United States: Capital Gains Tax Ruled to be an Excise Tax on the Privilege of Selling Assets — But There is a Silver Lining

In a 7-2 decision, the Washington Supreme Court has ruled that Washington’s capital gains tax is an excise tax and therefore not subject to the Uniformity Clause of the Washington state constitution. In Quinn v. Washington, Wash., No. 100769-8, 3/24/23, the Court accepted the state’s argument that the tax is imposed “on the sale or exchange of capital assets, not on capital assets or gains themselves.” The Court also rejected the plaintiffs’ other constitutional arguments finding no violation of either the State constitution’s Privileges and Immunities Clause or the Commerce Clause of the U.S. Constitution. The two dissenting justices agreed with the Superior Court that the capital gains tax is an income tax, not an excise tax, and that it violates the Uniformity Clause of the Washington Constitution.

Income Tax v. Excise Tax

The Superior Court had ruled that a tax based on net income reported on an individual’s federal income tax is a tax on income, not an excise tax on the privilege of selling property. The Washington Supreme Court, however, was unpersuaded by either the Superior Court’s reliance on Washington court cases logic and the U.S. Supreme Court’s caution that “labeling [a tax] a tax on ’business activity’ does not permit us to forgo examination of the actual tax base … ‘A tax on sleeping measured by the number of pair of shoes you have in your closet is a tax on shoes.’” Trinova Corp. v. Michigan Dep’t of Treasury, 498 U.S. 358, 374 (1991).

Silver Lining

There is a silver lining to the Court’s analysis. By concluding that a tax on capital gains is an excise tax on the privilege of owning and selling assets, and not overturning the Court’s prior decisions holding that income is property subject to the state constitution’s uniformity and levy limitations, the Court made it much harder for the Legislature to adopt a broad-based income tax. Instead, we now expect there likely will be pressure on the Washington Legislature to begin eroding the $250,000 exemption amount and/or increasing the tax rate beyond 7%.

Retroactive Effect

Because the Court found that the Capital Gains Tax is a valid excise tax, rather than an income tax, the tax became effective in January 2022. The tax on capital gains realized in calendar year 2022 is due April 18, 2023; as with federal income taxes, an extension for filing the tax return only extends the return filing date, not the tax due date. As the majority noted in its opinion, the State estimates that approximately 7,000 Washingtonians will be subject to the tax in its first year and is expected to raise over $500 million per year (currently earmarked for childcare and education though that can be changed).

Basics of the Tax

The tax is imposed on individuals who have long term capital gains, including gains from pass through entities. The tax rate is 7% on Washington taxable long term capital gains exceeding $250,000 and zero percent on gains under $250,000. The determination of Washington taxable capital gains begins with gains reported on the individual’s federal income tax return. Gains associated with intangible assets are assigned to Washington based on domicile. Gains associated with tangible assets are assigned to Washington if either (a) the property was located in Washington at the time of sale, regardless of whether the beneficial owner was a Washington resident or domiciliary at the time of sale or (b) the owner was a Washington resident at the time of sale and the property had been in Washington within a year of the date of sale. Gains associated with real estate, certain retirement accounts, and certain other assets are exempt. Anticipating the possibility of a Washington Supreme Court decision upholding the tax, the Department of Revenue has created a webpage dedicated to the capital gains tax.

Planning Opportunity

Many clients have already contacted Lane Powell about the impact of the capital gains tax, including the possibility of redomiciling to other states, such as prior to the sale of their business(es) or exercising stock options. We prefer to help clients come to Washington to create wealth here. But the ability to relocate in a sense makes this tax voluntary and, in the famous words of Justice Learned Hand:

“Anyone may arrange his affairs so that his taxes shall be as low as possible; he is not bound to choose that pattern which best pays the treasury. There is not even a patriotic duty to increase one's taxes. Over and over again the Courts have said that there is nothing sinister in so arranging affairs as to keep taxes as low as possible. Everyone does it, rich and poor alike and all do right, for nobody owes any public duty to pay more than the law demands.”

Further Review

With respect to the state constitutional issues, the Supreme Court’s decision represents the final word, although the parties have the right to request reconsideration of the decision. Additionally, the taxpayers could appeal the dormant Commerce Clause issues to the U.S. Supreme Court.