owned vehicles, automated technologies could increase vehicle miles traveled since it may reduce disincentives for long commutes. But if automated vehicles are deployed in a manner that is shared, pooled, and properly-sized, then automated vehicles could help reduce vehicle miles traveled.

We expect further and more concrete steps by OPR, CARB, Caltrans, and other state agencies to address the issues raised in the Automated Vehicle Principles, including new policies and proposed legislation. This will likely include measures to encourage cities to incorporate these principles into their land use and transportation planning efforts.

Last spring, we reported on Senator Scott Wiener’s SB 827, which proposed major increases in height and density for qualifying housing developments.  Battle lines quickly emerged, with supporters claiming that the legislation was a bold, necessary solution to the housing affordability and climate change crises, and opponents asserting that it was a threat to neighborhood stability and an invitation to gentrification.  The bill was ultimately killed in Committee.  On December 3, Senator Wiener introduced SB 50.  Like SB 827, SB 50 would constrain local agencies’ ability to impose height and density limits and minimum parking requirements on residential developments (projects with at least two-thirds of the square footage designated for residential use) that meet the legislation’s “transit rich” and/or “jobs rich” criteria.  SB 50 introduces the term “equitable communities incentives” to describe the bill’s various waivers, concessions and incentives.

Senator Wiener added new features, and modified others, to address criticisms of the prior bill.  Highlights include:

• Expanding density incentives beyond “transit-rich” projects to “jobs-rich” projects (based on criteria such as proximity to jobs, area median income and quality of public schools) to capture more affluent areas outside major transit corridors.
• Delaying implementation for designated “sensitive communities” (generally, those with a high risk of gentrification or displacement based on indicators such as percentage of tenant population living at or below the poverty line) to allow time for planning efforts directed at affordable multifamily housing.
• Designating properties as ineligible if they have housed tenants in the past 7 years, or if the owner has evicted tenants under the Ellis Act in the past 15 years, prior to submittal of a development application; and
• Providing that projects are generally subject to the more restrictive of SB 50’s affordable housing requirements, or local city inclusionary housing ordinances.

The legislation has a number of co-authors and several early supporters, including Mayors Breed and Schaaf and the State Building Trades Council.  It is expected to be opposed by many of the same local communities that resisted SB 827 based on concerns such as loss of local control and gentrification.  The bill is currently awaiting Committee referral.

 

After over seven years of planning and public outreach, as of January 7, 2019, the Central SoMa Plan and its implementing legislation are finally effective.  The City’s analysis concludes that the Plan area has development capacity for over 8,000 new housing units (approximately 33 percent of which will be affordable) and over 30,000 new jobs, and will generate over two billion dollars of public benefits.

The key takeaways are as follows:

Rezoning

The Plan area is an approximately 230-acre site that runs roughly from 2nd Street to 6th Street, and from Market Street to Townsend Street, excluding certain areas north of Folsom Street that are part of the Downtown Plan. Very broadly, the Plan and its implementing legislation increase permitted height and density and streamline zoning controls for the majority of the Plan area.  With the exception of the Key Development Sites discussed below, height limits in large portions of the Plan area generally increased from 85 feet or less to 130 to 160 feet, subject to bulk controls to encourage building sculpting.  In exchange for this upzoning, the Plan requires increased public benefits, including payment of significant development impact fees.  See our prior blog post for a summary of other required exactions and public benefits, including privately owned public open space (POPOS) requirements.

The predominant new base zoning district is Central SoMa Mixed Use Office (CMUO), which largely replaces relatively restrictive zoning districts with more flexible mixed-use zoning controls and eliminates Floor Area Ratio (FAR) limits for larger projects that participate in the Central SoMa Mello Roos Community Facilities District (CFD) Program described below. The CMUO zoning district is characterized as an Eastern Neighborhoods Mixed Use District and as such, Planning Code Section 329 Large Project Authorization from the Planning Commission is required for projects that are greater than 85 feet in height or propose the net addition or new construction of more than 50,000 gross square feet.  Large Project Authorization is required in addition to any other required entitlements, such as Conditional Use (CU) authorization for, e.g., new hotel uses in the Plan area.

