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Washington State Passes a New Capital Gains Tax

May 07, 2021

Who and What Are Subject to the Tax?

On May 4, 2021, Washington Governor Jay Inslee signed ESSB 5096 into law. Starting January 1, 2022, the state will impose a 7% excise tax on the sale or exchange of certain capital assets, such as stocks and bonds, held for more than one year. The tax is assessed on individuals (including spouses) with more than $250,000 of long-term capital gains, as adjusted under the bill.

Corporations are not subject to the capital gains tax. However, long-term capital gains recognized by passthrough entities (LLCs, partnerships and S corporations) create a tax obligation for the beneficial individual owner of the entity. Grantor trusts are treated the same way as passthrough entities, with the grantor paying any tax owed. Non-grantor trusts are exempt from the tax unless the trust is treated as a grantor trust for federal income tax purposes, which includes intentionally defective grantor trusts.

An estimated 7,000 Washington residents are subject to the tax, regardless of the location of the capital asset. Nonresidents are only subject to the tax if the capital asset sold or exchanged is located within Washington, or the non-resident individual is physically present in Washington for more than 183 days per year. A “day” means the individual is physically present in the state for any portion of a calendar day.

Who Is Exempt From the Tax?

There are a handful of industries exempted from the tax. For example, real estate held by an individual, passthrough or grantor trust are excluded. Additionally, depreciable property and property eligible for section 179 expensing are also exempt.

Long-term capital gains from the sale or exchange of timber and timberland, including Christmas trees, are excluded. This list of excluded items also contains retirement accounts, condemned property and goodwill received from the sale of certain auto dealerships. Lastly, farmers and ranchers with over 50% of gross sales (including capital gains) earned from farming and ranching will not be subject to this new policy.

Capital gains generated from the sale or exchange of a qualifying family-owned small business may be excluded from the tax. Qualified family-owned small businesses are defined as having less than $10,000,000 in worldwide revenue in the 12-month period immediately preceding the sale or exchange. The individual or family members must have been actively participating in managing the business and certain holding periods must be met.

Where Is the Money Going?

The tax is estimated to generate $445 million in the 2021 – 2023 biennium and $981 million in the 2023 – 2025 biennium. These funds will go to investments in education, childcare and early learning. The fiscal note indicates the Washington Department of Revenue budgets 20 new employees and increased expenses of $7 million per biennium to administer the tax.

Will the Tax Prevail?

Some legislators view this tax as a critical step toward creating more equality in Washington’s taxing system. While they specifically call this tax an “excise” tax, others consider it an income tax. Historically, Washington voters have repeatedly rejected new income taxes. The legislature debated and ultimately decided to make the bill subject to an emergency clause, which effectively prevents voters from overturning the law by referendum.

Just days after the bill passed, a lawsuit was filed in Douglas County on behalf of Washington citizens. The lawsuit challenges the constitutional validity of the tax and seeks to overturn it. In 1936, Washington’s Supreme Court ruled that all property must be taxed at the same rate and that income is considered property. The question is whether this or some other challenge to the tax will be decided before the tax becomes effective. The legal challenge will likely reach the Washington State Supreme Court who will determine the merits of this new tax.

What Should You Do Next?

Federal and state taxes are seemingly on the rise. You should begin tax planning now to take advantage of the historically low tax rates while you can! One option to consider is that since Washington doesn’t have a gift tax, you may want make wealth transfers to younger generations or non-grantor trusts before you could be subject to the new capital gains excise tax.

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