Washington enacts capital gains tax

In detail

In general, effective January 1, 2022, ESSB 5096 creates a 7% tax on the recognized taxable gains from voluntarily selling or exchanging long-term capital assets, including amounts of stock received as part of an employee compensation plan. The tax applies to natural persons and to individuals who are beneficial owners of long-term capital assets held by a pass-through or other disregarded entity. This means that capital gains realized by pass-through entities and disregarded entities need to be reported by the owners of such entities as subject to the tax. The result is that Washington will tax long-term capital gains reported on an individual’s federal income tax return, subject to certain carve-outs and deductions listed below.

Observation: Affected taxpayers should consider how the new Washington capital gains tax works in conjunction with federal capital gains tax proposals under possible consideration by Congress. Additionally, it is assumed that the legislature specifically classified this tax as ‘an excise tax,’ likely due to the state’s constitutional prohibition against income taxes.

As passed, ESSB 5096 includes language prohibiting a potential voter referendum. Washington’s Constitution gives the public the right of referendum. This right, however, is limited if a law is necessary for the immediate preservation of several categories, including the public peace, health or safety, support of the state government and its existing public institutions. ESSB 5096 provides that the tax “is necessary for the support of the state government and its existing public institutions,” thus closing any referendum opportunity.

Carve-outs and deductions

ESSB 5096 contains several carve-outs from the measure of the new long term capital gains tax, including the sale or exchange of:

• Short-term capital gain assets;
• Real estate (land and fixtures affixed to land, including leasehold improvements);
• An interest in a privately held entity only to the extent that any long-term capital gain or loss from such sale or exchange is directly attributable to real estate owned directly by such entity;
• Assets held under certain retirement accounts and employee benefit plans;
• Assets under imminent threat of condemnation proceedings;
• Depreciable property under IRC Sec. 167(a)(1) or property that qualifies for expensing under IRC Sec. 179;
• Timber, timberland, or the receipt of capital gains as dividends and distributions from related real estate investment trusts;
• Goodwill from the sale of an auto dealership;
• Commercial fishing privileges; 
• Cattle, horses, or breeding livestock if more than 50% of the taxpayer’s gross income for the tax year, including from the sale or exchange of capital assets, is from farming or ranching;
• A qualified family-owned small business; and
• Up to $100,000 in charitable donations to one or more qualified organizations in excess of $250,000.

Observation: While there is an exemption for real estate when an interest in an entity is sold, that exemption only applies to real estate owned directly by the entity which was sold.

What is included in capital gains?

While Washington does not typically conform to the Internal Revenue Code, ESSB 5096 adopts the definition of ‘capital asset’ found in Section 1221. Consequently, the 7% rate generally applies to the capital gains amount reported on an individual’s federal income tax return, subject to the exclusions noted above.  

Note: There are some adjustments to the federal determination of taxable capital gains that may be applicable. 

ESSB 5096 defines ‘Washington capital gains’ as an individual’s adjusted capital gains allocated to Washington State, less a standard deduction of $250,000. In the case of spouses or domestic partners, the combined standard deduction is still limited to $250,000, regardless of whether they file joint or separate federal returns. The deduction will be annually adjusted for inflation.

Gains allocated to Washington

Long-term assets include both tangible and intangible personal property. If the capital asset is tangible personal property, the tax will apply if the property is located in Washington at the time of the sale or exchange. The tax also could apply to tangible personal property if: 

1. The property was located in Washington at any time during the current or immediately preceding taxable year; 
2. The taxpayer was a Washington resident at the time of the sale or exchange; and
3. The sale was not subject to income or excise tax on the adjusted capital gain by another taxing jurisdiction.

If the capital asset is intangible personal property, then the tax will apply if the taxpayer is domiciled in Washington at the time of sale or exchange. However, a credit is allowed when excise tax is legally imposed by another jurisdiction and the capital gains were included in Washington capital gains.

Resident test

Under ESSB 5096, whether an individual is a Washington ‘resident’ is bifurcated into two tests. The first test applies if an individual is domiciled in Washington during the entire tax year, unless the individual maintained no permanent place of abode in Washington and did not spend more than 30 days of the tax year in the state. 

The second test applies if an individual is not domiciled in Washington during the tax year, but maintained a place of abode and was physically present in Washington for more than half the tax year (at least 183 days).

Observation: Domicile is not a defined term in the new capital gains tax law. Taxpayers living in multiple states should consider whether they are considered domiciled for Washington purposes.

Qualified family-owned business

A deduction is provided for the sale of substantially all of a qualified family-owned small business. To qualify for the deduction:

• The owner of the business must have held a qualifying interest for at least 5 years immediately preceding the sale or transfer of the business;
• The owner of the business or their family member(s) materially participated in operating the business for at least five of the last 10 years, unless the sale or transfer was made to a qualifying heir; and
• The business had worldwide gross revenue of $10 million or less in the 12-month period preceding the sale or transfer of the business.

Criminal penalties

In addition to the standard civil penalties and interest for noncompliance, ESSB 5096 makes it a Class C felony to knowingly attempt to evade the tax. Additionally, an individual can be charged with a gross misdemeanor for knowingly failing to pay the tax, file returns, keep records, or supply the taxing authority with requested information.

Pending litigation

Since the bill was signed into law, two separate groups have filed lawsuits for declaratory and injunctive relief. Both lawsuits challenge the validity of the capital gains tax, alleging that the tax violates Article VII, Sections 1 and 2 of the Washington Constitution and the Commerce Clause of the US Constitution.