The Plan area is also part of a new Central SoMa Special Use District (SUD), which creates an additional layer of zoning controls.  Some of the major SUD controls are: designating the largest sites (over 40,000 square feet) South of Harrison Street as predominantly non-residential; imposing new PDR/Community Building Space requirements on projects with at least 50,000 gross square feet of office space; imposing active ground floor requirements, including requiring “micro-retail” units between 100 and 1,000 square feet for certain projects; imposing renewable electricity requirements; and generally prohibiting new formula retail bar, formula retail restaurant, and standard group housing uses.  See new Planning Code Section 249.78 for a complete list of requirements and restrictions in the SUD.  Up to 25 feet of additional building height is permitted for certain projects in the SUD that provide certain additional public benefits, including 100 percent affordable housing projects.  See new Planning Code Section 263.32.

Again, there is generally no maximum FAR in the Plan area.  The purchase of Transfer of Development Rights (TDR) is generally required for larger non-residential projects (50,000 gross square feet or greater) on “Tier C” properties (as defined under Planning Code Section 423.2) for the portion of the project FAR between 3.0:1 and 4.25:1.  TDR must be obtained from a Preservation Lot (as defined under new Planning Code Section 128.1) also within the SUD or a lot containing a building with 100 percent affordable housing units.

Key Development Sites

The Plan identifies eight Key Development Sites, which are significantly upzoned, including increased height limits for towers 200 to 400 feet in height (depending on the site), in combination with more permissive Planning Code controls under the SUD and new Planning Code Section 329(e) exceptions, which vary to some extent by site.  Key Development Site projects must provide additional Qualified Amenities (as defined in new Planning Code Section 329(e)) and on-site childcare facilities (for office or hotel projects), in addition to the other required public benefits, including payment of substantial development impact fees.  There are also special height exceptions for qualifying projects on certain Key Development Sites under new Planning Code Sections 263.33 and 263.34.

Central SoMa Mello Roos CFD

The Central SoMa Mello Roos CFD Program participation requirement under new Planning Code Section 434 applies to projects in the Plan area that include new construction or the net addition of more than 25,000 gross square feet of non-residential development on “Tier B” or “Tier C” properties, or more than 25,000 gross square feet of new residential condo development on “Tier C” properties.  See the definitions under new Planning Code Section 423.2.  The CFD Program participation requirement is only triggered for projects that also exceed the applicable Prevailing Building Height and Density controls under Planning Code Section 249.78(d)(1)(B), meaning that many smaller projects are exempt.

Legislation for the formation of the CFD was introduced by the Board of Supervisors on December 4, 2018 (BOS File No. 180622).

Central SoMa Housing Sustainability District

The Central SoMa Housing Sustainability District (HSD) encompasses the entire Plan area.  As explained in more detail in our prior blog post, residential projects 160 feet in height or less (unless 100 percent affordable) in the HSD meeting specified criteria, including minimum density and affordability requirements, qualify for a 120-day streamlined ministerial (i.e., no CEQA) review and approval process, including design review by the Planning Department.

Qualifying projects first require an informational public hearing followed by Planning Department approval, which will be appealable to the Board of Appeals.

On September 30, Governor Brown signed AB 2923, which could pave the way for BART to develop up to approximately 20,000 residential units, plus about 4.5 million square feet of office and commercial uses, on about 250 acres of BART-owned land. It requires cities and counties to adopt local zoning standards for BART-owned land that conform to BART Transit Oriented Development (TOD) zoning standards and establishes a streamlined approval process for qualifying projects. The law sunsets on January 1, 2029.

