On-Demand: Washington Excise Tax
March 01, 2023
EisnerAmper explains who is impacted and how to get prepared for a time-sensitive tax change.
Today, we're going to go over the history of the excise tax, touch upon some of the definitions, and also go through the actual tax calculation. I wanted to point out some important deductions for you to know about and as well as exemptions. And of course, we want to talk about reporting requirements and what actions we need to be taking now.
So in terms of the history, in May 2021, the governor of Washington state signed into law a bill that created the Washington excise tax. It's important to understand the tax landscape in Washington state to understand how critical this is. Washington state has never levied a personal income tax since it became formed as a state, which was in 1889. In the 1930s, they tried to pass a personal income tax, but they failed.
When this excise tax came out, many people thought that this excise tax was very similar to an actual income tax. So as you could imagine, there was a lot of controversy in the state as to whether or not this was really an excise tax or an income tax, so much so that in March 2022, a group of individuals in Washington state went to the Douglas County Superior Court to try to fight this tax. And they won. The tax was deemed unconstitutional.
Then Washington state went ahead and appealed the decision to the Washington Supreme Court, and that's currently where the case is pending. In late January 2023, they held hearings at the Washington State Supreme Court. And at those hearings what they discussed were, is this really an excise tax or an income tax? And further, is this constitutional or not?
So the challenge that we face as tax practitioners and taxpayers is the decision that will be made by the Supreme Court will not be made until after the first excise tax payment is due, which is April 18, 2023. Therefore, we still need to understand the nuances of this tax, how it's calculated, and we do need to remit a tax payment. If it's found that it's unconstitutional, then Washington state is required to issue refunds back to all those that paid as well as interest. So that's where we stand and we're sort of in limbo. So that's the purpose of this webinar is to go over what we need to know now.
So to break down, I'd like to go over some definitions just to make sure we're all on the same page. So long-term capital gains. If I were to break that out, capital gains are just simply you purchase a capital asset at a low price and you sell it for a high price and you make a profit on it.
So the most simple example is, let's say I purchased Microsoft stock in late 2020 for $220 a share, and then I sell that stock in September 2022 for $250. I've now made a profit of $30. If those shares that I bought were $1,000, that's a $30,000 capital gain. So that's just in sum kind of what the capital gain piece of it is.
The long-term piece is that you have to have held the capital asset for more than a year. So then the question becomes, well, what is a capital asset? So Washington state basically defines a capital asset the same way that they would under federal law. And federal law does so by way of exclusion. It says that it's any asset other than, and the things that are other than are things like accounts receivables, inventory, things of that nature. But common examples that do include capital assets are, as listed on the slide, stocks, bonds, mutual funds, cryptocurrency, that's the latest thing going on, boats, and real estate. I will hit on real estate in a little bit because that's actually an exemption for this tax.
So the way the calculation works, it's fairly straightforward. You start off with your federal net long-term capital gain or loss, and that is defined as your excess of your long-term capital gains over your long-term capital losses. Now, the first question I always get at this point is, "Well, can I take my short-term capital losses and offset my long-term capital gains?" And the answer is no, because the focal point of this tax is only net long-term capital gains.
Now, one strategy that you could employ is harvesting losses. So what I mean by that is let's say you have Walmart stock. You purchased Walmart stock for $150 per share in the end of November 2020. You sell that stock for $130. You then generate a loss of $20. In addition, simultaneously, you purchased Amazon stock November 2018 for $80. You sell the stock in October 2022 for $100, and then you have a gain of $20.
So what you could do is you could sell your Amazon stock for a gain of 20, and then you could decide to sell your Walmart stock for a loss of 20, and you're harvesting loss is in that you're going to sell the Walmart stock in order to offset the gain of the Amazon stock. So that's one approach that you could take.
After you figure out what your federal net long-term capital gain or loss is, then you go ahead and you subtract out any long-term capital gains or losses that are not allocated to Washington state. If you are a Washington state resident, all of your gains are unfortunately allocable to Washington state. But if you're not a resident of Washington state, only tangible property would be sourced to Washington state. So things like stocks and bonds, which are intangibles, would not be sourced.
Then you're permitted to subtract out certain items that are exempt, which I will go through in detail in another slide. And then any long-term capital gain or loss carryforwards not allocated to Washington state are removed. At which point, you then get to your adjusted capital gain. After your adjusted capital gain, you then take two deductions, which I will talk about in more detail, the charitable donations deduction and the qualified family-owned small business deduction. There's also other deductions which are much more rare.
Then you are entitled to a standard deduction of $250,000. So when we keep saying that you're only required to pay tax on long-term capital gains in excess of $250,000, this is what we're referring to because there's a standard deduction that you're permitted.
Once you've come up with the amount after the 250,000, you then have your taxable amount. You multiply that by your 7% tax rate, and then if you paid taxes to another state on those same gains, you're entitled to a credit for taxes paid to those other jurisdictions in order to ensure that you are not subject to double taxation. At this point then, you now have your Washington excise tax due. So you know what your amount is.
Now, going into the charitable deduction. In order for it to be qualified charity, there's two components. One, it has to be deductible under federal law, and two, it has to be both managed and situated in Washington state, managed and directed in Washington state. It has a floor in that you can only start deducting in excess of $250,000. And it also has a maximum. So the maximum you're entitled to deduct is $100,000 per taxable year. Unfortunately, there are no carryforwards or carrybacks to other taxable years.
So here I've given you an example. So let's say all of your charitable donations are eligible as Washington charitable organizations. So the full 300,000 is. Then you subtract out the $250,000. You arrive at $50,000. Then you have to see if that amount is less than 100,000. So long as it's less, which it is in this case, then you can get the whole $50,000 allowable charitable deduction.
