Washington capital gains tax ruled unconstitutional

The Superior Court of Douglas County, Washington recently held that the long-term capital gains (LTCG) tax on individuals enacted by the state in 2021 violates the uniformity and limitation requirements of the Washington State Constitution.¹ According to the court, the tax is subject to the constitutional requirements because it is properly characterized as an income tax under Washington case law, rather than as an excise tax as argued by the state.

Background

On May 4, 2021, Washington enacted legislation imposing a 7% tax on the LTCG of individuals in excess of $250,000 resulting from the sale of certain capital assets.² The LTCG is effective on Jan. 1, 2022, but legal challenges were filed prior to the enactment of the tax. A law firm pre-emptively filed a lawsuit in the Washington Superior Court for Douglas County on behalf of several taxpayers on April 27, 2021, alleging the tax is unlawful and an invalid income tax under the state’s constitution. The plaintiffs claim the tax treats similarly situated taxpayers in different ways in violation of the constitution’s uniformity clause and also contravenes the constitution’s tax rate limitation.

Washington constitutional limitations on taxes

Washington has unique restrictions limiting the imposition of state and local taxes. Since 1930, the state constitution provides that all taxes on property, defined as “everything, whether tangible or intangible, subject to ownership,” must be uniformly applied.³ 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.⁴ The state constitution 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%.⁵

LTCG tax constitutes unconstitutional income tax

After explaining that it was not permitted to consider policy considerations such as whether schools are appropriately funded or the new tax improves the fairness of Washington’s tax structure, the court determined that the LTCG tax is unconstitutional under established Washington case law.⁶ In reaching its decision, the court noted that Washington courts decide whether a tax law is unconstitutional.⁷ Washington courts are required to consider “nearly a century of case law” that makes clear the uniformity requirement added to the Washington State Constitution in 1930 is the starting point for determining the constitutionality of a tax law.

The court considered three longstanding Washington Supreme Court decisions addressing uniformity, beginning with the Culliton v. Chase decision from 1933.⁸ In Culliton, the Supreme Court determined that a graduated income tax on net income approved by voters was unconstitutional because it violated the uniformity requirement. The court clarified that income taxes differ from excise taxes because excise taxes are levied on an activity such as the sale of a good rather than on income generated by an activity. Furthermore, the Culliton court characterized income as being included in the broad definition of “property.”

In 1936, the Washington Supreme Court considered another case, Jensen v. Henneford, concerning a graduated income tax on residents.⁹ The state in Jensen argued that the tax statute should be deemed a constitutional excise tax, rather than an unconstitutional income tax. The court rejected the state’s argument, stating that “[t]he character of a tax is determined by its incidents, not by its name.” The graduated income tax was unconstitutional as a tax on property that was not uniform.

The Washington Supreme Court again considered these issues in 1951 in Power, Inc. v. Huntley.¹⁰ This case concerned a “corporation excise tax” that was levied on a corporation’s net income. In Power, the court set aside the language of the tax, analyzed its “incidents,” and determined it was “a mere property tax masquerading as an excise.” The court concluded that the tax was unconstitutional as a nonuniform property tax. Rather than relying on the label that the state applies to a tax statute, a court must consider the “incidents” of how the tax functions and whether it is a tax on income.

In analyzing the LTCG, the Washington Superior Court listed the following incidents that indicate the LTCG tax is an income tax rather than an excise tax:

• It is derived from a taxpayer’s annual federal income tax reporting
• It levies a tax on the same LTCG that the IRS characterizes as “income” under federal law
• It is levied annually like an income tax rather than on each transaction like an excise tax
• It is levied on an individual’s net capital gain like an income tax
• 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
• 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
• Like an income tax and unlike an excise tax, the LTCG tax includes a deduction for certain charitable donations
• 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

The court rejected the state’s argument that the LTCG tax is an excise tax “that applies on the sale or transfer of property.” According to the court, the new tax is not levied on the “sale or transfer” of capital assets, but is levied on the receipt of capital gains. The court also disagreed with the state’s description of the LTCG tax as an excise tax because the tax “applies only upon the voluntary sale of a long-term asset.” The court described situations where the sale or transfer of a capital asset is not voluntary and constitutes an “absolute and unavoidable” tax that would be considered a property tax.