The new law seeks to ease traffic congestion and increase housing production and affordability by making it easier to develop housing on certain BART-owned land. An eligible TOD project (defined below) qualifies for streamlined ministerial approval (no additional CEQA review) if it meets certain standards related to height, floor area ratio, etc. There are exclusions for projects that have specified adverse, unmitigated environmental impacts.

An “eligible TOD project” is a project at an infill site on BART-owned land with at least 50 percent of the floor area of the project dedicated to residential uses, unless a local specific plan provides for a different amount of residential uses on the site. The site must form a contiguous area of at least 0.25 acres, with at least 75 percent of its area located within one-half mile of an existing or planned BART station entrance. It must also be within an area represented on the BART Board, which excludes areas south of San Francisco. Eligible TOD projects must also meet requirements regarding housing replacement, tenant displacement and relocation, affordable housing, and labor standards.

The law requires the BART Board of Directors to adopt new TOD standards for height, density, parking, and floor area ratio for eligible TOD projects on BART-owned land (TOD Standards) by July 1, 2020. Adoption of the TOD Standards is subject to CEQA review, with BART serving as the lead agency. The minimum TOD Standards are generally set as the 2017 BART TOD Guidelines (TOD Guidelines)—these also apply if BART has not adopted TOD Standards by July 1, 2020. The lowest permitted height is set at the higher of 150% of the height permitted in the TOD Guidelines or the approved height in nearby areas, as defined in the bill. There are also parking requirements for auto-dependent stations and limits on local parking requirements.

Affected local jurisdictions must adopt an ordinance that conforms to the TOD Standards within two years after BART’s adoption of the TOD Standards, or by July 1, 2022 if BART has not adopted TOD Standards for a station. The BART Board is required to review local zoning standards and confirm consistency with the TOD Standards. Certain local provisions are exempt from the TOD Standards if they are already in substantial compliance with the TOD Guidelines. Nothing in the new law affects the application of density bonuses.

AB 2923 was endorsed by the City and County of San Francisco, housing and other non-profit advocacy groups such as the Bay Area Council, SPUR, the Silicon Valley Leadership Group, SFHAC, YIMBY Action, and various building trades and business advocacy groups. The opposition included Alameda County, various East/North Bay cities, three members of the BART Board, the League of California Cities, and the American Planning Association, California Chapter.

Proposition C—the Commercial Rent Tax for Childcare and Early Education—is set to take effect on January 1, 2019, and increase the Gross Receipts Tax (“GRT”) on commercial rents in San Francisco.  As discussed in our previous post, Proposition C competed with Proposition D—the Housing For All Commercial Rent Tax—and prevailed with San Francisco voters in June.

The City’s existing GRT regime already imposes a tax on the gross receipts of many businesses operating within San Francisco, with a current GRT rate of approximately 0.3% imposed on commercial rents.  Gross receipts tax refers to the tax on the total amount of money received or accrued by a person from doing business in San Francisco, less specific statutorily excluded items.  In addition to the existing GRT, the City’s new Commercial Rent Tax imposes a tax of 1% on amounts received for rentals of “warehouse space,” and a tax of 3.5% on amounts received from rentals of other “commercial space” in the City.

The Commercial Rent Tax will significantly increase the local tax burden on commercial property owners in San Francisco, and taxpayers’ advocacy groups have filed suit against the City and County of San Francisco seeking to invalidate it, claiming that Proposition C was passed in violation of the California Constitution.  At issue is whether the “special tax” imposed by San Francisco voters by initiative requires a two-thirds majority to pass.

Unless the challenge is successful, the Commercial Rent Tax will take effect on January 1, 2019.  Landlords may be able to pass some of the resulting expense on to their tenants with triple net leases, depending upon the expense pass through language in the leases.  Going forward, landlords will need to consider this tax when drafting such provisions, and tenants will want to pay close attention as well when negotiating their leases.

