Ruling upholds Washington individual capital gains tax

On March 24, 2023, the Washington Supreme Court upheld the constitutionality of the long-term capital gains (LTCG) tax on individuals enacted by the state in 2021.¹ In reversing a state superior court, the Supreme Court held that the LTCG tax constitutes a valid excise tax levied on the sale or exchange of capital assets that does not violate Washington state constitutional provisions, or the Dormant Commerce Clause of the U.S. Constitution. As a result of this decision, LTCG tax payments for the 2022 tax year are due April 18, 2023.

Background

On May 4, 2021, Washington enacted legislation imposing a 7% tax on the Washington-allocated LTCG of individuals in excess of $250,000 resulting from the sale of certain capital assets.² LTCG are allocated to Washington and are includible in the LTCG tax base when intangible personal property is sold or exchanged, and the individual owner is domiciled in Washington at the time the sale or exchange occurred.³ Likewise, LTCG are allocated to Washington when tangible personal property is either: (a) located in Washington at the time of the sale; or (b) not located in Washington at the time of sale, but (i) the property was located in the state at any time during the taxable year in which the sale or exchange occurred or the immediately preceding taxable year, (ii) the owner was a Washington resident at the time the sale or exchange occurred, and (iii) the owner is not subject to the payment of an income or excise tax legally imposed on the long-term capital gains or losses by another taxing jurisdiction.⁴ In addition, the LTCG tax may apply to individual owners of flow-through entities which engage in transactions resulting in Washington-allocated LTCG.⁵

While the LTCG tax did not became effective until the 2022 tax year, legal challenges to the tax were filed prior to enactment of the legislation adopting the tax. A law firm preemptively filed a lawsuit in the Washington Superior Court for Douglas County on behalf of several taxpayers on April 27, 2021, alleging the tax is a property tax on income, in violation of the uniformity and levy limitations on property taxes in the Washington Constitution. The plaintiffs also argued that the LTCG tax violates the Privileges and Immunities Clause of the Washington Constitution and the Dormant Commerce Clause of the U.S. Constitution. In defending the LTCG tax, the state argued that it is a valid excise tax not subject to the state constitution’s uniformity and levy limitation requirements.

On March 1, 2022, the superior court granted the plaintiffs’ motion for summary judgment and held that the LTCG tax is a property tax on income that violates the Washington Constitution’s uniformity and levy limitation requirements.⁶ In characterizing the LTCG tax as a property tax on income, the superior court listed eight “incidents” of the tax that it viewed as ”hallmarks” of an income tax.⁷ The superior court voided the tax as unconstitutional because: (i) the $250,000 deduction violated the uniformity requirement; and (ii) the 7% rate exceeded the 1% constitutional maximum for property taxes. In light of this ruling, the superior court did not address the additional constitutional challenges. The Washington Supreme Court accepted the state’s request for direct review of the superior court’s decision.

Washington constitutional limitations on taxes

Washington has unique restrictions limiting the imposition of state and local taxes. Since 1930, article VII of the state constitution provides that all taxes on property, defined as “everything, whether tangible or intangible, subject to ownership,” must be uniformly applied.⁸ In applying this limitation to previously adopted taxes, the Washington Supreme Court has ruled that taxes on net income are taxes on property subject to the constitutional uniformity limitation.⁹ Article VII was amended in 1972 to provide that the aggregate of all taxes levied on real and personal property cannot exceed an annual rate of 1%.¹⁰

Excise tax not subject to uniformity and levy limitations

After reviewing the history of taxation in Washington and the LTCG tax enacted in 2021, the Washington Supreme Court held that the LTCG tax is an excise tax and therefore not subject to the Washington Constitution’s uniformity and levy limitations on property taxes. The Supreme Court determined that the superior court did not correctly apply the Supreme Court’s precedent firmly indicating that the LTCG tax is an excise tax. The court explained that a line of cases beginning with Culliton v. Chase¹¹ in 1933 “defines a ‘property tax’ as a tax on the mere ownership of property, while an ‘excise tax’ applies to the exercise of rights in and to property or the exercise of privilege.” Unlike a property tax, taxpayers do not owe the LTCG tax merely by virtue of owning property. Instead, the LTCG tax is an excise tax because it relates to the exercise of the right to sell or transfer capital assets.

The Supreme Court applied the key principles developed in several property and excise tax cases to conclude that the LTCG tax “falls squarely on the excise side of the line because it taxes transactions involving capital assets—not the assets themselves or the income they generate.” According to the Supreme Court, the LTCG tax is an excise tax because it relates to the exercise of rights in and to property. The LTCG tax differs from a property tax because no one owes the tax merely due to ownership of an asset. Because the LTCG tax only is owed when the taxpayer sells or exchanges a qualifying long-term capital asset, the tax is characterized as an excise tax.

