The legality of a capital gains tax was upheld by the Washington state Supreme Court last week, drawing questions about who is subject to the tax and the broader impact on the region’s business sector.
Seattle tech leaders had mixed reactions to the ruling. Advocates say it’s one way that Washington’s regressive tax laws can be altered to help low-income and rural communities. Opponents fear it will drive businesses out of the state.
Washington is one of nine states with no personal income tax; it generates most of its revenue through sales, property, and business and occupation (B&O) taxes.
The capital gains tax, which will help fund early-childhood education programs and school construction, is drawing national attention. The Wall Street Journal’s editorial board wrote that Democrats will use the judicial ruling to “redefine other income taxes as excise taxes.”
GeekWire spoke with tax and accounting experts to better understand the new ruling and its impact on individual taxpayers.
What is the capital gains tax?
The law imposes a 7% tax on capital gains of more than $250,000 from the sale of stocks, bonds, and other assets. The tax applies to gains made on or after January 2022 and the first payment is due on or before April 18 of this year. It’s paid on a calendar year basis. It affects individuals, not business entities (with some exceptions, as noted below).
For example, if a startup founder receives $10 million in personal proceeds as a result of a stock-related acquisition, they would be on the hook to pay $682,500 to the state for the new capital gains tax, as shown in this guide from the Department of Revenue.
Washington state’s 7% capital gains tax is the 12th-highest rate in the country. State capital gains tax requirements are in addition to federal capital gains taxes.
Are there any exemptions or exclusions?
Yes. The tax does not apply to real estate sales or exchanges, retirement account assets, timber and timberland, particular agricultural products, commercial fishing privileges, and eligible family-owned small businesses, according to the Department of Revenue.
Why is real estate exempt?
That’s what venture capitalist Bill Gurley wants to know. According to Grant Shaver, principal with accounting firm Clark Nuber, the number of taxpayers subject to the tax would increase exponentially if real estate was included, unless a separate threshold was imposed for the sale of real estate. There is already a real estate excise tax (REET) in Washington that applies to the gross sales of most real estate, Shaver said.
What qualifies as a family-owned small business?
To count as a family-owned small business, the taxpayer must meet the following criteria:
- They must have owned 50% of the business, directly or indirectly, for at least five years, either alone or with family members. Multi-family ownership requires the taxpayer to own at least 30% of the business and two families to hold 70% ownership, or three families to hold 90%.
- The taxpayer or their family must have “materially participated” in the business for at least five of the 10 years immediately preceding the sale. This means the individual or their family members were involved in the “operation of a business on a basis that is regular, continuous and substantial.”
- Revenue must not exceed $10 million in the 12 months prior to the sale.
Does the QSBS tax incentive apply in Washington?
Not explicitly. The qualified small business stock (QSBS) is a tax incentive that exempts capital gains tax from businesses with $50 million or less in assets, and provides up to a $10 million gain exclusion, or 10 times the cost of the investor’s basis. However, it’s considered an Internal Revenue Service (IRS) exemption, not a Washington state capital gains consideration, a Washington state Department of Revenue spokesperson told GeekWire.
It becomes complex if the taxpayer can’t use the federal exclusion in full the year the stock is sold and generates a federal carryover. “Washington law is silent as it pertains to any prior unutilized or carryover QSBS exclusion amounts,” Clark Nuber said in a blog post.
I made money off gains passed through from an S corporation. Do I have to pay the tax?
Yes. “The tax does apply to gains passed through from entities such as S-Corporations, partnerships, and trusts,” according to Clark Nuber.
“Individual owners of entities that are pass-through or disregarded entities for federal tax purposes may owe Washington’s capital gains tax on gains from sales or exchanges made by such entities,” according to the Department of Revenue.
This part of the law could “distort” decision-making for these types of businesses, said Victor Menaldo, a University of Washington political science professor. He said the businesses are “very vulnerable to this tax” versus large corporations.
“It may mean that fewer small businesses are born and more small businesses die prematurely,” he said. “Or, similarly, more businesses leaving town for states without capital gains taxes.”
I’m a tech startup founder. Do I have to pay the tax?
As noted in the example above, if your company is acquired, and you get a stock-related financial windfall, you will be subject to the tax on any gains above $250,000.
Does the tax apply to cryptocurrency?
Yes, if the taxpayer has held the cryptocurrency for at least one year prior to the sale, and you are domiciled in Washington state at the time the sale or exchange occurs.
I sold my yacht and made money. Do I have to pay the tax?
Yes, if the yacht was located in Washington at the time of the sale, or held in Washington by a Washington state resident within a year of the sale or the prior year, and a federal long-term capital gain is triggered as a result of the sale, according to Clark Nuber.
Do married couples have a higher shared amount for the $250,000 deduction?
No. This is different from federal law, which gives married couples a higher threshold.
Can I use short-term capital losses to help avoid paying the tax?
No. Unlike federal capital gains tax, short-term gains or losses are ignored in calculating the tax in Washington state.
Are there other deductions?
Yes. A $100,000 deduction is allowed for charitable donations made to Washington state nonprofits in excess of $250,000 per year per individual. The charitable donations deduction cannot exceed $100,000 per year. The amounts are adjusted for inflation annually.
Where do I pay this tax?
Can people avoid the tax?
Taxpayers could establish legal domicile in a different state, according to Seattle law firm Perkins Coie.
However, determining and substantiating where a domicile exists can be tricky as it is based on a number of different factors, according to Shaver. He added that the “allocation rule for gains from sales of intangibles refers to the taxpayer’s domicile, while the rule for gains from sales of tangible property refers to residency.”
Taxpayers can spread out their capital gains over several years to utilize the full annual $250,000 deduction, using charitable remainder unitrusts or other available methods, Perkins Coie said. They can also give the assets to lower-income beneficiaries or nongrantor trusts to minimize or avoid the tax altogether, the law firm wrote.