Commercial landlords in San Francisco who already pay tax on the lease of their space will find the process familiar, as returns for the new tax will be filed in the same manner and on the same schedule as the current gross receipts tax.  The rules for filing combined returns applicable to the current rent tax will apply: the taxpayer must file returns on a combined basis with all of that taxpayer’s related entities, i.e., those entities with which the taxpayer is permitted or required by the California Franchise Tax Board to reflect income on the same combined report.

For a more in-depth discussion of the GRT regime in San Francisco, including its history, the current applicability, and information about determining the tax, please refer to the recent Coblentz publication examining this topic.

Commercial Rent Tax for Childcare

Proposition C—the Commercial Rent Tax for Childcare and Early Education—is set to take effect January 1, 2019, and increase the Gross Receipts Tax (“GRT”) on Commercial Rents.

The imposition of the Commercial Rent Tax is expected to be a significant increase to the local tax burden on commercial property owners in San Francisco. To that end, taxpayers’ advocacy groups have filed suit against the City and County of San Francisco seeking to invalidate the tax and claiming that Proposition C was passed in violation of the California Constitution.¹ At issue is whether San Francisco voters can circumvent the requirement that Propositions that constitute a “special tax” must attain a two-thirds majority to pass as compared to the voter initiative process, which only requires a simple majority for approval. Last year, the California Supreme Court held in California Cannabis Coalition v. City of Upland that certain procedural standards applicable to measures proposed by legislators do not apply to measures proposed by voter initiative. The business organizations challenging Proposition C argue that the Upland decision did not go so far, as it did not address required voter threshold.

The City’s existing Gross Receipts Tax (“GRT”) regime already imposes a tax on the gross receipts of many businesses operating within San Francisco, with a current GRT rate of approximately 0.3%  imposed on commercial rents. In addition to the existing GRT, the City’s new Commercial Rent Tax imposes a tax of 1% on amounts received for rentals of “warehouse space,” and a tax of 3.5% on amounts received from rentals of other “commercial space” in the City.

Commercial landlords in San Francisco who already pay tax on the lease of their space will find the process familiar, as returns for the new tax will be filed in the same manner and on the same schedule as the current gross receipts tax. The rules for filing combined returns applicable to the current rent tax will apply: the taxpayer must file returns on a combined basis with all of that taxpayer’s related entities, i.e., those entities with which the taxpayer is permitted or required by the California Franchise Tax Board to reflect income on the same combined report.

Generally, the Commercial Rent Tax would not apply to businesses exempt from the existing GRT, including businesses with less than $1 million total in gross receipts, leases of retail spaces, leases for “industrial use,” leases for “arts activities,” most residential real estate leases, nonprofit organizations that are leasing spaces as commercial landlords, and leases to nonprofit organizations or local, state, or federal governments.

The imposition of the Commercial Rent Tax, on top of the existing tax on gross receipts, will likely be a significant increase to the local tax burden on commercial property owners in San Francisco. Landlords may be able to pass some of the resulting expense on to their tenants with triple net leases, depending upon the expense pass through language in the leases. Going forward, landlords will need to consider this tax when drafting such provisions, and tenants will want to pay close attention as well when negotiating their leases.

To better understand the additional tax burden posed by the Commercial Rent Tax, a discussion of San Francisco’s existing GRT regime follows.

San Francisco’s Existing Gross Receipts Tax Regime

Gross receipts tax refers to the tax on the total amount of money received or accrued by a person from doing business in San Francisco, less specific statutorily excluded items. The tax is payable by “persons” engaged in business in San Francisco, which includes any individual, firm, company, partnership, LLC, joint venture, association, proprietorship, domestic or foreign corporation, or any other group acting as a unit.²

“Gross receipts” are defined broadly to include all amounts that constitute gross income for federal income tax purposes, such as all receipts; cash; credits; and property of any kind or nature, and including any amount for which a credit is allowed by the seller to the purchaser, without any deduction therefrom on account of the cost of the property sold, the cost of materials used, labor or service costs, interest paid or payable, losses or any other expense whatsoever.³