The court explained that the LTCG tax is “wholly unlike” the broad-based net income taxes that the court previously struck down in Culliton. Instead, the LTCG tax is comparable to the real estate and rental excises that it upheld in prior cases in which the taxes were measured by income received from real estate sales or rentals but applied to real estate transactions. Similar to the taxes in those cases, the taxable incident of the LTCG tax is the transaction, rather than the ownership of property.

The plaintiffs unsuccessfully argued that the LTCG tax cannot be an excise tax because it lacks certain distinctive features of a classic excise tax. The court determined that the plaintiffs misconstrued prior cases indicating that excise taxes apply only to purely “voluntary” conduct. The plaintiffs contended that the LTCG tax may be owed in circumstances where the taxpayer does not “voluntarily” sell an asset such as a trust selling capital assets on behalf of trust beneficiaries. After acknowledging that the voluntary nature of a transaction that may result in a tax is a distinctive feature of excise taxes, the court determined that the plaintiffs’ view was too narrow. The nature of a tax does not change if there are some situations in which the taxpayer does not personally undertake the taxable transaction.

The court also rejected the plaintiffs’ argument that the LTCG tax cannot be an excise tax because it does not rest on the exercise of a taxable privilege. In response to this argument, the court noted that the state is not always required to identify a taxable privilege in order for a tax to be considered an excise tax. The lack of any taxable privilege is immaterial because the LTCG tax is in the distinct category of excise taxes relating to incidents of property ownership. Also, the plaintiffs argued that the LTCG tax is not an excise tax because it is not measured by the extent to which an individual engages in a privilege. The court agreed that excise taxes typically have a connection between the subject matter and the measure of the tax, but the court explained that when the LTCG tax is properly viewed as a tax on the exercise of rights in and to property, there is sufficient nexus between the subject of the tax and the measure of the tax.

In its final consideration of the excise tax issue, the Supreme Court concluded that the superior court misapplied the case law concerning the eight “incidents” to tax that the superior court had previously identified as “hallmarks” of an income tax. The Supreme Court rejected this approach because it erroneously views “incidents” as including a wide variety of items such as exemptions and deductions, the reliance on federal reporting mechanisms, and calculation methods. Under Washington case law, a “taxable incident” is the activity that triggers the tax. When the Washington Supreme Court considers the nature of a tax, it examines: (i) the subject of the tax (“taxable incident”); and (ii) the measure of the tax. In this case, the taxable incident is the sale or exchange of qualifying capital assets, and the measure of the tax is the gain. Consistent with Washington case law, the incidents of this tax confirm that it is an excise tax. Instead of focusing on these elements, the Supreme Court claimed that the superior court mistakenly analogized between the LTCG tax and the federal individual income tax.

Privileges and Immunities Clause of Washington Constitution not violated

The Washington Supreme Court determined that the LTCG tax does not violate the Privileges and Immunities Clause of the Washington Constitution. The plaintiffs unsuccessfully claimed that the LTCG tax implicates the fundamental right to be exempt from taxes from which other Washington residents are exempt. The court held that there is no fundamental right of Washington residents to enjoy the same tax exemptions received by all other Washington residents. Furthermore, even if the LTCG tax grants a privilege or immunity implicating a fundamental right, there are reasonable grounds supporting the legislature’s classification choices, including the legislature’s express purpose to fund public education through adoption of the tax. 

No violation of dormant Commerce Clause of U.S. Constitution

The Washington Supreme Court held that the LTCG tax does not violate the Dormant Commerce Clause of the U.S. Constitution. In making this determination, the court applied the U.S. Supreme Court’s four-prong test from Complete Auto Transit, Inc. v. Brady requiring that a tax be: (i) applied to an activity with a substantial nexus with the taxing state; (ii) fairly apportioned; (iii) nondiscriminatory with respect to interstate commerce; and (iv) fairly related to the services provided by the state.¹² After the plaintiffs and the state agreed that the LTCG tax meets the fourth prong of the test, the court ultimately determined that the LTCG tax does not violate any of the first three prongs of the Complete Auto test.

The first prong was met because there was substantial nexus to support Washington’s taxation of capital gains from the sale or exchange of tangible property located outside the state. The power to dispose of capital assets is exercised in the state of the taxpayer’s domicile. Furthermore, the taxpayer’s in-state domicile provides a sufficient nexus between Washington and the capital gains from the sale or exchange of intangible property. The court determined that the second prong was met because the tax is fairly apportioned to ensure that each state taxes only its fair share of an interstate transaction, and the tax was both internally and externally consistent.¹³ In determining internal consistency, the court noted that the LTCG tax includes a credit to prevent multiple taxation. Regarding external consistency, the court explained that LTCG tax statutes specify when capital gains are apportioned to Washington and provide a tax credit to prevent any risk of multiple taxation. Finally, the court held that the tax met the third prong because it does not discriminate against interstate commerce. Although the court rejected the plaintiffs’ facial challenge of the statute, the court acknowledged that its holding does not prevent future as-applied challenges under the Dormant Commerce Clause.¹⁴

Commentary

Washington’s LTCG tax has received considerable attention as an initiative designed to supplement the state’s somewhat limited revenue stream given the lack of a traditional income-based tax. In its goal to supplement the funding of public education, the state has estimated that the LTCG tax will generate nearly $2.5 billion in revenue in its first six years of operation. The Washington Department of Revenue estimates that approximately 7,000 individuals will pay the LTCG tax in the first year of operation.

