The Washington State capital gains tax, which went into effect on January 1, 2022, has been held unconstitutional by the Douglas County Superior Court. Created in 2021, the tax was ostensibly labeled an “excise” tax in an effort by the Washington State Legislature (Legislature) to avoid difficulties associated with implementing an income tax in the state of Washington. The judge, however, was not persuaded.

IN DEPTH

Citing to authority from the Washington State Supreme Court, the trial judge held that courts must look through any labels the state has used to describe the statute and analyze the incidents of the tax to determine its true character. Here, the judge reviewed the most significant incidents of the new tax, including:

• It relies on federal income tax returns that Washington residents must file and is thus derived from a taxpayer’s annual federal income tax reporting;

• It levies a tax on the same long-term capital gains that the Internal Revenue Service (IRS) characterizes as “income” under federal law;

• It is levied annually (like an income tax), not at the time of each transaction (like an excise tax);

• It is levied on an individual’s net capital gain (like an income tax), not on the gross value of the property sold in a transaction (like an excise tax);

• Like an income tax, it is based on an aggregate calculation of an individual’s capital gains over the course of a year from all sources, taking into consideration various deductions and exclusions, to arrive at a single annual taxable dollar figure;

• Like an income tax, it is levied on all long-term capital gains of an individual, regardless of whether those gains were earned within Washington and thus without concern of whether the state conferred any right or privilege to facilitate the underlying transfer that would entitle the state to charge an excise;

• Like an income tax and unlike an excise tax, the new tax statute includes a deduction for certain charitable donations the taxpayer has made during the tax year; and

• Unlike most excise taxes, if the legal owner of the asset who transfers title or ownership is not an individual, then the legal owner is not liable for the tax generated in connection with the transaction.

The court found that these incidents show the hallmarks of an income tax rather than an excise tax, and because the new capital gains tax did not meet the uniformity and limitation requirements of the Washington State Constitution, it was unconstitutional.

The Washington State Attorney General has already indicated that the ruling will be appealed; in all likelihood, this issue will ultimately be decided by the Washington State Supreme Court.