Phase-In of Gross Receipts Tax

On January 1, 2014, San Francisco began making the transition to the GRT for all business activities attributable to San Francisco. The GRT was to be phased in over five years, with incremental decreases in payroll expense tax corresponding to incremental increases in GRT. By 2018, the phase-in was to adopt the GRT base rate at 100% and the payroll expense should have been phased out to zero. However, this did not happen, and the current rates are shown below.⁴

Year	% of Adopted Gross Receipts Base Rate	Payroll Expense Tax Rate
2014	10%	1.350%
2015	25%	1.162%
2016	50%	0.829%
2017	75%	0.711%
2018	100%	0.380%

 

Therefore, for 2018, both payroll expense tax and GRT are payable by San Francisco businesses.

Determining the Gross Receipts Tax

The rate of the GRT is dependent upon the type of business activities and the amount of gross receipts.⁵  Businesses conducting business both within and outside San Francisco must apportion their gross receipts to determine gross receipts subject to the GRT.⁶  Businesses located entirely outside San Francisco are still subject to the GRT to the extent their gross receipts are allocable to San Francisco.⁷

There are multiple methods of apportionment, and the method varies depending on type of business activity. The primary methods of allocation and apportionment are set forth in Code section 956.1, summarized as follows:

(1) Real or Personal Property. Gross receipts related to real property located in San Francisco and personal property delivered to San Francisco are allocable to San Francisco;
(2) Services. Gross receipts from services are allocable to San Francisco to the extent the purchaser of the services received the benefit in San Francisco;
(3) Intangible Property. Gross receipts from intangible property are allocable to San Francisco to the extent the property is used in San Francisco;
(4) Payroll. Gross receipts apportioned based on payroll is calculated by determining the amount of all non-exempt gross receipts multiplied by the fraction of payroll in San Francisco over combined payroll.

In addition to the GRT, there is a San Francisco Business Registration Fee, which is based on gross receipts for the immediately preceding year and the type of business activity.⁸  Under the current structure, there are thirteen levels of Registration Fees that may apply, ranging from $90 for businesses with $100,000 or less in gross receipts to $36,225 for businesses with $200,000,001 or more.⁹

Exemptions & Exclusions from Gross Receipts Tax

1. Small Business Exemption
Exempted from the GRT are small businesses with less than $1,000,000 in San Francisco gross receipts.¹⁰ This number is adjusted annually for inflation, putting the 2018 threshold at $1,090,000.  Note that businesses with $500,000 or more in San Francisco gross receipts must still file a GRT return or be subject to a penalty, and businesses operating in San Francisco must still pay the Business Registration Fee regardless of the amount of gross receipts.¹¹  A residential landlord is considered a “small business enterprise” within the meaning of the exclusion if and only if the landlord leases fewer than four units in any individual building.

2. Tax Reimbursement Exclusion
Excluded from the computation of gross receipts are federal, state and local taxes for which a taxpayer is reimbursed by means of a separately stated charge.¹²

3. Investment Exclusion
Gross receipts do not include any “investment receipts,” which are defined as interest, dividends, capital gains, other amounts received on account of financial instruments, and distributions from business entities, provided such amounts are derived exclusively from the investment of capital and not from the sale of property other than financial instruments or from the provision of services.¹³ 

Gross receipts do not include allocations of income or gain, or distributions from an entity treated as a pass-through entity for federal income tax purposes, provided such allocations or distributions are derived solely from an investment in such entity and not from the provision of services.¹⁴

4. Exclusion for Amounts Received from Related Persons
Amounts received from a related person or entity, including gross receipts of a pass-through entity which is itself subject to the GRT, are excluded from gross receipts.¹⁵

5. Rent Controlled Buildings Exclusion
Lessors of residential real estate may exclude from gross receipts 50% of the total amount received from the rental of real property to tenants in occupancy at any location in San Francisco that is subject to limits on rent increases.¹⁶