So one strategy you could employ here is just being more careful, you might want to consider making more donations to organizations located in Washington state. The second item is you could try to employ bunching, which is that if you know that you have a particular year in which you're going to have large, long-term capital gains, then you might want to make a bunch of charitable deductions in that year as opposed to over several years.
So the next item is your qualified family-owned small business deduction. So in order to have a qualifying interest in this entity, you need to have either owned 50% of the business, it could be a sole proprietorship, or you could own 30%, but then you have to meet certain qualifications. You have to have held that qualifying interest for the five-year holding period requirements, five years prior to the sale. And then the small business piece is this gross revenue $10 million. What it says is that for the 12-month period prior to the date of sale, your gross revenue must have been $10 million or less.
The next prong is that you have to meet the material participation rules. And what that is is that you have to materially participate in the business at least five out of the 10 years. And this rule, if you are familiar with the passive activity loss rules, this rule follows the same federal rules that apply to passive activity loss rules. There's one exception. You don't have to meet the material participation rules if you go ahead and sell it to a qualifying heir.
So I think for this deduction, if you're looking to sell your business, you want to carefully go through and see if you can try to meet these requirements. For example, if you have only held the company for four years, maybe hold it on longer for five. Of course, if that makes sense in the business transaction itself. So just looking into this, if you're looking to sell your family business, these are items that you want to consider to meet and be qualified for this deduction.
There's several exemptions. So what this means is when you're going to figure out your excise tax, the first thing you do is you separate out your gains that are allocable to Washington state and gains that are not allocable to Washington state. So those gains that are not allocable to Washington state, you sort of throw out. Now, you're left with gains allocable to Washington state. Of those, some of those are still exempt. So you want to be careful to review this list to see if any of these gains might qualify.
So the biggest one is real estate. So either land and structures or if you own it through, let's say a partnership interest. And any assets that are held in a retirement account are not subject to the Washington excise tax. There's other more specific ones listed here as well. So again, to carefully go through each of your gains just to see if you might meet any of the exemptions might be worthwhile and would help reduce this tax.
So as far as reporting requirements, you are required to report online. So you must report this information online. The website is live. The due date is the same as your individual tax filings. And it's, again, you can take an extension, but it's an extension to file. It's not an extension to pay. So as long as the federal return is extended, you can also extend this tax. And penalties and interest will apply if you don't make the payments on time.
So those were the main items that I wanted to go through with the group and wanted to see if there's any questions that the group might have. So one question that I'm seeing right off the bat, which I think is a great question, is well, do I need to file a Washington excise tax return if I have a loss? And the answer is no. So if you don't have a tax liability, you don't have to file a return. Okay? The other question that I'm getting in here is where do I file it? Well, there's an online website that you can go on. You first register yourself and then at that point then you select to file a capital gains report.
Another one just popped up saying that do non-residents of Washington state need to file a Washington excise tax return? And the answer is is that if they have gains, long-term capital gains allocable to Washington state, the answer is yes. The other question I have is also would a donation to a, let me pull this up, would a donation to a DAF at a Washington Community Foundation qualify? I would have to look into that. That's a great question. I will certainly get back to you.
So to answer if you only have a gain from the sale of an exempt asset, do you still have to file a Washington return? So if there's no liability, the answer is no, but you definitely want to check to see what makes that exempt. Oh, another good question just came up. Do I need to file if gains are less than 250,000? The answer is no because there would be no tax liability. So the effective date of this law is technically, it was January 1, 2022. So as of now, that's the date in which it's effective.
So are long-term capital gains from family partnership reported on a K-1 subject to the excise tax if they exceed $250,000? I don't believe there is an exemption for that. So allocable to Washington state, what does allocable to Washington state mean? It means that it's usually that you have a tangible property sitting in that state in which you sell. But one big exception is real estate. So just keep that in mind.
So another question came up. Could you say more about why Washington isn't allowing short-term capital gains to be netted against long-term capital gains? Because they're only targeting net long-term capital gains, which is defined in the code. Washington state is referencing federal law and federal defines net long-term capital gains as the difference between long-term capital gains and long-term capital losses.
Okay, I'm going through more questions here. So this is an individual tax. So there's a lot of questions about partnerships. This only pertains to individuals. It does not pertain to partnerships just to be clear. Oh, so artwork is a good example. One question was can you give an example of capital gains from tangible property that isn't real estate? So artwork is a great example of something that's tangible.
The question about is this excise tax deductible on the federal return? Great question. I would have to look into that to see. So does the filing of a federal extension extend the filing of the Washington return? Yes, it does. I don't know if there's any specific forms. I believe they do accept the federal extension. I will go into more detail and write back all of these answers to each person who's sending me just to clarify.
So there's another question about earnouts. So Washington state does conform to, they do conform to the installment sale method. But I'm really glad that you mentioned that because in general, Washington state does conform to federal law, however they do with the installment sale method, but they don't with qualified opportunity zone funds. So no different than any other state. You do need to look to see if Washington state does conform to that particular law. And guidance is coming out every day on this. So some of the questions might not be completely addressed just yet because this law is evolving.
And the other thing I wanted to point out is that long-term, that if you have capital losses, long-term capital losses, unfortunately they're not allowing carryforwards. That was actually a question that came up when I attended one of the hearings back in December, and they're not allowing you to carryforward losses, which is unfortunate. So the $250,000 comes in after the long-term capital gains is offset by capital losses.
So yes, estimate payments do need to be made, and I think the first legitimate payment is due April 18th. So I'm not sure that we have to worry about it this year because obviously the law, it's in legal status. But I think going forward, we are going to have to start paying estimates on this excise tax, assuming it stays intact.