In granting the plaintiffs’ motion for summary judgment, the court concluded that the LTCG tax is properly characterized as an income tax under the three Washington Supreme Court cases discussed above, rather than as an excise tax as argued by the state. As a tax on the receipt of income, the LTCG tax also is properly characterized as a tax on property. The court concluded that the LTCG tax violates the uniformity and limitation requirements of the state constitution. The tax violates the uniformity requirement by imposing a 7% tax on an individual’s LTCG exceeding $250,000 but imposing no tax on capital gains below this threshold. The tax violates the limitation requirement because the 7% tax exceeds the 1% maximum annual property tax rate of 1%.

Commentary

Controversial in scope, the LTCG tax is the latest in a series of provisions and initiatives designed to supplement the state’s somewhat limited revenue streams given the lack of a traditional personal and corporate income tax. For example, in 2019, Washington enacted a payroll tax to fund long-term care.¹¹ Also, the state legislature currently is considering a 1% wealth tax on residents with intangible financial assets of more than $1 billion.¹²

The LTCG tax was challenged prior to being approved by the governor last year, and given the continuing uncertainty over the status of the tax, Washington taxpayers with significantly appreciated stock holdings that are closely following this litigation should evaluate whether a stock sale could escape taxation.¹³ With historic uniformity restrictions developed by case law and constitutional tax rate restrictions in effect, the state’s attempt to enact a facial excise tax in the form of an LTCG tax did not pass judicial scrutiny, because of several elements implying that the LTCG substantively acted as a prohibited income tax. With this decision being appealed by the state, future consideration by the Washington Supreme Court remains a strong possibility.

1 Quinn/Clayton v. Washington, Washington Superior Court for Douglas County, Nos. 21-2-0075-09 and 21-2-00087-09, March 1, 2022.

2 Ch. 196 (S.B. 5096), Laws 2021, codified as WASH. REV. CODE §§ 82.87.010–82.87.150. Note that this is codified in Title 82, Excise Taxes. The tax is 7% of an individual’s “Washington capital gains,” which is an individual’s “adjusted capital gain,” after certain deductions. “Adjusted capital gain” means federal net LTCG with specified adjustments. Capital losses cannot be carried forward or back, and the tax does not apply to short-term capital gains. The tax only applies to Washington “resident” individuals and does not apply to corporations or other entities. The first payments are due by April 18, 2023. For further discussion of this tax, see GT SALT Alert: “Washington enacts individual capital gains tax.”

3 WASH. CONST. art. VII, § 1.

4 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).

5 WASH. CONST. art. VII, § 2.

6 Prior to considering the plaintiffs’ constitutional argument, the court addressed the state’s motion to strike certain declarations submitted by a witness and the state’s motion challenging the plaintiffs’ standing to facially challenge the constitutionality of the LTCG tax legislation.

7 Kunath v. Seattle, 444 P.3d 1235 (Wash. App. 2019).

8 25 P.2d 81 (Wash. 1933).

9 53 P.2d 607 (Wash. 1936).

10 235 P.2d 173 (Wash. 1951).

11 Ch. 363 (H.B. 1087), Laws 2019, enacting WASH. REV. CODE § 50B.04.080. This legislation established a new 0.58% tax on employee wages beginning Jan. 1, 2022. However, legislation was enacted in 2022 to delay implementation of this tax to July 1, 2023. Ch. 1 (H.B. 1732), Laws 2022.

12 H.B. 1406 and S.B. 5426, reintroduced Jan. 10, 2022.

13 The information on the Washington Department of Revenue’s website concerning the LTCG tax indicates that the Department is aware of the Douglas County court’s decision and is awaiting the court’s final order before providing a further update. Capital Gains Tax, Washington Department of Revenue, accessed March 24, 2022.

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