The Washington State Supreme Court ruled that a new state capital gains tax is constitutional as an “excise tax” under Washington law. The opinion, released March 24, 2023, surprisingly concludes that a tax on capital gains is not a tax on income (unconstitutional in Washington state) but is instead a “valid excise tax under Washington law.” This is due, in part, because:
“…taxpayers do not owe the capital gains tax merely by virtue of owning capital, like a property tax. Instead, the tax relates to the exercise of rights “in and to property”—namely, the power to sell or transfer capital assets—like an excise.”
This new opinion is novel and runs against long held federal and state precedent indicating capital gains are “income” and thus taxes on capital gains are an income tax.
Still, this new “excise tax” is now in effect and applies to applicable capital gains generated in 2022 forward, meaning effected taxpayers may need to make payments to Washington State by April 18, 2023.
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Background on Washington State Capital Gains Tax
On May 4, 2021, Washington State Governor Jay Inslee signed into law an “excise tax” on certain capital gains. Generally, this legislation imposed a 7% tax on the net annual amount of long-term gains from the sale or exchange of stocks, bonds, and other capital assets in excess of $250,000 (for both single and married filing joint filers).
The legislation stated this new revenue will be used to fund certain K-12 education, early learning, and childcare programs.
In response, several lawsuits challenged the validity of this new “excise tax” because the Washington state constitution bars an income tax, and a tax on capital gains is generally considered a tax on income under federal and state tax principles. These lawsuits (and related decisions) ultimately produced the Supreme Court decision.
Exemptions and Deduction
There are numerous exemptions and deductions to consider, meaning gain from the sale of certain capital assets is not subject to this new tax. Examples include gains from the sale of:
- Certain real property
- Interests in an entity if that entity holds certain real property
- Retirement account assets
- A taxpayer’s interest in a “qualified family-owned small business” (as defined in the legislation, but generally businesses with less than $10 million in annual revenue)
Long-term capital gains or losses derived from the sale of intangible personal property are allocated to Washington state and subject to the tax if the taxpayer was domiciled in Washington at the time the sale or exchange occurred. But gain from the sale of goodwill associated with certain auto dealerships is exempt.
Gain from the sale of tangible personal property is allocated to Washington state if the property is located in the state. Gain from the sale of tangible personal property not located in Washington state at the time of sale can still be allocated to Washington state if the property was located in Washington state at any time during the taxable year, the taxpayer was a Washington state resident at the time of the sale or exchange, and the gain is not subject to tax from another taxing jurisdiction. A credit is allowed against the B&O tax for any excise tax owed from the same sale.
Taxpayers Subject to the New Tax
Individual Washington state residents are generally subject to this new tax. This includes individuals allocated a share of long-term capital gain from a pass-through or disregarded entity, such as a partnership, S corporation, grantor trust, or limited liability company taxed as one of the former. Nonresident taxpayers can also be subject to this tax for sales of tangible personal property allocated to Washington state. Taxpayers owing tax under this new legislation will be subject to a new tax filing regime with the Washington State Department of Revenue (WA DOR).
Effective as of January 1, 2022
This new tax on capital gains is effective as of January 1, 2022, with 100% of any payments due on or before April 18, 2023 (even if a filing extension is requested). Many affected taxpayers may be surprised that they now have a Washington State tax liability on account of capital gains recognized in 2022.
Some of these taxpayers have already filed their federal tax returns and thus may need to examine their reported capital gains to determine if they owe additional tax to Washington state. Taxpayers owing this tax are required to register online first before making payments and the WA DOR administers a website providing further information. Penalties (up to 29%) and interest can apply for late payments so effected taxpayers should immediately consult their tax advisor to advise on next steps.