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Washington Capital Gains Tax
Supreme Court of the State of Washington upholds state’s 7% tax on
long-term capital gains, starting from January 1, 2022
On March 24, 2023, the Supreme Court of the State of Washington issued its opinion in Quinn v. State of Washington, reversing the lower court and upholding the Washington state capital gains tax (codified at RCW 82.87). Previously, on March 1, 2022, the Superior Court of Douglas County had ruled that Washington’s capital gains tax should be classified as a property tax on income, and therefore was unconstitutional based on the limitations on property taxes that appear in the Washington State Constitution. The Washington Supreme Court reversed this result and held that the Washington capital gains tax is a valid excise tax that is applied to the sale or exchange of certain capital assets.
The Quinn v. State decision will have a significant impact on M&A and other major transactions involving Washington residents. The Washington Department of Revenue (“DOR”) has yet to issue regulations or other significant guidance to fill out details of the new tax regime. But, we expect supporting details to be released in the near future. In the meantime, the DOR will have its hands full in managing the new tax, starting in mid-April of 2023.
Below is a list of several key points related to the Washington capital gains tax, along with observations about the effect of this tax in M&A transactions.
- When does the capital gains tax apply? The new capital gains tax applies starting in 2022. Thus, sale and exchange transactions that closed on or after January 1, 2022 are potentially subject to this tax, and individual taxpayers will need to report these capital gains with their 2022 federal income tax return on or before April 18, 2023. Capital gain transactions that close in 2023 will be reported and subject to tax on or before April 15, 2024. The DOR has announced on its website that it will respect installment sale rules. Thus, installment sales that closed prior to January 1, 2022 are not subject to the tax, but installment sales closing on or after January 1, 2022 will be subject to the tax as each payment is reported under the installment method.
- How is the Washington capital gains tax calculated? The tax equals 7% multiplied by a taxpayer’s “Washington capital gains.” The term Washington capital gains refers to the taxpayer’s federal net long-term capital gain as reportable on his or her federal income tax return, as adjusted for certain Washington deductions and exemptions. The key deduction is a $250,000 base deduction (where the same amount applies for both single or married individuals). The $250,000 deduction is adjusted each year based on the consumer price index for the Seattle area.
- What is a capital gain? The Washington capital gains tax adopts the federal definition of “capital asset” when determining the taxable gain from a sale or transfer of the asset. So, the sale of corporate stock and other investment assets, if appreciated, will generate a capital gain under Washington law. In addition, a “Washington capital gain” includes gains from the sale of property used in a trade or business that is eligible for long-term capital gain reporting for federal tax purposes– e.g., machinery, vehicles, intangible property, goodwill, patents and various other favored assets (such as certain agricultural products). Any other asset that is afforded long-term capital gain treatment under the federal tax code is also included in the Washington capital gain definition.
- Who pays it? Individuals owe the tax. Business entities and trusts are not liable for it.
Allocation of long-term capital gains to Washington. There are two rules:
- Intangible property rule. Gain from the sale of intangible personal property (such as stock, including closely held stock, bonds or goodwill) is allocated to Washington if the individual is domiciled in Washington at the time of the sale. Domicile is not defined in the statute, but in general it is the place at which a person has been physically present and regards as such person’s true home, and to where such person intends to return even though he or she may be residing elsewhere. In certain cases, a person can establish domicile in a location outside of Washington and not be subject to the capital gain tax on sales occurring after domicile has been established in the new location. Whether a person has established domicile in a new location is shown by many factors which bear on such person’s true intent.
- Tangible personal property rule. If the property in question is tangible personal property (such as art or collectibles), then gain from a sale is allocated to Washington if the tangible personal property was located in Washington at the time of the sale. Or, if the property was not located in Washington at the time of the sale, gain is still allocated to Washington if (1) the property had been located in Washington during the year of sale or the previous year, (2) the individual was a Washington resident at the time of the sale, and (3) the sale was not subject to an income or excise tax of another jurisdiction.
Real Estate Transactions.
- Do I owe Washington capital gains tax when I sell real estate? Generally, no, subject to a caveat for sales of entities that own real estate. (See #8 below). Under the general rule, the tax does not apply to the sale or exchange of real estate, regardless of how long the property was owned, whether the seller occupied the property, where the property is located (in Washington or outside of Washington), or what type of property it is (commercial or residential).
