The conservative Freedom Foundation filed a lawsuit Wednesday in an effort to stop the capital gains tax approved by the Washington state legislature only four days ago. The legislation places a 7% excise tax on the sale of stocks, bonds, and businesses — the first tax of its type in state history.
The lawsuit, expected by both proponents and opponents of the new tax, asserts that the new tax is illegal under the Washington state constitution which sharply limits income taxes. Backers of the tax, approved in the form of SB 5096, counter that the tax isn’t an income tax at all but an excise tax which is common and legal in the state.
The tax would be narrowly applied to capital gains of more than $250,000. And it would exempt a laundry list of potential capital gains including real estate land and structures; retirement accounts; livestock for farming or ranching; and the sale of timber and timberlands, among other exceptions.
If it survives legal challenges, it will take effect in January 2022 and would apply to capital gains for that year. The tax has divided the tech community — some see it as either a necessary change to the state’s regressive tax system or, alternately, as a startup killer because stock frequently is used as compensation.
What taxes will be central to the lawsuit?
All of the following taxes are likely to be discussed in court, either as a claim that new capital gains belong in one of the buckets, or that case law regarding other taxes either permits — or prevents — a capital gains tax:
An income tax, which effectively does not exist in Washington, is a graduated tax based on earnings. The more a person makes, the more they are supposed to pay.
A property tax is a flat tax on an existing asset, such as an owned property. The government taxes it on its value, up or down, each year.
An excise tax is a tax on economic activity. A sales tax is an excise tax, for example.
A business and occupations tax is a tax on all of the gross receipts coming into a business.
And an estate tax is a one-time tax specifically applied to the transfer of property from one generation to the next. The estate tax in Washington is substantial, from 10% to 20%.
So what’s the issue?
This discussion actually goes back to 1933. That year, the state Supreme Court overturned a voter-approved graduated income tax when it ruled that income is property. State law dictates — then and now — that property taxes must be uniform at 1%, not graduated. So if income is property and property can only be taxed at 1% across the board, any income tax must be 1% or less under state law. The capital gains tax that was passed is 7%.
So income taxes are not technically illegal in Washington state?
Here’s the thorny problem: Income taxes, despite what you might think, are not specifically forbidden in Washington. What’s forbidden are graduated property taxes. But when the state Supreme Court in the 1930s said income was property, it married the two legally. So an income tax is legally a property tax.
What does this marriage mean?
Literally, it means lawmakers could pass a state income tax of no more than 1% and avoid any legal challenge because it would be considered a legally allowed uniform property tax. But the Democrats’ rationale for a capital gains tax is to change the state’s notoriously regressive tax code and move away from the type of taxes, such as sales tax, that burden low-income people proportionally more than the wealthy. The capital gains tax is an effort to open a new revenue source that targets high-income residents.
So then are capital gains taxes a form of income tax?
This depends on which level of government you ask and in which state. And it will be central to the court case. The federal government does categorize capital gains as part of income taxes. But many states do not. The way the legislation was written asserts that this capital gains tax is an excise tax. And as an excise tax, it would be perfectly legal. As an income tax, no.
What makes it an excise tax?
The pro-capital gains tax argument calls it an excise tax for good reason: Excise taxes are broadly legal at varying rates, such as the 10.25% sales tax rate in Seattle. Proponents will use existing real estate sales as proof. For example, when an owner sells a house, that owner must pay the excise tax — not the buyer — based on the value of the house. So with capital gains, the seller of the stock would, in the same way, pay a one-time, 7% fee based on the sale of that stock as a singular economic activity.
And what makes it an income tax?
This argument actually goes back even earlier than 1933. Voters in Washington in 1930 approved the 14th amendment to the state constitution. And it declared, among other things, that the state was to tax “intangible property” subject to ownership. Some law researchers say the “intangible” language specifically targeted stocks and bonds as real property. And as it is a property and it is income at sale, then it is restricted to a 1% tax at most, making SB 5096 an illegal, non-uniform property tax. Plus, the feds call capital gains income. So there’s that.
What gets reported to the IRS, after the sale, is income, opponents say. So that tax is on income, they say. And when it comes to the real estate excise tax comparison cited by the proponents, those opposing the income tax counter this: A capital gains tax as written in the legislation only considers the increase in the price of the stock, or what it earned (thus equalling income). A real estate excise tax, also called a financial transaction tax, doesn’t look at what the property earned but what its value was at the time of sale. So they are not comparable, the argument goes.
Of course. A few things. First, both the business and occupation tax which is based on a business’s gross receipts, and the state’s estate tax are, according to some tax experts, actually taxes on income. These both exceed 1% but are legal. This could end up cited in the upcoming fight.
And some legal experts, such as the University of Washington’s Hugh Spitzer, see the challenge to the capital gains tax as more fraught than the challengers acknowledge. He said the 1933 decision that put the state in this position — income as property — wasn’t based on the soundest legal reasoning. The court, Spitzer said, misapplied earlier case law. The challenge on the capital gains tax could tug a legal string that could unwind case law stretching back decades. And that could lead to the state’s first legal income tax, he said.
Editor’s note: Both Hugh Spitzer and Jason Mercier of the conservative Washington Policy Center contributed analysis to this story.
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