6. Other Exemptions
The following are also specifically exempt from the GRT:

Formally recognized tax-exempt organizations under either the California Revenue and Taxation Code or the Internal Revenue Code;

• Banks, financial corporations, and insurance companies;
• Businesses engaged as for-hire motor carriers;
• Businesses engaged in intercity transportation as a household goods carrier;
• Charter-party carriers operating limousines that are not domiciled or maintained in the City; and
• Any other person the City is prohibited from taxing under State law.¹⁷

Quarterly Estimated Tax Payments

In February 2017, the San Francisco Board of Supervisors passed Ordinance 026-17, which requires quarterly estimated payments for payroll expense taxes and GRT, and permits taxpayers to apply refunds of overpayments of the business registration fee, the payroll expense tax, and the GRT to subsequent tax periods.  Every business with San Francisco gross receipts of more than $1,090,000 or payroll expense of more than $300,000 is required to make three quarterly estimated tax payments and file an annual tax return. Residential landlords that rent four or more units, with annual gross receipts less than $1,090,000 and payroll expense less than $300,000 are only required to file an annual tax return.¹⁸ For businesses not fitting these criteria, no annual return is required for GRT and payroll expense tax.

The required quarterly estimated payments are the lesser of (1) 25% of the prior year or (2) 25% of the current year tax liabilities. If a taxpayer fails to make the estimated payment, there is a penalty equal to 5% of the underpayment.¹⁹ The quarterly estimated payments due are billed and posted in March. The first, second, and third estimated tax payments for a tax year are due on or before April 30, July 31, and October 31, respectively. The fourth quarter payment is due by February 28 of the following year. These payments are credited against a person or combined group’s total annual payroll expense tax or GRT for the year in which the payments are made.²⁰

For more information, contact Tax Partner Jeffry Bernstein at jbernstein@coblentzlaw.com or Real Estate Partner Barbara Milanovich at bam@coblentzlaw.com. Research analysis provided by Jessica N. Wilson and Heather Webb.

 

¹See Complaint to Invalidate Special Tax, Howard Jarvis Taxpayers Assn. v. City and County of San Francisco, Superior Court of California (filed August 3, 2018).
²Code § 6.2.
³Code § 952.3(a).
⁴ OFF. OF THE CONTROLLER AND OFF. OF THE TREAS. & TAX COLLECTOR, SAN FRANCISCO BUS. TAX REFORM:  ANNUAL REPORT FOR 2017  8 (Oct. 2017).
⁵See Chart 1.
⁶See Code §§ 956.1; 956.2.
⁷Code § 956.1(f).
⁸Code § 855(e).
⁹See City and County of San Francisco Treasurer & Tax Collector, Business Registration Fees for the Registration Year Ending June 30, 2018, http://sftreasurer.org/RG18Rates (last visited August 17, 2018).
¹⁰Code § 954.1(b).
¹¹Code § 954.1(c).
¹²Code § 952.3(c).
¹³Code § 952.3(d).
¹⁴Code § 952.3(e).
¹⁵Code § 952.3(d).
¹⁶Code § 954(d). The limits on rent increases must be imposed by San Francisco’s Residential Rent Stabilization and Arbitration Ordinance.
¹⁷Code § 952.3(f)(1) – (6); see also Code § 954(a).
¹⁸City and County of San Francisco Treasurer & Tax Collector, Gross Receipts and Payroll Expense, http://sftreasurer.org/2017GRPY.
¹⁹See San Francisco Ord. No. 26-17 (Feb. 10, 2017).
²⁰See City and County of San Francisco Treasurer & Tax Collector, Gross Receipts Tax and Payroll Expense Tax Quarterly Estimated Payments, http://sftreasurer.org/gross-receipts-tax-and-payroll-expense-tax-quarterly-estimated-tax-payments (last visited August 17, 2018).