The uncertainty over whether the LTCG tax would be ultimately sustained by the Washington courts will provide an immediate challenge for individuals with significant capital gains that need to carefully evaluate whether and to what extent the tax may apply. Following the superior court’s decision, the Department was granted a stay of the ruling to allow the agency an opportunity to administer and implement the tax for the 2022 tax year in case the Supreme Court reversed the superior court’s decision regarding the constitutionality of the LTCG tax.¹⁵ As a result, the Department launched an online registration and filing system for the LTCG tax that went live in February 2023.¹⁶ Because the state’s highest court determined the LTCG tax is constitutional and valid, individuals are now required to pay the tax, with payments for the 2022 tax year due by April 18, 2023. While LTCG tax returns are also due on this date, these returns may be extended for six months if an extension of time for filing the federal income tax return has been obtained upon provision to the Department of evidence confirming such extension. The extension to file a return does not provide an extension of time to pay the LTCG tax.¹⁷

1 Quinn v. Washington, Washington Supreme Court, No. 100769-8, March 24, 2023. Seven of the nine justices joined the majority opinion. Two justices filed a dissenting opinion.
2 Ch. 196 (S.B. 5096), Laws 2021, codified as Wash. Rev. Code §§ 82.87.010–82.87.150. Note that these laws are codified within Title 82, Excise Taxes. The individual’s “Washington capital gains” subject to the LTCG tax is an individual’s “adjusted capital gain” (i.e., federal net LTCG with specified adjustments). Wash. Rev. Code §§ 82.87.020(1), (13); 82.87.060. Capital losses cannot be carried forward or back, and the tax does not apply to short-term capital gains. Wash. Rev. Code § 82.87.040. For further discussion of this tax, see GT SALT Alert: “Washington enacts individual capital gains tax.” 
3 Wash. Rev. Code § 82.87.100(b).
4 Wash. Rev. Code § 82.87.100(a).
5 Wash. Rev. Code § 82.87.040(4)(b). 
6 Washington Superior Court for Douglas County, Nos. 21-2-0075-09 and 21-2-00087-09, March 1, 2022. For further discussion of this case, see GT SALT Alert: “Washington capital gains tax ruled unconstitutional.”
7 The superior court listed the following incidents that indicate the LTCG tax is an income tax rather than an excise tax: (i) it is derived from a taxpayer’s annual federal income tax reporting; (ii) it levies a tax on the same LTCG that the IRS characterizes as “income” under federal law; (iii) it is levied annually like an income tax rather than on each transaction like an excise tax; (iv) it is levied on an individual’s net capital gain like an income tax; (v) like an income tax, it is based on an aggregate calculation of capital gains, less various deductions and exclusions, to arrive at the taxable amount; (vi) similar to an income tax, it is levied on all of an individual’s LTCG, regardless of whether the amounts were earned within Washington and regardless of whether the state conferred a privilege to facilitate the underlying transfer that would justify the state to impose an excise tax; (vii) like an income tax and unlike an excise tax, the LTCG tax includes a deduction for certain charitable donations; and (viii) if the owner who transfers title or ownership is not an individual, the owner is not liable for tax generated by the transaction, unlike an excise tax.
8 Wash. Const. art. VII, § 1.
9 Power, Inc. v. Huntley, 235 P.2d 173 (Wash. 1951); Jensen v. Henneford, 53 P.2d 607 (Wash. 1936); Culliton v. Chase, 25 P.2d 81 (Wash. 1933).
10 Wash. Const. art. VII, § 2.
11  25 P.2d 81 (Wash. 1933).
12  430 U.S. 274 (1977).
13  As explained by the court, a tax is internally consistent when it is “structured so that if every State were to impose an identical tax, no multiple taxation would result.” The external consistency tax considers “whether the State has taxed only that portion of the revenues from the interstate activity which reasonably reflects the in-state component of the activity being taxed.” Goldberg v. Sweet, 488 U.S. 252 (1989). 
14 Two justices joined a dissenting opinion arguing that the LTCG tax is an income tax on property that violates the 1% annual limit on property taxes, rather than an excise tax. The dissent could not find a Washington case upholding a tax as an excise tax where the measure of the tax was net income or gain. Instead, these taxes were invalidated as nonuniform property taxes. 
15 Capital Gains excise tax ruled constitutional, Washington Department of Revenue, March 24, 2023.
16 For further information, see the Washington Department of Revenue’s website at Capital gains tax. 
17 Wash. Rev. Code § 82.87.110(5).