Washington's legislature passed a new capital gains tax in April (Engrossed Substitute S.B. 5096), which was signed by Governor Inslee on May 4, 2021. The new law will take effect January 1, 2022.
The bill is part of a multi-year push by the legislature to "rebalance" a state tax system that it calls "the most regressive in the nation" in Section 1 of the bill "by increasing taxes on the wealthiest residents." Previously in 2019, the legislature enacted a new set of graduated tax rates for the real estate excise tax on transfers of real estate as well as a new, extraordinary rate of business and occupation (B&O) tax on the largest multistate financial institutions. (The latter tax was invalidated by a trial court as an unlawful discrimination against interstate commerce. An appeal is pending in the Washington Supreme Court.)
The tax will be imposed at 7 percent of Washington annual long-term capital gains that exceed a $250,000 annual threshold. State estimates for who will pay the tax are under one-quarter of 1 percent of the population. The tax does not apply to legal entities themselves, and the bill is structured to try to avoid taxing gains on the sale of assets that are physically located outside Washington. The amount of tax is based on what taxpayers report as their net long-term capital gain for federal income tax purposes, with adjustments.
Who Are the Taxpayers?
Taxpayers are individual persons only, not entities.
Notwithstanding the intent to impose greater taxes on the state's "wealthiest residents," nonresidents of Washington are also subject to the tax if they sell tangible personal property located in Washington at the time of sale. But only individuals domiciled in Washington are subject to tax on the sale of intangible investments.
Individual taxpayers, however, are deemed to be taxable on the sale of property held "beneficially" through pass-through and disregarded entities, as understood for federal income tax purposes, or through certain trust arrangements, to the extent of their ownership interest in the entity or trust. (For further information about how trust assets are to be taxed, see the companion alert prepared by DWT's Trusts and Estates group.) This is consistent with the federal income tax treatment of pass-through and disregarded entities, which typically are not subject to an entity-level tax.1
Ironically, this scope of tax encourages the "wealthiest residents" to arrange for asset ownership through C corporations (but see the evasion penalty section below). It is, however, a balancing act: while use of a C corporation to mitigate the state tax currently may be a planning opportunity, given the low corporate federal income tax rate, a C corporation's income is taxed twice—once to the corporation and again when dividends are passed to shareholders.
The cost of this structure from a federal income tax perspective could outweigh the Washington tax benefit if the federal corporate income tax rate increases, as currently proposed by the Biden Administration.
How Is the Taxable Gain Calculated, and How Is the $250,000 Threshold Applied?
The tax base is called "Washington capital gains." It is equal to an individual's "adjusted capital gain" less $250,000 per annual return filed, with some other deductions described below. Because married couples who file a joint federal return are also required to file the new joint state capital gains return, there is some ambiguity around whether joint-return filers will have just one $250,000 threshold, while spouses who file separate federal returns will each have a $250,000 exclusion.
The calculation of the "adjusted capital gain" starts with the individual's net federal long-term capital gain for the year. It is then modified to take into account gains and losses on the sale of assets that are excluded from the scope of the tax, whether by exemption or because they are not deemed Washington capital assets. Before outlining the details of the calculation, we list the exemptions and the scope of taxable assets.
What Assets Are Exempt From the Tax?
The act exempts the following classes of assets:
- All real estate, both land and improvements.
- An interest in a privately held entity to the extent the gain or loss from the sale of the interest is "directly attributable to the real estate owned directly by such entity." Sales of interests in entities that own other real-estate investment vehicles will not qualify for this exemption.
- Timber, timberland, and other timber transactions that qualify for federal capital gains treatment under IRC § 631(a) or (b),2 and dividends and distributions received from REITs that are proceeds of the sale of timber or timberland.
- Assets held in retirement accounts.
- Assets taken through condemnation proceedings, or sold under imminent threat of condemnation.
- Cattle, horses, and other livestock sold by a person who, in the year of sale, received a majority of the person's gross income from farming or ranching (including the proceeds of capital-asset sales).
- Certain commercial fishing privileges.
- Property used in a trade or business that is depreciable under IRC § 167(a)(1) or expensible under IRC § 179. Business sole proprietors and pass-through entities will track their federal tax treatment of such property into the Washington capital gains tax.
- Goodwill associated with franchised auto dealerships. (Purchased goodwill associated with most other businesses should be excluded from the Washington tax by reason of the exclusion for property that is depreciable under IRC § 167.)
What Assets Are Subject to Tax?
What's left? If subject to federal long-term capital gain treatment, the following:
- Tangible personal property located in Washington at the time of sale and not exempt.
- Tangible personal property located in other jurisdictions, and not exempt, if (1) it had been located in Washington sometime earlier in the current year or sometime in the prior year, (2) the seller was a Washington resident at the time of sale, and (3) the seller was not subject to another state's income or excise tax on the gain.
- An individual is a Washington resident if:
- The individual is domiciled in Washington, unless the individual has no permanent "abode" in the state and meets certain other requirements.