- Flow-Through and Disregarded Entities – a limited look-thru rule. If an individual sells stock in a private company, or an interest in an LLC or partnership, and the company or partnership holds real estate, the new statute applies a look-through rule to permit an exemption for long-term capital gain attributed to the real estate. There are special reporting requirements to support the claimed value of the exempt real estate. However, as currently drafted, this exemption rule requires the entity to “directly own” the underlying real estate. One uncertainty is whether this exemption (or any other exemption) will apply to exempt long-term capital gains when a resident sells stock or an LLC/partnership interest in a holding company, where that holding company owns one or more subsidiary entities that own real property.
- Qualified family-owned small business deduction. A deduction is available for taxpayers who sell their qualified family owned small business (“QSFOB”)—meaning that a taxpayer may deduct from his or her Washington capital gains the amount of capital gains derived from the sale of a QSFOB. In general, to qualify for this deduction: (1) a taxpayer must sell substantially all (at least 90%) of the QSFOB’s assets or interests therein; (2) the QSFOB had $10,000,000 or less in worldwide gross revenue (indexed for inflation) during the 12 months preceding the sale; and (3) the taxpayer materially participated in the QSFOB for at least 5 of the preceding 10 years. In addition, at least 50% QSFOB must be owned by members of the taxpayer’s family. However, if less than 50% but 30% or more of the QSFOB is owned by the taxpayer and taxpayer’s family, then the taxpayer may qualify for this deduction if: (1) 70% is owned by members of two families; or (2) 90% owned by members of three families.
- Other Exemptions. The following items are generally exempt from the Washington capital gains tax: (1) real estate (but see #8 above); (2) retirement savings accounts; (3) cattle, horses, and other livestock sold by a taxpayer who, in the year of sale, received a majority of gross income from farming or ranching; (4) depreciable or expensed business assets under Internal Revenue Code Sections 167 or 179; (5) certain commercial fishing privileges; and (6) timber, timberland, or the receipt of Washington capital gains as dividends and distributions from real estate investment trusts derived from gains from the sale or exchange of timber and timberland.
Observations. The effect of the new Washington capital gains tax on M&A deals.
- M&A Closings – Net Tax Effect. Mid-market M&A deals in the Pacific Northwest commonly involve transactions structured as asset sales for federal income tax purposes. For Washington-resident sellers, those deals typically resulted in an effective tax rate in the range of 20-25%, comprising a 20% federal capital gains tax and often some additional ordinary income and transactional taxes. The new Washington capital gains tax will increase the effective tax rate on many deals to a 27% baseline rate, and probably around 27-30% once other taxes are included.
- A significant uncertainty – flow-thru entities and tiered structures. Deal makers and other practitioners should be wary about transactions involving flow-thru entities or tiered structures – especially with real estate and other exempt assets. Federal tax law applies well-known look-thru and deemed transaction rules that afford taxpayers a high degree of certainty when structuring sales and redemptions of equity in partnerships, LLCs and S-Corporations. Washington State has very little, if any, history in applying these kinds of rules. On its face, new RCW 82.87 is much more limited than federal tax law when it comes to flow-thru entities. Deal structures involving flow-thru entities should be carefully reviewed against RCW 82.87 and future guidance, especially in situations where an exemption is intended to apply.
- Family owned and small business deduction – timing is important. The QSFOB deduction provides a complete deduction of all gains if a taxpayer qualifies, and provides no deduction if a taxpayer does not. This means that in close-call situations (i.e., where the 12-month gross revenue is just under the $10 million figure, as adjusted for inflation), it will be critical to close a sale prior to hitting the $10 million revenue threshold. Also, this exception is not limited to traditional single family ownership – thus, many entities held 50:50 by two unrelated persons, or even 1/3 each by multiple people, could qualify for this exception, even if they are not all family members.
For more information or questions, please contact Chris Brown at 206.224.8008, moc.elttutrraknull@nworbc, Chuck Robinson at 206.224.8031, moc.elttutrraknull@nosniborc, or the KTC attorney with whom you typically work.