Washington’s New Capital Gains Tax
On May 4, 2021, Washington Governor Jay Inslee signed Senate Bill 5096 into law, imposing a new tax on capital gains for Washingtonians.
Beginning January 1, 2022, a flat rate of 7% will apply to a Washington resident’s net long-term capital gains in excess of a standard deduction and various exemptions. The standard deduction is $250,000 for each individual or married couples. In other words, for a married couple, the deduction is $125,000 per spouse. This means that the first $250,000 of capital gains are excluded from the new Washington tax.
Some transactions that normally give rise to long-term capital gains (the type of capital gains to which this tax applies) are specifically excluded from the tax. These excluded transactions include certain real estate transactions, sales of assets in a retirement account, transfer of assets as part of a condemnation proceeding, sale of livestock related to farming or ranching, sale of certain types of property used in a trade or business, sale of capital assets used in a trade or business by a sole proprietorship, sale of timber and timberlands, sale of commercial fishing privileges, and goodwill received from the sale of a franchised auto dealership.
There are a few notable deductions against the new capital gains tax that are available. Most notably, a deduction is available for the sale of all or substantially all of a qualified family-owned small business. What is a “qualified family-owned small business”? The new law defines it as a business where: (1) the owner of the business held a qualifying interest for at least five years before the sale; (2) the owner or his/her family member materially participated in operating the business for at least five of the ten years preceding the sale; and (3) the business had gross revenue of under $10 million in the 12-month period preceding the sale or transfer of the business. There is also a deduction for capital gains donated to certain qualified organizations; however, the deduction may not exceed $100,000 per year.
Despite making its way through the legislative process and being signed by Gov. Inslee, the law’s fate remains uncertain. Many Washington residents are already asking whether this new law is unconstitutional. The answer is that we will not know until the Washington Supreme Court weighs in but several groups believe its constitutionality to be shaky and lawsuits are already filed. Washington’s own state constitution provides that all taxes on property ownership must be uniformly applied and cannot exceed an annual rate of 1%. In previous court rulings, the Washington Supreme Court has struck down various forms of income taxes. There are, however, other cases where taxes on the use, enjoyment, or privilege of engaging in an act (i.e., not directly tied to ownership) are constitutional and taxable (e.g. Washington’s real estate excise tax or the B&O tax). The new capital gains tax is over the 1% limitation and given the disparate standard deduction and exemptions, the courts will likely debate on whether this can be considered “uniformly applied.” The heart of the debate, however, is the issue of whether this capital gains tax is a tax on income or an excise tax on property, and it is difficult to predict how the Washington Supreme Court will answer that question.
Some recurring questions being asked about the new capital gains law are whether it applies to business entities and trusts and how to plan for this new tax. The new tax would not apply to corporations or some trusts, but individuals allocated capital gains from pass-through entities and certain types of trusts would be subject to the capital gains tax. There are opportunities to minimize the tax by positioning yourself to take advantage of any exemptions, qualifying for the family-owned small business deduction, changing domicile before the capital gains realization event, and structuring transactions to push the recognition of capital gains prior to January 1, 2022.
If you have any questions or would like to discuss planning opportunities, please do not hesitate to contact any member of Helsell Fetterman’s Tax Department.