- The individual is not domiciled in Washington but had a Washington "place of abode" and was present in the state at least 183 days in the year of sale.
- But a partial-year rule applies; for example, a person who sold taxable assets in January as a bona fide Oregon resident under these rules, and then relocated to Washington for domicile purposes in July, would not be taxable on the gain from the January sale.
- Intangible personal property, and not otherwise exempt, if sold (directly or beneficially) by a person with a Washington domicile at the time of sale.
- The act does not define "domicile." This part of the tax does not rely on the definition of "resident."
- All interests in legal entities and any type of investment security or financial instrument are included, except as to (1) gains associated with real estate assets an entity may hold, to the extent discussed above under "Exemptions," and (2) assets in retirement accounts.
- Intellectual property rights are included.
Calculating the Taxable Gain and the Tax
- 1. Start with the federal net long-term capital gain on the federal return.3
- 2. Add in the following amounts, if included in calculating federal net long-term capital gain:
- Long-term capital losses on assets that are exempt from the tax (such as real estate);
- Long-term capital losses on assets that are not allocated to Washington (such as intangible assets sold in the part of the year before the individual became domiciled in Washington, and most tangible personal property not located in Washington at the time of sale); and
- Any loss carryforwards attributable to assets that are not allocated to Washington (same examples as in the prior bullet).
- 3. Subtract out the following amounts, if included in calculating federal net long-term capital gain:
- Long-term capital gains on assets that are exempt from the tax; and
- Long-term capital gains on assets that are not allocated to Washington.
- 4. Subtract any available deduction for the sale of family-owned small business assets (described under the next heading).
- 5. Subtract $250,000 per "individual" taxpayer (but note again the ambiguity whether married couples filing jointly get one or two $250,000 deductions). This amount is subject to an inflation index.
- 6. Subtract any qualifying "excess" charitable contributions to Washington-managed nonprofit organizations. Complicated! If you donate at least $250,000 in the year to one or more Washington-managed 501(c)(3) organizations, you may deduct additional donations to the same types of organizations up to $100,000. No additional "excess" contributions may be carried forward or back. The inflation index also applies to these amounts.
- 7. Multiply the remaining amount by 7 percent.
Who Can Claim the Family-Owned Small Business Deduction?
The deduction does not apply to any business that had more than $10,000,000 in gross worldwide receipts in the 12 months immediately preceding the sale. The inflation index applies to this amount.
To qualify for the exemption, the sale must entail substantially all the assets of the business, or substantially all the individual taxpayer's interest in the business. "Substantially all" means 90 percent or more. For this test, "assets" includes all the business's real and personal property, even if otherwise exempt from tax.
The qualifying "family" characteristics are:
- The individual taxpayer must have held an interest in the business for at least five years immediately before the sale, and it must have been a "qualifying interest," namely:
- The individual owned the business as a sole proprietor, or
- The individual and/or members of the individual's "family" owned at least 50 percent of the business, or
- The individual and/or members of the individual's "family" owned at least 30 percent of the business, and either:
- 70 percent of the interests in the business were owned directly or indirectly by members of two families; or
- 90 percent of the interests in the business were owned directly or indirectly by members of three families.
- "Members of the family" of an individual include the individual's ancestors, spouse or registered domestic partner (RDP), lineal descendants and lineal descendants of the spouse or RDP, siblings and their lineal descendants and the spouses and RDPs of any of them. Lineal descendants include legally adopted children. (This definition piggybacks on the definition in the Washington estate tax provisions for favorable treatment of family farm assets.)
- The individual taxpayer or members of the family must have "materially participated" in the operation of the business for at least five of the 10 years immediately before the sale, unless the sale was to another member of the family.
- In other words, the five-year ownership period is mandatory for all qualifying sales, including a sale to a member of the family, but the five-out-of-10-year material-participation period is mandatory only for sales outside the family.
How to Calculate the Family-Owned Small Business Deduction?
The deduction is limited to gains that would otherwise be included in Washington capital gains. This means starting with the total net long-term capital gain from the family-owned business sale and going through the same calculation in Steps 1 through 4 above, in order to strip out gains and losses attributable to exempt assets and to strip out gains and losses attributable to non-Washington assets.
What Other Adjustments Are There?
Credit for Other States' Taxes
Taxpayers may claim a credit for lawful income and excise taxes owed to other jurisdictions on capital gains included within the individual's Washington capital gains. For example, an individual who qualifies as a resident in California even with a domicile in Washington might pay California income tax on the gain from investment assets, and may be able to credit the California tax against the Washington tax (but not below zero).
There is no carryforward or carryback for unused credits.
No Carryforward for Margin of Gains Below $250,000
If an individual's adjusted capital gains are less than $250,000 for a year, and the resulting Washington capital gain is less than zero, the difference is not carried forward to any other year.
