Why a popular tax break that helped Philadelphia’s small businesses may be going away

Tens of thousands of companies that are currently exempt from Philadelphia’s business tax would have to start paying it under a provision of Mayor Cherelle L. Parker’s city budget proposal that was prompted by a lawsuit challenging the legality of a popular tax break.

Since 2015, Philadelphia has effectively exempted companies that make less than $100,000 from business in the city from paying the business income and receipts tax, or BIRT, thanks to a tax break created by City Council and known as the exclusion. Since the onset of the pandemic, the city hasn’t even required those businesses to file tax returns.

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That has saved Philadelphia’s smallest homegrown businesses — as well as firms based elsewhere with minimal commercial activity in the city — from the headache of having to deal with the much-maligned BIRT, an unusually complicated business tax for a municipal government.

But Parker is now moving to repeal the exclusion because the city Law Department does not believe it will prevail against a lawsuit challenging the tax break’s constitutionality that was brought by the Massachusetts-based medical device manufacturer Zoll Medical Corp., which does business in Philadelphia.

An attorney for Zoll declined to comment.

Getting rid of the exclusion would be a step backward in the city’s efforts to help small-business owners regardless of when it happened. But it’s particularly painful that the change could take effect this year, because city leaders are attempting to launch a major reform of the tax code that they say is meant to make BIRT less burdensome for smaller firms.

Here’s what you need to know about why the tax break is going away and what it means for Philly’s businesses.

For the last decade, all businesses have been allowed to exclude their first $100,000 in revenue generated in Philadelphia when calculating their BIRT liability.

For businesses that make less than $100,000 in the city, that meant they owed nothing. For firms making more than that, they were able to deduct that amount before calculating what they owed, similar to how the federal income tax’s standard deduction works.

The exclusion, which was championed by former Councilmembers Maria Quiñones Sánchez and William J. Green IV, was widely applauded as a boon to small business. A 2024 Pew study that looked at tax return data from 2017 to 2021 found that about three-quarters of businesses had no BIRT liability thanks to the exclusion.

The report also found that the exclusion was a major reason why BIRT is a progressive tax, meaning it has a higher burden on firms that make more money than it does on companies with less income.

But there have long been concerns about whether the exclusion is legal under the state constitution, and those concerns are coming to the surface now.

Parker’s decision to ask Council to repeal the BIRT exclusion for next year was a begrudging one.

“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 on Thursday. “But we are not going to turn our backs on these businesses.”

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Zoll Medical Corp. last year sued the city, raising two issues with BIRT: that the formula the city uses to calculate a company’s net income is unfair, and that the $100,000 exclusion is not allowed under the Pennsylvania Constitution’s uniformity clause, which requires all taxpayers be charged the same rate for any state or local tax.

The state uniformity clause is the reason Philadelphia cannot charge people who make more money a higher rate for the wage tax, and why it can’t apply different real estate tax rates to residential and commercial property owners.

Zoll is contending that the clause should also prohibit the city from exempting businesses that make under $100,000 from paying BIRT while charging all other firms 5.81% of business’ net income or profits and 0.1415% of their gross revenue.

The city has denied all claims, arguing that the exclusion conforms with the uniformity clause because it allows all taxpayers, including Zoll, to deduct $100,000 from their taxable revenue, not just those who make less than that amount.

The case is pending in Common Pleas Court. But Parker said she was frustrated the city has to choose whether to continue to enforce a law with significant legal concerns.

“Do I know what will happen? Absolutely not,” Parker said. “But the fact that Philadelphia is in this position bothers me.”

Not everyone agrees the city should roll over so quickly. Quiñones Sánchez said she thinks the city would prevail if it fought it out in court.

“I don’t buy it,” Quiñones Sánchez said. “Let’s go and protect it. Let’s defend it.”

Quiñones Sánchez noted that no one questions the legality of the real estate tax’s homestead exemption, which allows homeowners to cut $100,000 off the assessed value of their properties. Similar to how the BIRT exclusion effectively eliminates the tax bills of firms making less than $100,000, the homestead exemption effectively allows homeowners whose properties are worth less than $100,000 to pay nothing.

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The homestead exemption, however, is explicitly authorized in state law, while the BIRT exclusion is not.

City Solicitor Renee Garcia said that while the exclusion’s legality may have been debatable in the past, recent court decisions have made it more likely that the tax break would be deemed unconstitutional.

“When the BIRT exemption was adopted, some case law suggested that an income threshold like the $100,000 exemption would be defensible,” City Solicitor Renee Garcia said in a statement. “In recent years, the Pennsylvania Supreme Court has issued a series of cases that made it very clear the BIRT exemption is at risk. It is in City’s best legal interest to sunset the provision because the law has been clarified.”

The Pennsylvania Supreme Court, in a 2017 ruling in Nextel Communications vs. the Commonwealth of Pennsylvania, considered the constitutionality of a state law that placed a $3 million cap on how much net loss businesses could carry over from year to year to reduce their state business tax liability. The justices found that the law violated the uniformity clause because — much like the BIRT exclusion — it is a flat-rate tax break that effectively created two categories of taxpayers based on income or loss levels.

If Parker’s plans proceed, all Philadelphia businesses will have to file and pay the BIRT starting this year. The first tax returns without the exemption would be due April 15, 2026.

The Pew study found that an average of 35,500 businesses had BIRT tax liabilities from 2017 to 2021. Removing the exclusion could mean that more than 120,000 firms with business in Philadelphia will have to pay the tax next year.

To ease the burden, Parker included in her budget proposal a $30 million fund to provide grants and technical assistance for businesses navigating how to file their BIRT returns.

Parker has also proposed lowering BIRT’s two tax rates in the next city budget, which takes effect July 1. Under her proposal, the tax on net income would be 5.71% and the gross receipts rate would go from 0.1415% to 0.141%. Those cuts would cost the city $9.2 million next year.

The mayor said she hopes the city will continue to reduce the tax over the next 15 years, eventually eliminating the gross receipts levy entirely while cutting the net income tax in half.

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The Tax Reform Commission, which was convened last year by Council President Kenyatta Johnson, has recommended Parker and Council first prioritize eliminating the net income portion of BIRT before circling back to do away with gross receipts as well. But the administration chose to push for gross receipts cuts immediately due to the disproportionate impact that the exclusion will have on small businesses, Finance Director Rob Dubow said.

“If you look at the gross receipts, we think it has a bigger impact on smaller businesses, like corner stores and grocery stores,” Dubow said. “And so with the [exclusion] going away, that would also have a bigger impact on smaller businesses, which made reducing the gross receipts tax more important.”

Staff writer Ryan W. Briggs contributed to this article.

This story has been updated with additional comment from City Solicitor Renee Garcia.