Federal Loss Carryforwards
If an individual's federal net long-term capital gain amount includes loss carryforwards that are directly attributable to losses on assets allocated to Washington sold in a prior year, they are included in the computation of Washington capital gains. Under federal income tax rules, excess capital loss can be carried forward indefinitely until it is used, subject to a number of limitations.
Federal Loss Carrybacks
No federal loss carrybacks are included in the calculation of Washington capital gains for any year. In other words, no amended returns are permitted on account solely of a federal loss carryback.
Later Federal Adjustments
Nothing in the act expressly requires an amended Washington capital gains tax return if the IRS later makes adjustments to the individual's federal net long-term capital gain for a year. The Department of Revenue has authority to audit the Washington returns for a period up to December 31 of the fourth full year following the due date of the Washington return.
Coordination With B&O and Other Taxes
The act provides a credit under the B&O tax for any B&O tax otherwise due on a sale or exchange that is taxed under the capital gains tax. For example, "gross income of the business" subject to B&O tax includes "gains realized from trading in stocks, bonds and other evidences of indebtedness."
It is possible that investment gains would be captured by both taxes, and a credit is supplied to prevent B&O tax in that case. However, real estate excise tax can be imposed on the sale of a controlling interest of an entity that indirectly holds Washington real estate at effective rates close to 3.5 percent of the gross property value, and the capital gains tax can apply to the gain on the sale as well.
Returns and Payment
For individuals who owe tax, returns are due on the same schedule as federal tax returns, including extensions. Taxpayers must also provide a copy of their federal return to the Washington Department of Revenue.
Payment is required upon the original due date of the return, regardless of extensions. Payment must be made electronically unless the department grants a waiver.
Spouses must file Washington returns in the same manner as their federal return, whether joint or separate. State registered domestic partners who file a joint federal return may file separate state returns. Spouses and RDPs who file joint returns are jointly and severally liable for the tax imposed on either of them, with certain exceptions.
A late-filing penalty may be imposed for delinquent returns at 5 percent per month, to a maximum of 25 percent of the tax due.
Other penalties applicable to excise taxes also apply to the capital gains tax, including an underpayment penalty of up to 29 percent and an assessment penalty of another 5 percent if the department assesses additional tax and the underreporting was 20 percent or more of the tax due.
In addition, a felony penalty is imposed for knowingly attempting to evade the tax. "Evasion" is not defined in this act, but the department may rely on factors elsewhere in the excise tax statutes, such as structuring transactions for no economic purpose other than the avoidance of tax.
The act also imposes a misdemeanor penalty for knowingly failing to file a return that is due, or to pay tax due, or to keep records or supply information as required by the act or cross-referenced administrative provisions.
Constitutional and Ballot Challenges to the Tax
At least one suit has already been filed in Douglas County by the Freedom Foundation, alleging that the capital gains tax is a species of "income tax" and, as such, it violates the Washington constitution's requirement that "income taxes" and other forms of property tax be levied equally on the same kind of property. Given the general deduction of $250,000 as well as other limitations on the scope of the tax, the capital gains tax would fail this equality requirement if it applies. More suits are very likely coming.
The state will no doubt defend the tax as a proper excise and will point to the facts that the B&O tax already can apply to investment gains and the real estate excise tax applies to the sale of real property investments, and the constitutionality of these taxes has been upheld.
Some specific elements of the tax that cross state boundaries may be vulnerable to attack under the federal constitution's commerce clause. The act provides that the invalidity of any specific provision does not affect the remainder of the act.
One or more ballot challenges are also expected. The legislature included a proviso that the tax is "necessary for the support of the state government and its existing public institutions." The intent is to make a signature drive for a referendum more difficult, though the validity of an voter initiative is not undermined by the phrase. An initiative requires twice the number of signatures and has tighter deadlines.
1 For instance, in the case of a partnership (including an LLC treated as a partnership for federal income tax purposes) or S corporation, gain from the sale of property passes through, and is taxed to, the owners who report their respective allocable shares of such gain on their personal tax returns. Note, unlike an S corporation which requires a pro rata allocation of capital gain among the shareholders based on stock ownership, a partner's allocable share of a partnership's capital gain from the sale of property is dictated by the applicable partnership agreement or limited liability company agreement, as the case may be, which in theory could specially allocate such gain to particular partners, subject to IRC § 704(b).
2 In effect, these are elections that permit the portion of a taxpayer's gain attributable to appreciation in the value of timber to qualify as capital gain, even if the timber is held for sale to customers.
3 This is the excess of long-term capital gain over long-term capital loss for the year reportable for federal income tax purposes. Under the federal income tax rules, capital gain or loss is considered long term if resulting from the taxable disposition of a capital asset held for more than one year. Note that, to the extent gain or loss from the sale of a long-term capital asset is not taken into account in calculating federal net long-term capital gain, such as gain from the sale of "qualified small business stock" excluded from federal gross income under IRC § 1202, the tax does not apply. However, certain federal adjustments, such as relating to tax benefits attributable to qualified opportunity zones, are disregarded in calculating the tax.